MONEY1

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Evolution of Domestic Monetary System "[t]he use of counting and numbers, of calculating and figuring, propelled a tendency toward rationalization in human thought that shows in no human culture without the use of money. Money did not make people smarter; it made them think in new ways, in numbers and their equivalencies. It made thinking far less personalized and much more abstract." Weatherford The 1970s will be remembered as a decade where the country and its policy makers experimented with monetary policy, and in this section we will examine the experiments in monetary policy of the 1970s in the context of developments in the domestic monetary systems. There will be three sections: Evolution of money Money demand, money supply, and interest rates Money and the economy Evolution of Money Money is one of the greatest discoveries/inventions of all times. Glyn Davies, in his History of Money suggests "[t]he use of counting and numbers, of calculating and figuring, propelled a tendency toward rationalization in human thought that shows in no human culture without the use of money. Money did not make people smarter; it made them think in new ways, in numbers and their equivalencies. It made thinking far less personalized and much more abstract." It is therefore not surprising that money altered the nature of relationships. "Money connected human in a more extensive and efficient way than any other known medium. It created more social ties, but in making them faster and more transitory, it weakened the traditional ties based on kinship and political power." For example, you and I may know very little about each other, but money provides a common denominator that could be the basis for establishing a relationship. Whereas in the past we may have been likely to do things for family and friends because we would have expected reciprocal treatment, money allowed us to expand the "group" of those who we might cooperate with. Money also allowed people to be more empirical. "The decimal system, and its twin, metric measurement, not only changed the way people handled money and numbers but also transformed the way people thought. A new empiricism in thought, coupled with money's strict discipline in the use of numbers and categories [emerged]. ... the new class of intellectuals no longer sought to discover knowledge only through studying the works of ancient scholars and religious writers. They themselves could create knowledge through observation and the recording of events around them." On a more practical level, in a very real sense we can think of money as the oil keeping the economic engine running smoothly to produce the goods and services we consume. Just think back over the past 24 hours and list the transactions you have been involved in, the transactions at the center of any advanced economic system. In a class of ECN 100 meeting early in the morning, you are likely to find someone who has already bought the newspaper, paid a tuition bill, paid the rent, made the monthly car payment, bought breakfast, purchased gasoline and bridge tokens. We could go on but you get the point - these transactions are so numerous and painless they slide by almost unnoticed - and on one side of each transaction was money, either cash, a check, plastic, or e-money. Without these monies the transactions would not have been possible, or at least a good deal more painful - and without these transactions we would not have our modern economy. For those of you who have not grasped the full significance of money, consider the problem of a carpenter who needed a plumber. The carpenter could have spent the day producing woodwork for sale and used the money to pay for a plumber's services. An alternative would have been to spend the day looking for a plumber who happened to need the services of a carpenter. Rather than spending time doing what they did best, carpentry and plumbing, the two would spend their time searching. What happens in the first system is the plumber and carpenter are able to specialize in what they do best and minimize the time and effort spent searching, so society has access to additional plumbing and carpentry services and people live in better homes with better water systems. If you are going to have specialization rather than self sufficiency, and you will want that because of variations in skills, preferences, and resource endowments, then you will need a system to facilitate the massive number of exchanges required to move goods and services around. The earliest system of exchange was barter - a system where the plumber and carpenter would need to find each other for a direct exchange of services - but this system was too cumbersome to allow much specialization that Adam Smith later identified as the secret to economic growth.1 Keynes, whose theories of fiscal policy we studied in detail in the last unit, also recognized the long history of man's experiments with money. Keynes writes: "Money is a far more ancient institution than we were taught to believe some few years ago. Its origins are lost in the mists when the ice was melting, and may well stretch back into the paradisaic intervals in human history of the inter-glacial periods, when the weather was delightful and the mind free to be fertile of new ideas in the Islands of the Hesperides or Atlantis or some Eden of Central Asia." (Keynes, J.M.Treatise on Money) We have come a long way since those early days, and in this section we will focus on the word evolution. Today's monetary system can be traced back to the early civilizations of China and the Mediterranean, and the history of money is intricately related to the rise and fall of nations and the emergence of the business class. If we are going to "efficiently" move through 4,500 years of evolution, we will need some organizing principles - a means of creating order out of the myriad of events filling thousands of pages of history. Our focus will be on productivity - how society reduces the full cost of "producing" money. The important "leaps forward" in the evolution have created significant reductions in the cost of supplying and using money. A money system will beat out a barter system since there are fewer resources devoted to transactions in the money economy and more energies devoted to producing things individuals desire - food, shelter, clothing.... Similarly, when two monetary systems exist, the monetary system requiring fewer resources to produce the money will come to dominate. We begin our analysis of money and its relationship to the economy by answering a few important definitional questions. What is money? Why are there so many monies? Why does the US have $s? How do we measure the money supply? What is money? Money is difficult to define even though we know it when we see it. The best way to define money is by the functions it performs, which is good since the functions have remained constant even though the actual "things" used as money have changed. Above all else, money is a medium of exchange. You have certainly used money to pay for your food at the supermarket, to pay for the movies, or to buy gas for your car. We use money when we buy and sell commodities or services. Money is also useful as a unit of account. All prices are denominated in terms of a monetary unit, dollars, yen, or marks for example, which allows one to minimize the information needed to make price comparisons. Rather than having to keep track of all pair-wise values, 20 packs of cigarettes for one sweater, which can be traded for 4 CDs, which means that 1 CD equals 5 packs of cigarettes, you need only know the prices of the products denominated in terms of a monetary unit. A pack of cigarettes equals $2.50 while the sweater and CD cost $50 and $12.50. Money also shares an important property with other financial assets, it is a store of value. If you sell something today, maybe your labor for wages, you receive money you can use to purchase something in the future. Money acts as a bridge between the present and the future - it stores value just as a refrigerator stores food to be used at a later date. To function as a store of value, people must have confidence in the money, which is why you will find the word "trust" on the bills that circulate as money in the US. Why are there so many monies? Anyone who has studied history or traveled abroad realizes that both money and language vary across time and space. The existence of separate languages and monies is the result of historical accident, the product of a distant time where societies developed in virtual isolation, and current developments in the monetary system are simply corrections to the "historical accidents." Both languages and money have evolved in all parts of the world as individual societies have developed systems to facilitate cooperation and the transactions accompanying specialization and division of labor. As the world becomes smaller, as a result of advances in transportation and communication technology, we can expect to see an erosion of the existing national differences in both monies and languages. This is clearly evident in the movement toward a common European currency and the establishment of a supranational monetary authority. In 1999 many people were shocked to hear Argentinean officials were considering replacing the peso with the dollar, but this is precisely what we see in Europe as independent European nations eliminate their currency in favor of the euro. As for languages, the explosive growth of the Internet is speeding the movement toward English as a common language.2 To begin our search for money, it is helpful if we accept the fact that what any society uses as money will posses certain properties. It must be durable, divisible, transportable, readily accepted, and not easily duplicated. Ice cream would be out as money because it fails the durabil