1.

3 THE FUNCTIONS AND FORMS OF MONEY

Money exists in all modern economies and it clearly plays a major role in the
exchange of goods and services. One way, then, to explain why it exists is to
analyses de process of exchange. The conventional approach to this is through
an explanation of individual behavior, asking why individual people (economic
agents) engage in exchange. The first problem we face is that we face a
complex world with a past which has determined endowments and institutions
and with interactions and reactions which are difficult to decipher and which
may occur with very long time lags. People have unclear and conflicting
motivations and many variables that influence decisions change at the same
time. The degree of complexity is such that analysis of economic behaviour
requires us to make many simplifying assumptions. Economists, typically, have
approached this by excluding from consideration history, taking exiting capital
and labour endowments and wealth as given, and assuming that the
distribution of these endowments does not change.

Since the utility-maximising individual is assumed to be central to economic

analysis, the simplest beginning of all is with a single person (Robinson Crusoe)
on a desert island. He is self-sufficient and no exchange is possible. There is
clearly no need for money. The Robinson Crusoe of economic models has no
history. When he has any human characteristics at all, these are allocated to
him on an ad hoc basis which suits the particular story being told. For example,
one story beings with two Robinson Crusoes on the same island. Both are old
and with poor memories. They meet occasionally but only to have dinner with
each other.

However, their memories are so bad that they both forget who provided the
most recent dinner. From here develops an account of money as a device for
keeping records.

If we extend the model to many individuals, each agent remains, in effect, a

Robinson Crusoe, acting as if no one else exited. Even in such a world,
however, agents soon realize that utility can be much increased through the
division of labour, specialization and participation in exchange. Within a family
in a traditional society, a certain degree of specialization is possible one
member of the family catches fish, a second tends the familys animals, a third
weaves cloth and so on but a more thorough exploitation of specialization
requires exchanges and this implies the establishment of markets.

All exchange proceeds through markets, which are treated as a logical

construct without institutional and social detail. The only available basis for
judging welfare in this abstract world is through the most efficient use of scarce
resources. The performance of the economic system is, then, judged in real
terms. This is still true in modern economic analysis. We know that in practice,
people often make judgments in money terms. For example, the rich
occasionally gain utility by engaging in extravagant consumption with the
purpose being to demonstrate to other how much they can afford to spend.
Such ideas form a part of specific areas of economic analysis but do not
influence the general presumption that the aim of all economic agents is to
maximize utility with utility being judged in terms of real consumption. Indeed,
in orthodox economics, any decision based on money rather than real values
must be an example of money illusion a confusion of money and real values
and can occur only in the short-run when the system is in disequilibrium. Thus,
it is inadvertent and temporary.

Salto de parrafos

Money, then, enters the story as a way of dramatically reducing the number of
price ratios with which people had to cope. This could be done by the adoption
of one of the goods as a unit of account in which the price of all other goods
could be expressed. The great reduction in information costs resulting from the
use of a unit of account (money) allows people to spend a greater proportion of
their time producing goods and services, thus improving their standard of
living. In analyzing this role, Goodhart describes money as a one of the social
artefacts (along with the distribution network and organized markets) that have
evolved to economise on the use of time, which is seen as the ultimate scarce
resource.

This idea can be extended in a number of ways. For instance, the high
information costs in a barter economy would mean that many decisions would
be made on the basis of incomplete information, creating uncertainty for
market participants and allows a more efficient use of resources.

We may have an explanation of money as a unit of account but this is not

sufficient to explain why money actually needs to change hands. That is, why
did money develop as a means of payment? Goodhart accounts for this by
stressing another informational problem associated with market exchange- the
lack of information about the trustworthiness and/or creditworthiness of the
counter-party to the exchange. This, he says truly makes money essential. If
everyone in a market could be fully trusted, all exchange could be based on
credit and with multilateral credit and a complete set of markets, money would
not be needed. An unwillingness of trades to extend credit or to accept other
goods as a means of payment means that money is required if some goods are
to be purchased. This has become known as a liquidity or cash in advance
constraint.

There are two major criticism of this examination of a movement from a barter
to a monetary economy. Firstly, the barter/money distinction proposes a static
view of economies all are classed as one of two simple possibilities even
though exchange is a social process and money a social invention. In any
modern economy, monetary exchange and barter both occur, sometimes in a
single transaction. The tendency to think in terms of simplified models can lead
to a failure to consider the way in which economic change and the nature of
exchange interact. We are more likely to interpret the complex real world in
shocks. For example. Problems with the testing of demand for money functions
in the 70s and 1980 led to the apparent discovery by monetary economists
of financial innovation as if this had not always been a part of the development
of the process of exchange.

Secondly the barter/monetary exchange distinction is ahistorical and implies

that money came into existences solely to facilitate exchange. However, there
is no evidence that barter preceded money anywhere other than in pre-
economic societies in which exchange was only ceremonial. Indeed, Wray
(1990) argues that money evolved before markets. Developed and that its use
grew more quickly than the growth of markets. This is not a matter of pedantry
since the ahistorical money does not exist and then simply add money. This
remains a powerful idea real economy and that money has no impact on the
functioning of the real economy.

We can summarise the argument to this point by saying that money exists in
modern economies because:

- Exchange encourages the division of labour and specialization and the

more efficient use of time
- Money reduces the cost of exchange by acting as a unit of account
- Money is needed as a means of payment because of the existence of
inadequate information and uncertainty in markets.

Indeed that definition takes us a little further than our explanation above by
introducing the notion of money as a store of value. This can also be accounted
for in terms of a lowering of transactions costs as well as helping us to
understand what types of asset might serve as money. As long as money is a
durable asset, its existence allows the separation of the decision to buy sell in
the market from the decision to buy. In other words, it greatly reduces the
problem associated with the double coincidence of wants and gives sellers of
products time to collect the information need to make wise purchases.

We can easily make other points about the nature of asset that might serve as
money. For it to be easily used in exchange it would need to be easily
transportable and easily divisible into small parts and be able to be used in
units of a standard value. Finally, for it to be generally acceptable it would need
to be an asset whose value was not subject to sharp changes. That implies that
the conditions of supply of the asset would need to be relatively stable.
Thus, coins whose metal content was lower than the stated weight were the
most likely to stay in circulation. The possibility of making a profit from
reducing the amount of metal in coins led to an important development in
banking. As Galbraith explains, public bank were set up in the seventeenth
century, initially in the Netherlands, to guarantee the value of coins by
weighing them and assessing the true value of metal in the coins. At the same
time, as nation states became more important, governments began to take
over the responsibility for the minting of coins, reducing considerably the
variety of coins in circulation.

However, we have seen that goods and services can be acquired through going
into debt or by liquidating other assets. Thus, at the level of the individual
economic agent, holding of narrow money do not act as a constraint on
expenditure. People who have assets and/or are able to borrow will almost
always be able to obtain funds in the form necessary to undertake expenditure.
From the point of view of exchange, it is difficult to see why they should be
particularly concerned with the proportion of their assets that they hold in the
form of narrow money. Yet, even of we exclude credit buy widen out definition
of money to include relatively liquid assets, we muddy the waters by including
assets that people might choose to hold for reasons that have nothing to do
with the desire to enter into exchange.

1.4 Formal definition of Money

Expressions along these lines commonly used in textbook include

- A temporary store of purchasing power

- An asset that gives immediate command over goods and services
- A property eight generally acceptable in exchange.

Before that though we might just pause to note that this is our first encounter
in this book with a fundamentally important principle for monetary policy (as
opposed to theory), namely that the creators of money are private sector
institutions whose responsibilities as agents of monetary policy.

1.6 Summary

Monetary economics is concerned with monetary relationships in the economy.

Monetary policy is central to government economic policy and the interest rate
decisions of central banks are everywhere seen to be very important. However,
monetary economics is still often seen as an esoteric subject and is less widely
studied than many other areas of economics. This is partly due to the
controversial nature of the subject. This, in turn, derives in part from debates
over the role of money in the economy and views of precisely what money is.

The existence of money may be explained by analyzing the process of

exchange through barter and then considering the gains in efficiency and the
reduction of transaction costs through the adoption of money. This can easily
explain moneys role as a unit of account. Lack of information about the
trustworthiness of the counter-party to an exchange can explain the role of
money as a means of payment. The use of money as a store of value also
reduces transaction costs in exchange. However, this leaves open the question
of precisely what money is. Clearly, it can take different forms in different
places and has taken a variety of forms at different times ranging from
commodity moneys to bank deposits that may be transferred electronically.

Much exchange in modern economies occurs through the use of credit rather
than definitions of money that concentrate on assets that act in final
settlement of debt. Credit is not classed as money because it creates debt
rather than finally settling it. However, from the point of view of the individual
economic agent, the lack of narrow money seldom acts as a constraint on
exchange since exchange can proceed through borrowing or through the
conversion of other assets into assets acceptable in settlement of debt. The
demand for narrow money has little significance at an individual level.

Even in the aggregate, the demand for money is only of real importance if we
assume the money supply to be exogenous and the demand for money to be a
stable function of a small number of variables.