A Financial Analysis of

Monetary Systems
Eric Tymoigne
Lewis and Clark College
April 2015
Road Map
1. Finance: A World of Promises
2. Financial Approach: What is a Monetary System?
3. Fair Value of Monetary Instruments vs. Value of the
Unit of Account
4. Financial Approach: Implications for Analysis of
Monetary Systems
Finance: World of promises
Financial instruments are promises involving future
monetary payments, i.e. future delivery of specific
amounts of a specific unit of account.
Finance establishes a legal framework to record the
creation and fulfillment of promises, and it measures,
more or less accurately, the credibility of these
promises at any point in time.
Monetary instruments are specific sorts of promises
Characteristics of financial
instruments
Similar characteristics:
They are denominated in a unit of account
The issuer is known: name, illustration, electronic signature, etc.
They have a term to maturity: zero (instantaneous, at the discretion of the bearer) to infinite (at the
discretion of the issuer)
The issuer promises to take back its financial instrument at maturity
The fair value of many financial instruments is determined by the discounted value of future
payments (value at which a promise circulates among bearers)

P is the nominal fair value, Y is nominal income, FV is the nominal face value, d is the discount rate
applied by bearers of the financial instrument.

At one extreme are modern government monetary instruments Pt = FV0.

At the other extreme are consols Pt = Et(Y)/dt.
Characteristics of financial
instruments
Differences:
Term to maturity: time lapse until issuer promises to take back its financial
instrument (full repayment of principal)
Benefits for the bearer
Redemption clause: can be used to pay the issuer or not, convertible or not
Availability of guarantees in case of default: collateral, recourses
Negotiability: transfer of ownership between bearers
Credibility: creditworthiness of issuer
Liquidity: depends on previous characteristics and structure of financial market
Acceptability will vary: most acceptable are short-term, highly credible,
negotiable promises.
Monetary instruments are just specific sort of financial instruments.
Financial Approach: What is a
monetary system?
Monetary system = unit of account + monetary instruments
Monetary instruments
Contemporaneous government monetary instruments are just a specific sort
of promise: unconvertible, zero-coupon, zero-term-to-maturity, negotiable,
unsecured, non-recourse financial instruments denominated in a unit of
account => only promise made by government is to take them back in
payment at any time (directly or through banking sector): N = 0, Y = 0.
Bank monetary instruments are similar except that there is a recourse (they
are not legal tenders) and they are convertible.
Gold coins are similar to modern government instruments except that they
are secured; however, the gold content is not the monetary instrument, the
coin is.
Financial Approach: What is a
monetary system?
Unit of Account
Strictly use to measure
Must exist before any financial instrument exists: Early
Mesopotamia, no monetary instruments, just a unit of
account.
Is different from monetary instruments
One measures (UA) the other records the measurement (monetary
instrument)
Nominal value of monetary instrument changes in terms of UA (one
cowrie shell equals one cowrie at one time, and three cowries at
another time)
Fair value and Value of the Unit of
Account.
The purchasing power of monetary instruments can
change for two reasons:
Change in their fair value: microeconomic conditions related
to the issuer
Change in the value of the unit of account: value of all
financial instruments relative to goods and services (inflation,
deflation, devaluation, etc.)
While monetary instruments now circulate at par (fair
value equals face value) this was not always the case
for many difference reasons
Fair value of Monetary Instrument
throughout history
Massachusetts Bay colonies:
Unstable political situation: Government that issued the bills may no longer exist soon
Inadequate monetary mechanisms: Tax to redeem them is only levied at a later date
(no instantaneous effective maturity even though accepted at any time on paper)

Medieval precious metal coins:

Unstable political situation: King who issued the coins may be overthrown
Frequent changes in face value: crying up and crying down
Frequent changes in market value of precious metal content: may rise above the face
value
Interactions between two previous changes: debasement, export and melting down of
coins
Fraud due to poor technique of production
Value of the Unit of Account
Massachusetts Bay colonies: Deflationary tendencies and dilemma
The retirement of a large proportion of the circulating medium through annual
taxation, regularly produced a stringency from which the legislature sought relief
through postponement of the retirements. If the bills were not called in according
to the terms of the acts of issue, public faith in them would lessen, if called in
there would be a disturbance of the currency. On these points there was a
permanent disagreement between the governor and the representatives. (Davis
1900, 21)
One answer: postpone tax levy: this fact alone would have caused them to
depreciate, even if the amount then in circulation had been properly
proportioned to the needs of the community (Ibid., 20) => fair value declines
(N increases and d does too because default relative to terms of the promise)
Correct answer: Accept bills for all payments due to government and the net
injection of bills should be equal to the desired net saving of the domestic
private sector (assume no foreign sector): (G T)* = (S I) d
Implications: Questions to ask when
studying in monetary history
What is the unit of account?
Who is the issuer?
What is the nominal value of a financial instrument in terms of the
unit of account?
What is the fair value of a monetary instrument? How did it change
and why?
Why did the value of the unit of account change?

A mere recollection of objects and acknowledgement that they

passed hands is a very superficial analysis, and it may be erroneous.
Implications: Commodity and
Monetary Instrument
A commodity can be used as a monetary instrument but in the process of
monetization it becomes more than a commodity: its monetary value (fair
value) will differ from its commodity value.
For a commodity to be a monetary instruments:
The name of the issuer must be inscribed on the commodity
The issuer must be willing to take it in payment at anytime: instantaneous maturity
The monetary instrument must have a face value: the value at which the issuer
takes it back in payment.

Gold (nugget or bullion) was never a monetary instruments, gold coins

were.
Cowry shells were monetary instruments in some specific cases
Implications: Legal Tender, Medium
of Exchange and fixed price
To check if a monetary instrument is present the
following conditions are insufficient:
A commodity bought and sold at a fixed price (Grierson):
commodity has an administrated price
Existence of legal tender laws (Davidson, Mann): many
commodities have been used to final settlements =>
payment in kind, not monetary payment
Medium of exchange (Menger): if a commodity is used in all
transactions then it is a case of generalized barter instead of
monetary transactions