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Sunday, July 24, 2011

Money, inflation and interest rates

What is money?
A standard way to begin a discussion about money is to try to define what it is. This is somewhat difficult to do because historically many things have been used as money - shells, beads, cigarettes, pieces of paper. What characteristics make any of these suitable as a form of money? 

One way to think about this is to define money in terms of the services it provides. Money is an asset. An asset is something that serves as a store of value, that is something that can transfer purchasing power from today to the future. Notice that money might not be the best way to store value (cash for example is money and does not pay interest and loses value because of inflation). But, lots of things, stocks, bonds, real estate, can and do fulfill that function. Money is really quite different from other assets because it provides
another important service - it serves as a medium of exchange. The medium of exchange role implies that it is freely exchanged for goods and services and it has wide acceptance and (generally) well understood value; in other words money can be used to make transactions. Another service that money provides is that it serves as
a unit of account. The role of unit of account means that when we talk about the value of other assets or consumption goods we use monetary units as a standard way of denominating them. The unit of account means also means that money is the good we use to measure prices, that is we define the concept of price of an object as the number of units of money that are required to purchase that object. This is important to recognize as when we think about inflation, that is how price level change, we have to think about how the stock of money changes. The fundamental prerequisite for functions 1,2 and 3 is that money has to have current and future value.
After outlining its functions we can then state that money is the stock of assets that can be used to make transactions (stock of liquid assets). How does money come into being and why are people willing to accept some forms of money? Or in other words where does the value we attach to money come from? We know that different forms of money have evolved naturally in many societies. One example that is often cited is that cigarettes became used as a form of money in POW camps during World War II. They are also often used as a form of money in U.S. prisons. What problems does the existence of an accepted form of money solve? The easiest way to understand this is to imagine a simple economy in which individuals all specialize in the production of a single good. Some grow wheat, some harvest wood, some raise chickens and some educate the young. Specialization, as we learned studying international trade, is efficient but how do educators and wood harvesters get to eat? how food producers get wood and educate their young?. People benefit from
transacting with one another. But if this were a pure barter world, then transactions could only take place when we found someone who offered in trade something we desire and who desired that which we produce. This is called the double coincidence of wants. The point is that transacting in such a world would be very inefficient.
Suppose, instead that there were some accepted medium of exchange. It need not be anything with intrinsic value. It could be stones of a certain size and shape, or pieces of paper embossed with a picture of long dead politicians. All that is required is that everyone agree that it is the medium of exchange and agree on its relative
value. In this world, educators could now exchange education services for money and use the money to purchase wheat and wood without worrying about whether the producers of wheat and woods that he encountered had any need for education services. The acceptance of a medium of exchange thus facilitates transactions in the society because it removes an important impediment to economic activity. As money
plays an important role in society it is important that its supply keeps up with the growth of the society. But who decides what is money?
There can be two main types of money: Commodity money and Fiat Money. Commodity money is a form of money that also has intrinsic value (for example gold coins or cigarettes): everything can be commodity money as long as it is accepted: for example candies sometimes are given as change: this is the case of commodity money. Fiat Money is a form of money that has no intrinsic value (for example dollar bills). Fiat money is declared money by some institution. Commodity money was the only form of money that was used on the world until fairly recent times. Now most countries use Fiat Money even though some countries are still -de facto- using commodity money systems. The main advantage of commodity money (for example gold) is that its value is guaranteed from the fact that people use gold for a variety of reasons (jewelry, industrial use etc.) and so it does not require a social convention.
The main disadvantage of commodity money is that its supply cannot be controlled easily. For example when gold was the only form of money, shortages of gold or big gold discoveries affected the quantity of money. Fiat money (Let it be money) on the other hand does not have intrinsic value (it is useless) and all its value comes from social acceptance, from the diffused belief that money will be used and accepted in
the future. The quantity of Fiat money can be controlled easily and cheaply, since mostly it consists of pieces of paper. The fact that Fiat money can be controlled by the issuer might be an advantage and a disadvantage. If the issuer is trustworthy (like for example the Federal Reserve Bank) having control over the money supply is a good thing because it can be used to achieve price stability. If on the other hand the issuer is not very trustworthy (like the Argentinian Central Bank in the '80s ) then control is a bad thing because it allows the government to use money creation to finance all sort of expenditures and this leads to price instability, to large unexpected wealth transfers and, in extreme cases, to the collapse of the exchange system (we
will discuss more about this later).

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