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Summary Chapter 4: The Monetary System - What is it and How does it work?
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CHAPTER 4: THE MONETARY SYSTEM: WHAT IS IT AND HOW DOES IT WORK?- The two arms of macroeconomics policy are monetary and fiscal policy
- Fiscal policy – governments decisions about spending and taxation; made of elected
representatives
- Monetary policy – decisions about the nation’s system of coin, currency and banking; made
by central banks
WHAT IS MONEY?
- Money does not refer to all wealth, but only one type of it
- Money – the stock of assets that can be readily used to make transactions
FUNCTIONS OF MONEY
- Money has three purposes
o A store of value
A way to transfer purchasing power from the present to the future
Money is not a perfect store value: if the prices are rising, the amount you
can buy with any given quantity of money is failing
o Unit of account
Provides the terms in which prices are quoted and debt are recorded
The price of goods relative to other goods
o A medium of exchange
Used to buy goods and services
The medium of exchange is used to buy other things – goods and services –
is sometimes called the asset’s liquidity
It is the economy’s most liquid asset
- To better understand the functions of money, try to imagine an economy without it -> a
barter economy
- This economy’s trade requires the double coincidence of wants -> the unlikely
happenstances of two people each having goods that the other want at the right time and
place to make an exchange
- A barter economy permits only simple transactions
TYPES OF MONEY
- Money that has no instructive value -> fiat money
- Established as money by government decree, or fiat
- Most societies in the past have used a commodity with some intrinsic value of money –
called commodity money
- An example is gold, if the economy used gold as a currency, the economy is said to be on a
gold standard
- Gold is a form of commodity money because it can be used for various purposes – jewellery,
dental fillings and so on – as well as for transactions
Development of flat money
- Any society, no matter how primitive, some form of commodity money arises to facilitate
exchange: people are willing to accept a commodity currency such as gold because it has
intrinsic value
, - To understand the development of commodity money to fiat money – imagine an economy
where people carried bags of gold
- To buy something, an agreement on the weight of the gold is agreed upon, and the sale is
made
- Government might get involved in the monetary system to help people reduce transaction
costs
- To reduce these costs, the government can mint gold coin of known purity and weight
- Next step – government accepts gold from the public in exchange for gold certificates ->
promise to be able to redeem quantity of gold
- Then, eventually, bills were created to represent the value of itself
- Finally, the gold backing becomes irrelevant – no one redeems gold because it’s irrelevant
- Thus, the system of commodity money evolves into a system of fiat money
HOW THE QUANTITY OF MONEY IS CONTROLLED
- Quantity of money available in an economy is called the money supply
- The government controls the supply of money: legal restrictions give the government a
monopoly on the printing of money
- Government’s control over the money supply is called monetary policy
- Monetary policy is delegated to a partially independent institution called central bank
- The central bank of SA is the south African reserve bank
- Decisions about the monetary policy are made by a committee
- This committee consist of two groups:
o Members are appointed by the president are confirmed by congress
o President of the regional banks are chosen by these banks’ board of directors
- Primary way in which the central bank controls the supply of money is through open-market
operations
- Conversely, when the central bank wants decrease the money supply, it sells some
government bonds from its own portfolio
HOW THE QUALITY OF MONEY IS MEASURED
- Goals are to determine the money supply affects the economy
- Because money is the stock of assets used for transactions, the quantity of money is the
quantity of those assets
- The most obvious assets to include in the quantity of money is currency
- Second type of assets used for transactions is demand deposits – funds people hold in their
checking accounts
- Demand deposits are therefore added currency when measuring the quantity of money
- Money market mutual funds allow investors to write cheques against their accounts,
although restrictions sometimes apply with regard to the size of the cheque or the number
of checks written
- Assets should be included in the money stock, more than one measure is available
M1, M2, M3
- M1, M2, M3 are all measures of money supply, the amount of money in circulation at a
given time
- M1, also called narrow money, normally include coins and notes in circulation and other
money equivalents that are easily convertible into cash
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