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Chapter 27

ECON 295 Chapter 27: Chapter 27 notes.docx

Course Code
ECON 295
Kenneth Ragan

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Chapter 27
Money and Banking
I) The Nature of Money
A) What is Money?
Medium of exchange: Anything that is generally acceptable in return for goods and services
a) Money as a Medium of Exchange
Barter: A system in which goods and services are traded directly for other goods and services.
The double coincidence of wants is unnecessary when a medium of exchange is used.
By facilitating transactions, money makes possible the benefits of specialization and the division
of labour.
To be efficient, money must have a number of characteristics:
Easily recognizable and readily acceptable
High value relative to its weight
It must be divisible
Reasonably durable
Difficult to counterfeit
b) Money as a Store of Value
To be a satisfactory store of value, money must have a relatively stable value.
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 undermined.
c) Money as a Unit of Account
Money may also be used purely for accounting purposes without having a physical existence of
its own.

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B) The Origins of Money
a) Metallic Money
There was a time when silver and gold were used as money.
The market value of the metal (weight) in the coin was equal to the face value of the coin.
People would clip a thin slice off the edge of the coin and keeping the valuable metal became
To prevent this, the idea arose of minting the coins with a rough edge.
This practice is called milling.
The rulers that had the power to mint coins, would sometimes debase the coins: they would ask
their subjects to bring in all their coins to be melted down and coined afresh with a new stamp.
However, some inexpensive metal would be thrown in.
Through debasement, the amount of money in the economy (but not the amount of gold) had
The eventual result was inflation.
Gresham’s law: The theory that “bad”, or debased, money drives “good”, or undebased, money
out of circulation.
Gresham’s law predicts that when two types of money are used side by side, the one
with the greater intrinsic value will be driven out of circulation.
b) Paper Money
People would deposit gold with goldsmiths for safekeeping.
The goldsmiths would issue a receipt that was physically convertible to gold.
The transferring of paper receipts rather than gold was essentially the invention of paper money.
Paper money represented a promise to pay so much gold on demand.
Bank notes: Paper money issued by commercial banks.
They were nominally convertible into gold. We say that paper money was backed by precious
At any one time, most of the bank’s customers would be trading in the bank’s paper notes
without any desire to convert them into gold.
As a result, the bank was able to issue more paper money redeemable in gold than the amount
of gold that it held in its vaults.
The money could be invested profitably in interest-earning loans to households and firms.
To this day, banks have many more claims outstanding against them than they actually have in
reserves available to pay those claims.
We say that the currency is fractionally backed by the reserves.

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However, banks could be prone to “bank runs” if they issued too many paper notes compared to
the metal they were holding.
c) Fiat Money
In time, only central banks were permitted by law to issue currency.
Originally, the central banks issued currency that was fully convertible into gold.
The practice of backing currency with gold is known as a gold standard.
Gold standard: A currency standard whereby a country’s currency is convertible into gold at a
fixed rate of exchange.
Central banks could issue more currency than they had in gold.
For example, if the central bank decided to hold gold reserves equal to at least 20% of its
outstanding currency, the total amount of currency would be limited to five times the gold
During the World Wars, almost all countries abandoned the gold standard.
Fiat money: Paper money or coinage that is neither backed by nor convertible into anything
else but is decreed by the government to be accepted as legal tender.
If fiat money is generally acceptable, it is a medium of exchange.
Is its purchasing power remains stable, it is a satisfactory store of value.
If both of these things are true, it serves as a satisfactory unit of account.
Today, almost all currency is fiat money.
C)Modern Money: Deposit Money
Deposit money: Money held by the public in the form of deposits with commercial banks.
Bank deposits are not money. Today, just as in the past, banks create money by issuing
more promises to pay (deposits) than they have cash reserves available to pay out.
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