ECON 304 Lecture Notes - Barter, Market Economy, Commodity Money

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Published on 21 Apr 2013
School
University of Waterloo
Department
Economics
Course
ECON 304
Economics 304: Monetary Economics
Jean-Paul Lam
Lecture 2
Money
Contents
1 Introduction 2
2 What is money? 2
2.1 Functions of money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..... 3
3 Money as Medium of exchange 3
3.1 Searchcosts......................................... 4
3.2 Medium of exchange in an OLG model . . . . . . . . . . . . . . . . . . . . ...... 5
3.2.1 Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 6
3.2.2 Optimal consumption choice . . . . . . . . . . . . . . . . . . . . . . ..... 7
3.2.3 Equilibrium in a barter economy . . . . . . . . . . . . . . . . . . . ...... 8
3.2.4 Equilibrium with money . . . . . . . . . . . . . . . . . . . . . . . . . . .... 9
3.3 Monetary equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...... 10
3.3.1 Budget constraint . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... 10
3.4 Optimal allocation under a stationary equilibrium . . . . ............... 11
4 Money as a Medium of Account 15
4.1 Money as a Store of Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..... 16
5 Monetary standards 16
6 Empirical measures of money 18
7 Conclusions 19
8 References 19
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1Introduction
In this lecture, we explore the properties, functions and importance of money. Money as we will
see is a special commodity that plays a very important role in the economy. We begin by defining
what money is, then we explain in details (using models) the functions of money and we conclude
by providing an overview of how money is measured and the dierent monetary standards across
time. In subsequent lectures, we will look at the importance of money and its relationship with
output and inflation in the short and long-run.
2Whatismoney?
Money can mean dierent things to dierent people. Many people use the term money to describe
wealth, income or how much one earns per year. Economists have a very dierent view of what
money is. In fact, economists have a more precise definition ofmoney. Moneyisanassetlike
bonds and equities but it has many special characteristics that these other assets do not. Money is
defined as a worthless commodity (money does not pay any interest) that can be used to purchase
goods, services or other assets. Money for many economists represent a claim individuals (holders
of money) have on the assets of the government.1If money is a commodity that is worthless,
then why do individuals or societies value money? Is it because we, collectively believe that it has
value and it will always be accepted as a means of exchange? Is it because, it provides special
functions that none of none of the other assets can provide? Orisitbecausewebelievethatthe
government will guarantee that money has value as it represents on claim on some government real
assets? To obtain answers to the following (and other) questions, we need to study the functions
and characteristics of money.
Money is generally accepted as a means of payment. For example, coins, banknotes, cheques
written, e-money, plastic cards, traveller’s cheques and soonaregenerallyacceptedinexchange
for goods and services. The monetary base is money issued by the central bank and consists of
notes and coins that is currency in circulation. The rest is known as reserves which are accounts
that banks hold at central banks.
Typically a commodity should possess the following characteristics before being used as money:
1. Durable: money should retain its shape and form after even alongperiodoftime. For
example, coins and notes should last for a long period.
2. Easily transportable: Money should be light and convenient to transport.
3. Divisible in small parts: Money should be available in dierent denominations to facilitate
transactions.
4. Units of standard value: Money over time must look the same and should be easily recognized.
This allows for easy transactions.
5. Worthless as a commodity: Notes and coins should not have a value that is higher than their
actual denomination or face value.
1Money can be viewed as short-term government debt. This debt is valuable since it represents a claim on future
taxes that the government can raise to pay back holders of thatdebt.
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6. Cannot be copied or duplicated: Counterfeiting should notbepossible. Forthistohappen,
money has to contain a lot of security features (holograms, watermarks, microscopic features,
etc...) and should be issued by a single entity, currently thegovernment.
2.1 Functions of money
Money serves three main functions:
1. Medium of exchange
2. Medium of account
3. Store of value
We d es crib e the se functions in details.
3MoneyasMediumofexchange
The medium of exchange function of money is the most importantfunctionofmoney. Moneyis
acommoditythatisacceptedasameansofpaymentforothergoods and services. Money is a
special asset because of this function. Other assets, such asstocksandbonds,cannotbeusedto
buy goods and services.
To fully understand the medium of exchange function, consider two possible economies: a
barter economy where individuals exchange goods (or commodities) for goods(orcommodities)
and a monetary economy where there exists a certain durable and transportable commodity that
is generally acceptable in exchange for any other good or service, which we can call money. At this
stage, we do not care whether money takes the form of a commodity or simply is at money.
For bar te r to op e rate, do uble coinc id ence of want s mu st pr evail. That is for barter to operate I
must have something you want and you must have something I want. If I want a litre of milk and
Ihaveapoundofcheese,thenImustfindorsearchforsomeonewho has a litre of milk but who
also wants a pound of cheese in exchange.
For economies, that have a small amount of go ods and services,thistradearrangementdoes
not present many challenges and problems. However, for largeeconomies,tradearrangementsina
barter economy can be very inecient as individuals are forced to spend a large amount of their
time and resources in the activity of searching for suitable partners for trade. Put simply,
the search costs under barter are very high and the probability of success, that is solving the double
coincidence of wants is low.
On the other hand, in a monetary economy,moneyisusedtoconducttransactions.Money
facilitates transactions since individuals can use money toperformtransactionswithoutengaging
in a lengthy and costly search process. This is because in a monetary economy, the need for the
double coincidence of wants is eliminated.
In a monetary economy, an individual can simply search for thegoods/servicesshewantsto
purchase and then exchange the money for the goods she desires. In a monetary economy, trade
no longer requires the double coincidence of wants to prevail. Everything is paid with a medium
of exchange, that is money. The use of money as a medium of exchange implies lower search and
transactions costs.
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Document Summary

3. 2 medium of exchange in an olg model . 3. 4 optimal allocation under a stationary equilibrium . 4. 1 money as a store of value . In this lecture, we explore the properties, functions and importance of money. Money as we will see is a special commodity that plays a very important role in the economy. We begin by de ning what money is, then we explain in details (using models) the functions of money and we conclude by providing an overview of how money is measured and the di erent monetary standards across time. In subsequent lectures, we will look at the importance of money and its relationship with output and in ation in the short and long-run. Money can mean di erent things to di erent people. Many people use the term money to describe wealth, income or how much one earns per year. Economists have a very di erent view of what money is.

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