27.1 the nature of Money
What is money
Money is defined as any general accepted medium of exchange.
Medium of exchange: anything that generally accepted in return for goods and services sold.
Money also acts as store of value and as a unit of account.
Money as a medium of exchange:
Barter: a system in which goods a services are traded directly for other goods and services.
The major difficulty with barter is that each transaction requires a double coincidence of wants meaning anyone
who specialized in producing one commodity would have to spend a great deal of time searching for satisfactory
The use of money as a medium of exchange solves this problem, as people can sell their output for money and
then in separate transaction, use the money to buy what they want from others.
The double coincidence of wants is unnecessary when a medium of exchange is used.
Money greatly contributes to the efficiency of the economic system.
To serve as an efficient medium of exchange it must carry some characteristics:
1. Easily recognizable and readily acceptable
2. Must be divisible because money that comes only in large domination is useless for transaction having only a
3. Reasonably durable
4. It must be difficult but not impossible to counterfeit.
Money as a store of value:
Money is a convenient means of storing purchasing power; goods may be sold to date for money and the value
may then be stored until it is needed for some future purchase. To be a satisfactory store of value, however,
money must have a relatively stable value.
When the price level in stable the purchasing power of a given some money is also a stable, when the price level
is highly variable, so is the purchasing power of money, and the usefulness of money as a store of value is
Money as a unit of the account:
Money may also be used purely for accounting purposes without having to physical existence of its own
The origins of money
years ago, the market value of the metal was equal to the face value of the coin
Greshams law: the theory that bad or debased, derives good, or undebased, money out of the circulation
Debasing was that people would by coins and melt them and take little amount of real valuable metal and other
unvaluable metal and mix them together to make coins and use them in the circulation of money in the
economy as a result, the value of the real coin decreased and increased inflation and derived the real valuable
coins out of the circulation, which lead to only paper money to be valuable.
Greshams law predicts thats when two types of money are used side by side, the one with the greater
intrinsic value will be driven out of circulation
Since carrying gold was risky people would leave their gold with goldsmith for secure safe and gold smith would
give them a receipt so that they can claim their gold whenever they need to buy something. Later on buyer
began to transfer to receipt to the seller as a medium of exchange which was backed up by the gold in the vault
of the goldsmith.
This receipt became the paper money represented a promise to pay so much gold on demand. In this case the
promise was made first by goldsmith and later and by banks. Such paper money was backed by precious metal
and was convertible on demand into this model.
Bank notes: paper money ensured by commercial banks which was nominally convertible to gold.
Each bank issued its own notes, and these notes were convertible into cooled at the issuing bank, therefore man
to notes from many different bands circulated side by side, each of them being backed by gold at the bank that
Fractionally backed paper money: Many goldsmiths and banks discovered that it was not necessary to keep 1 ounce of gold in the vaults for every
claim to 1 ounce circulating as paper money. At that time some of the bands customer would be withdrawing
gold, others would be depositing it, and most would be trading in the bands paper notes without any need or
desire to convert that into gold.
As a result Banks was able to issue more paper money redeemable in gold than the amount of old that each held
in its vault, as a result the money could be invested profitably in interest earning loans to households and firms
which was a good business for the banks, where banks claims outstanding against those household and firms
than they actually have in reserve available to pay those claims, which is called the fractionally backed by the
The major problem with the fractionally backed convertible currency was maintaining its convertibility into the
precious metal behind it, becomes if the bank issued too much paper money and found itself unable to redeem
its currency in gold when the demand for gold to rise even slightly higher than the usual, it too would then have
to suspend payments and all holders of these notes would suddenly find that the notes to be worthless
As time went on, currency issued by private banks became less common and central banks took control of
issuing currency permitted by the law.
Originally, the central banks issued currency that was fully convertible into gold, so gold would be brought to the
central bank, which would issue currency in the form of gold certificate that, asserted that the gold was
available on demand. The reserved gold thus set an upper limit on the amount of currency that could circulate in
Gold standard: a currency standard where by a countrys currency is convertible into gold at a fixed rate of
However, central banks, like private banks before them, could issue more currency than they had in gold
because in normal times only a small fraction of the outstanding currency was presented for payment at any one
time. Thus, even though the need to maintain convertibility int