11.1 The Nature of Money

Question 1

What is money?

Answer 1

Money is any generally accepted medium of exchange, which means anything widely accepted in a society in exchange for goods and services.

Question 2

What is a Medium of Exchange?

Answer 2

Anything that is generally accepted in return for goods and services sold.

Question 3

Other than a medium of echange, what other roles does money have?

Answer 3

Although its medium-of-exchange role is perhaps its most important one, money also acts as a store of value and as a unit of account.

Question 4

Defiition of Barter

Answer 4

A system in which goods and services are traded directly for other goods and services.

Question 5

What is the major difficulty with barter?

Answer 5

The major difficulty with barter is that each transaction requires a double coincidence of wants

Question 6

What is a double coincidence of wants?

Answer 6

A double coincidence of wants: Anyone who specialized in producing one commodity would have to spend a lot of time searching for satisfactory transactions.

The double coincidence of wants is unnecessary when a medium of exchange is used.

Question 7

What does money make possible?

Answer 7

By facilitating transactions, money makes possible the benefits of specialization and the division of labour,

Question 8

To serve as an efficient medium of exchange, money must have a number of characteristics…

Answer 8

It must be both easily recognizable and readily acceptable.

It must have a high value relative to its weight, because otherwise it would be a nuisance to carry around.

It must be divisible, because money that comes only in large denominations is useless for transactions having only a small value.

It must also be reasonably durable.

It must be difficult, if not impossible, to counterfeit.

Question 9

Why is money a store pf purchasing power?

Answer 9

Money is a convenient means of storing purchasing power; goods may be sold today for money and the money may then be set aside until it is needed for some future purchase.

Question 10

What condition must be fulfilled in order for something to be a satisfactory store of value?

Answer 10

To be a satisfactory store of value, however, money’s purchasing power should be relatively stable over time.

Question 11

Why is money used for accounting?

Answer 11

Money is also used for accounting, and its use for such purpose does not rely on its physical existence. Canadian businesses, governments, and households all record their financial accounts in terms of dollars. Expenditures and receipts and deficits and surpluses are computed in dollar terms even without the immediate presence of physical money.

Question 12

Does money need to have a physical presence?

Answer 12

Note that money need not have a physical presence to serve as a medium of exchange, a store of value, and a unit of account.

Question 13

What does your bank deposit serve as?

Answer 13

Your bank deposit serves as a medium of exchange.

Serves as a good store of value, as long as inflation is low.

Finally, your bank account is clearly useful as a unit of account.

Question 14

Why were precious metals the origional money?

Answer 14

They were precious because their supplies were relatively limited, and they were in constant demand by the wealthy for ornament and decoration. Further, they were easily recognized, they were divisible into extremely small units, and they did not easily wear out. For these reasons, precious metals came to circulate as money and to be used in many transactions.

Question 15

Before coins, how were purchaces made?

Answer 15

Before the invention of coins, it was necessary to carry the metals in bulk. When a purchase was made, the requisite quantity of the metal was carefully weighed on a scale.

Question 16

What did the invention of coinage eliminate?

Answer 16

The invention of coinage eliminated the need to weigh the metal at each transaction, but it created an important role for an authority, usually a king or queen, who made the coins and affixed their seal, guaranteeing the amount of precious metal that the coin contained.

Question 17

What was the practivce of clipping?

Answer 17

However, coins often could not be taken at their face value. The practice of clipping a thin slice off the edge of the coin and keeping the valuable metal became common. This, of course, served to undermine the acceptability of coins, even if they were stamped.

Question 18

What is milling and how did it get around the problem of clipping?

Answer 18

To get around this problem, the idea arose of minting the coins with a rough edge. The absence of the rough edge would immediately indicate that the coin had been clipped. This practice, called milling, survives on Canadian dimes, quarters, and two-dollar coins as an interesting anachronism to remind us that there were days when the market value of the metal in the coin was equal to the face value of the coin.

Question 19

What is debasing?

Answer 19

When old kings or rules would add additional metal to coins they were having newly minted

Through debasement, the amount of money in the economy (but not the amount of gold) had increased.

Question 20

What was the ventual result of debasement?

Answer 20

The eventual result of such debasement was inflation. The subjects had the same number of coins as before and hence could demand the same quantity of goods. When rulers paid their bills, however, the recipients of the extra coins could be expected to spend them. This caused a net increase in demand, which in turn bid up prices. Thus, increasing the money supply by debasing the coinage was a common cause of inflation.

Question 21

What is Gresham’s Law?

Answer 21

Gresham’s Law

The theory that “bad,” or debased, money drives “good,” or undebased, money out of circulation.

Question 22

What does Gresham’s Law predict?

Answer 22

Gresham’s Law predicts that when two types of money are used side by side, the one with the greater intrinsic value will be driven out of circulation.

Question 23

What was essentially the invention of paper money?

Answer 23

If people knew the goldsmith to be reliable, there was no need to go through the cumbersome and risky business of physically transferring the gold. The buyer needed only to transfer the goldsmith’s receipt to the seller, who would accept it as long as they were confident that the goldsmith would pay over the gold whenever it was needed. This transferring of paper receipts rather than gold was essentially the invention of paper money.

Question 24

When paper money first came into being, what did it represent?

Answer 24

When it first came into being, paper money represented a promise to pay so much gold on demand. In this case, the promise was made first by goldsmiths and later by banks. Such paper money was backed by precious metal and was convertible on demand into this metal.

Question 25

What are Bank Notes?

Answer 25

Bank notes

Paper money issued by commercial banks.

Question 26

Why do we say that currency is fractionally backed by reserves?

Answer 26

At any one time, some of the bank’s customers would be withdrawing gold, others would be depositing it, and most would be using the bank’s paper notes without any need or desire to convert those notes into gold.

As a result, the bank was able to issue more paper money redeemable in gold than the amount of gold that it held in its vaults. This was good business because the extra paper money could be invested profitably in interest-earning loans to households and firms.

To this day, banks have many more claims outstanding against them than they actually have in reserves available to pay those claims. We say that such a currency is fractionally backed by the reserves.

Question 27

What was the major problem with a fractionally backed currency?

Answer 27

The major problem with a fractionally backed currency was maintaining its convertibility into the precious metal behind it. The imprudent bank that issued too much paper money would find itself unable to redeem its currency in gold when the demand for gold was even slightly higher than usual. It would then have to suspend payments, and all holders of its notes would suddenly find that the notes were worthless.

Question 28

When did central banks take over issuing currency?

Answer 28

As time went on, currency (notes and coins) issued by private banks became less common, and central banks took control of issuing currency. By the early decades of the twentieth century in the United States and Canada, only central banks were permitted by law to issue currency.

Question 29

What is “Gold Standard”?

Answer 29

Gold standard

A currency standard whereby a country’s currency is convertible into gold at a fixed rate of exchange.

Question 30

When did almost all the countriesi n the world abandon the gold standard?

Answer 30

During the period between the First and Second World Wars (1919–1939), almost all the countries of the world abandoned the gold standard; their currencies were thus no longer convertible into gold. Money that is not convertible by law into anything tangible derives its value only from its general acceptability in exchange.

Question 31

What is Fiat money?

Answer 31

Fiat money

Paper money or coinage that is neither backed by nor convertible into anything else but is decreed by the government to be legal tender.

Question 32

What is legal tender?

Answer 32

Legal tender is anything that by law must be accepted when offered either for the purchase of goods or services or to repay a debt.

Question 33

When can fiat moeny serve as a medium of exchange, a store of value and a unit of account?

Answer 33

If fiat money is generally acceptable, it is a medium of exchange. If its purchasing power remains stable, it is a satisfactory store of value. If both of these things are true, it serves as a satisfactory unit of account. Today, almost all currency is fiat money.

Question 34

If you want to make a purchase from some retail outlet or repay a debt, you have three options for how to make that payment…

Answer 34

First, you can withdraw cash from your bank account and use it to make a transaction.

Second, you can write a cheque to the recipient, who then deposits the cheque in their own bank account. A cheque is simply an order for a transfer of funds from your account to the recipient’s account, possibly at a different bank. The development of automatic teller machines (ATMs) in the past 40 years has made the cash option much more convenient than it was before ATMs existed, and the cheque-writing option was common until quite recently, but is now much less so.

Your third option involves an electronic transfer of funds.

Question 35

What is deposit money?

Answer 35

Deposit money

Money held by the public in the form of deposits with commercial banks.

Question 36

How do banks create money?

Answer 36

Bank deposits are money. Today, just as in the past, banks create money by issuing more promises to pay (deposits) than they have cash reserves available to pay out.

Question 37

What is another modern form of money?

Answer 37

Another modern form of money is “cryptocurrencies” such as Bitcoin, Ethereum, and Ripple. These technically fascinating currencies are privately controlled, offer considerable privacy to users, and are seen by many as a great investment opportunity.