Introduction

• Monetary economics focuses on money and monetary relationships, particularly links between money, prices, output, and employment, making it a subset of macroeconomics.
• Monetary economists are often concerned with the relationship between money supply growth and inflation, but the field is broader than just this.
• The study of monetary relationships has a long history, with the aim of understanding monetary policy and how governments or central banks can influence economic performance or avoid harming the real economy.
• Monetary policy is now seen as crucial for household welfare and business profitability, with central bank decisions on interest rates and exchange rate changes regularly making news.
• The debate over whether the UK should join a monetary union is one of today’s key political decisions, highlighting the significance of monetary policy.
• Despite its importance, monetary economics is often considered esoteric and is studied by only a small number of undergraduate students, largely because the subject is controversial and complex.
• The nature of money itself leads to controversy in the field, as money has been explored by anthropologists, philosophers, and social historians, each often referring to different concepts.
• In everyday language, money is used in various ways, often confused with income or wealth, as Adam Smith noted in 1776, but in economics, these terms are distinct.
• In economics, wealth is created in the real economy through the production and exchange of goods and services, while money serves two roles: facilitating exchange and expressing value in a common unit.
• This leads to a distinction between real values and money/nominal values, where money is used to express wealth but is not synonymous with it.
• A major question in monetary economics is the neutrality of money, or whether changes in the money supply affect real variables like output and employment or only prices.
• Definitions of money are not neutral and can influence economic analysis, so understanding the meaning of money is critical to the study of monetary economics.

The various meanings of ‘money’

• Chambers 20th Century Dictionary (1983) defines money as coin, any currency used in commerce, or wealth, but monetary economics separates money from total wealth.
• In monetary economics, money refers to a medium of exchange or means of payment, representing the most liquid part of wealth—easily exchanged for goods and services.
• Historically, money was identified with coin, as illustrated in old texts like “Sing a Song of Sixpence.” The Oxford English Dictionary still defines money primarily as current coin or metal stamped for exchange and value measurement.
• The idea of commodity money—a commodity with intrinsic value used in exchange—was common in primitive societies, with precious metals like gold and silver frequently turned into coins of specific weight.
• Although commodity money is largely irrelevant today, its concept is useful in understanding how economists think about money, which can take various forms, reinforcing its abstract nature.
• Money’s abstract role is preserved as a unit of account, allowing the value of different goods and services to be expressed in a common unit, whether or not they are exchanged.
• The dictionary moves beyond coin to include currency, defined as anything circulating in the process of exchange, broadening the notion of money beyond cash to other forms of payment.
• For most people, currency implies notes and coins (or cash), but in monetary economics, money is any asset accepted in exchange for goods and services, even when no physical asset is transferred, like in cheque or debit card transactions.
• Neither the cheque nor the debit card is considered money, but the bank deposits they reference are, since payment is validated by the circulation of these deposits.
• Money, in monetary economics, is not income or wealth, but any asset acceptable for exchange. The demand for money is indirect—what people truly demand are goods and services, but they need money to facilitate the exchange.
• Money must be generally acceptable in exchange for goods and services, unlike assets like a stamp collection, which, although valuable, is not widely accepted in transactions.
• Money is a subset of assets acceptable in exchange, and defining general acceptability introduces uncertainty, as acceptable assets can vary between countries and time periods.
• Goodhart (1989) highlights that money is a social phenomenon, existing in all societies but manifesting differently across them.
• A second issue is defining exchange, as many exchanges are based on the promise to pay later, meaning a debt is incurred. Exchange can occur without an immediate transfer of money.
• One definition of money is anything acceptable in final settlement of debt, but this differs from the idea that money facilitates exchange.
• For instance, purchasing a car on credit: the exchange happens when you obtain and use the car, even if you settle the debt years later. The economic consequences—like production decisions at Ford—occur after the physical exchange, not after debt settlement.
• When goods are purchased with a credit card, the exchange occurs when the credit card is accepted, and the seller is paid by the bank. However, since the buyer enters debt, the credit limit on the card is not considered money.
• Money is a narrower concept than credit, as credit allows exchanges, but money is limited to assets that are not tied to debt
• The credit card case differs from buying a car, as the debt is no longer tied directly to any specific purchase.
• A bank can sell a purchaser’s debt to another firm, detaching it from the original act of exchange.
• The purchaser may repay the credit card debt by borrowing from another bank, finance company, or by re-mortgaging their house.
• Debt can be passed on to future generations or be eliminated by bankruptcy or death.
• The medium of exchange appears to be the credit allowed by the bank rather than the money the purchaser eventually uses for repayment.
• A distinction exists between money and credit, where an exchange is incomplete until the debt is settled, requiring money.
• Despite this distinction, from the perspective of the economy, the impact of money and credit is nearly identical.
• Money is sufficient for exchange but not always necessary, as many transactions now occur with credit.
• Though some transactions, like paying bus fares, still require banknotes, coins, or cheques, the number of such transactions is decreasing.
• Inconvenience from not having money is usually short-term if one has wealth or creditworthiness to borrow against.
• The ultimate constraint on exchange is the lack of wealth or the ability to borrow, not the lack of money specifically.
• This analysis understates the importance of money in exchange, ignoring its role as a unit of account.
• People are not restricted in the long-term by a lack of money but rather by a lack of wealth or credit.
• The idea of an excess demand for money (where demand exceeds supply) only makes sense at an aggregate level.
• Most individuals wish to acquire more goods and services, not due to a lack of money, but due to a lack of wealth.
• At the aggregate level, the supply of money may be higher or lower than the total demand, affecting the ability of firms and individuals to complete exchanges
• Discord between macroeconomic and microeconomic significance of money contributes to challenges in understanding the demand for money.
• Microeconomic theories often focus on individual-level demand for money, while empirical studies address the aggregate demand.
• At the microeconomic level, people need money only in the short term, contrasting with the idea of needing it for planned transactions.
• Individuals using credit cards may need money only at the end of the month to make repayments.
• It is more accurate to describe people’s demand as a need for spending resources, which include wealth and borrowing capacity, rather than just money.
• Wealth consists of a person’s real and financial assets, but it also includes human wealth (skills and abilities that allow borrowing against future income).
• Human wealth broadens Milton Friedman’s concept of wealth and helps explain why banks lend to individuals with low current wealth but high future income potential.
• Banks may also lend based on other factors like family wealth, a business plan, or partnerships with individuals who have a good track record.
• Liquidity refers to the ability to quickly convert assets into money with little risk, with money being the most liquid asset.
• Illiquid assets, like houses or equities, are not easily converted to money, but they can still be liquid if borrowed against.
• Lack of liquidity might affect individuals’ convenience, such as not having cash to buy a beer, but this can often be solved through borrowing or by accessing cash machines.
• Spending resources may be illiquid, but individual demand for goods and services is generally not constrained by a lack of money for long periods.
• Microeconomic demand for money has little economic significance in the long run, as money shortages are typically short-term inconveniences.

Money in the aggregate

• Borrowing money could be seen as part of the total money supply in the economy.
• If the money supply is fixed or growing at a predetermined rate, a demand surge for goods and services could lead to a shortage of money in the aggregate.
• Those holding cash or bank deposits would be unaffected, as there is no shortage of notes and coins from the central bank.
• The shortage manifests in bank deposits not growing fast enough, because banks may be unwilling or unable to lend more at current interest rates.
• Two outcomes may follow:
  • Interest rates might rise to curb borrowing, introducing a constraint on aggregate expenditure.
  • Authorities may seek to restrict borrowing in other ways, like setting minimum repayment amounts.
• Monetary control can be seen in two conflicting ways:
  • The authorities may have direct control of the money supply (exogenous view), keeping supply unchanged and letting market forces raise interest rates.
  • Alternatively, the authorities might control interest rates, responding to inflationary pressure by raising rates, indirectly impacting the money supply (endogenous view).
• The debate between exogenous and endogenous money supply models has been long-standing, though the practical difference seems small.
• Banks might respond to increased borrowing demand by tightening lending conditions, restricting credit without necessarily raising interest rates.
• Credit constraints could result from asymmetric information or pressure from the monetary authorities to control the quantity or type of loans banks make.
• Banks’ reluctance to meet increased loan demand can seem counterintuitive, given that lending is a primary source of their profits.
• The view that authorities have direct control over the money supply relies on a predictable relationship between the monetary base and bank deposits.
• If banks cannot meet increased loan demand, it may be due to a shortage of monetary base as they attempt to increase lending.
• However, if the authorities cannot control the monetary base, banks might continue to meet increased credit demand, leading to a rise in bank deposits and overall money supply.
• A crucial issue in monetary economics is understanding how money is created and the extent of monetary authority influence on this process.
• A decline in demand for goods and services could reduce credit demand, potentially lowering the money supply and interest rates.
• The monetary authorities may change their policy to influence the demand for goods and services without an actual change in that demand.
• For instance, authorities may aim to reduce inflation by decreasing the money supply, leading to higher interest rates that discourage borrowing.
• Effective monetary policy requires a belief in a stable relationship between money supply and overall spending in the economy.
• This stability implies a consistent relationship between the amount of money and total spending, meaning the velocity of money must be stable.
• The central policy question is whether authorities can effectively control spending by limiting bank lending or the willingness of individuals to borrow or convert wealth into liquid forms.
• Chapter 6 will delve into the links between monetary policy and aggregate demand, focusing on the transmission mechanism.
• An increase in goods and services demand may prompt monetary authorities to respond to prevent inflation if they can supply more money without raising interest rates.
• If borrowing is unrestricted and interest rates remain stable, increased demand for goods and services will materialize, possibly leading to price increases.
• The fear of inflation drives the authorities’ decisions, highlighting the importance of monetary policy effectiveness in managing inflation and its impact on the real economy.
• Distinction between short-run and long-run effects of monetary policy is commonly made in economic analysis.
• Students often find the terms ‘short run’ and ‘long run’ confusing due to their association with equilibrium frameworks.
• In equilibrium analysis, the system is initially in equilibrium, which is disturbed by a shock, while all other factors remain unchanged.
• Economic agents respond to the shock, aiming to return the system to equilibrium.
• In money markets, equilibrium occurs when demand for money equals supply of money (or their growth rates are equal).
• The ‘long run’ is defined as the time needed for the system to regain equilibrium; the ‘short run’ refers to the period the system is out of equilibrium.
• There is no direct calendar-time equivalent for short-run and long-run because real-world economies:
  • Experience frequent shocks and rarely achieve equilibrium.
  • Encounter changes in other elements that may interact with the initial shock.
  • Generate expectations about future changes based on shocks and subsequent adjustments.
• Consequently, monetary policy is always considered to operate within the short run.
• This view may conflict with alternative definitions, such as those used by the Bank of England Monetary Policy Committee.
• According to their model, changes in UK interest rates have maximum impact on inflation approximately two years later.
• Thus, short-run effects might be discussed as impacts within six months to a year, while long-run effects could span two years or longer.
• Such definitions can be useful but are somewhat arbitrary and disconnect from the traditional notion of long run as equilibrium.
• In an equilibrium framework, the long run represents an ideal state where all expectations are realized and agents are free from money illusion—they do not confuse real values with monetary values.

The development of money within economies

• Extensive discussion on the meaning of ‘money’ has been conducted, examining its links to prices and output, but the significant role of money in an economy remains unclear.
• A deeper analysis of money in exchange is necessary to understand its importance.
• Goodhart (1989a) views money as a social artefact that has evolved alongside distribution networks and organized markets to optimize the use of time, which is a fundamental scarce resource.
• The value of money arises from incomplete information in markets, where collecting information for efficient exchange is time-consuming.
• In the absence of money, market exchanges incur high transaction costs, particularly due to uncertainty from inadequate information.
• The use of money reduces uncertainty for market participants and facilitates a more efficient allocation of resources (Brunner and Meltzer, 1989).
• A common narrative in monetary economics describes an evolution from primitive economies to modern monetary systems through various stages:
  • Initial self-sufficiency of families with no trade.
  • Emergence of exchange solely through barter.
  • Development of commodity money.
  • Transition to coins, bank notes, bank deposits, and increasing reliance on electronic transfer of deposits.
• This narrative highlights the differences between monetary and non-monetary exchange (barter), focusing on the costs involved and how moving to money reduces these costs.
• However, this perspective presents an overly simplistic view of economic functioning.
• The barter/money distinction offers a static outlook, categorizing economies into two simplistic categories.
• Exchange is a social process, and money is a social invention, with its role differing across economies and evolving over time.
• In modern economies, both monetary exchange and barter coexist, with their relative prevalence changing constantly.
• Both methods can be utilized within a single transaction, such as part-payment for a car through trading in an old model.
• Relying on stereotypical economic models may lead to neglecting the dynamic interactions between economic change and the nature of exchange.
• Equilibrium models serve as useful analytical tools but should not be imposed on the more complex realities of the real world.
• A recent example is the recognition by monetary economists of ‘financial innovation’ to address discrepancies in their money demand models.
• Financial innovation has always been present, necessitating the analysis of interactions among real economies, market processes, and institutions in the study of monetary economics.
• The barter/monetary exchange distinction is ahistorical, suggesting that money emerged solely to facilitate exchange.
• This perspective leads to the idea that one can analyze a barter economy without money and later incorporate money, influencing modern economic views that see money as a mere veil over the real economy (Pigou, 1949).
• Such views also suggest that money is neutral, meaning it has no impact on the functioning of the real economy.
• However, there is no evidence that barter existed before money, apart from pre-economic societies where exchange was mainly ceremonial.
• Wray (1990) posits that money actually evolved before markets developed and that its use expanded much more rapidly than market growth.
• This distinction is significant, as differing views on the origin of money lead to different definitions and analyses of the monetary economy.
• The idea that money is a later addition to a barter economy is sometimes recognized as historically inaccurate but justified as a hypothetical reconstruction of history (Samuelson, 1973).
• This raises the question of why economists pursue such reconstructions, prompting an exploration of its appeal.
• The discussion begins with the concept of self-sufficiency, often illustrated by the figure of Robinson Crusoe—an isolated individual producing solely for himself.
• This portrayal is flawed as it neglects the social context of economic actions, including relationships of power and labor, such as Man Friday, the servant/slave in Defoe’s novel.
• The analysis establishes production as a central measure of progress, suggesting that advancement from self-sufficiency requires division of labor and specialization.
• In traditional societies, some specialization occurs within families, but broader specialization necessitates exchange and the establishment of markets.
• Markets are often treated as abstract constructs, divorced from institutional and social details, leading to the notion that all exchange occurs through markets.
• The welfare of an economy in this model is judged solely through consumption, with a focus on maximizing individual utility through efficient resource use.
• While people may judge performance in monetary terms, orthodox economists argue against this, labeling it as money illusion—the confusion between money and real values.
• The orthodox view assumes people return to real-value judgments once they recognize the source of confusion, which oversimplifies human behavior and society.
• This leads to the belief that economies can be analyzed entirely in real terms, based on several assumptions:
  • Economic behavior is separable from social relationships and institutional contexts.
  • Individuals aim for the maximization of their utility.
  • Utility stems solely from the consumption of goods and services.
• The notion that money is neutral and influences no real economic factors is thus not a conclusion of analysis but an initial assumption.
• This position suggests that economic exchange can be understood without money, which reinforces the assumption that market exchange preceded the advent of money.
• The incorrect belief in barter economies necessitates logical reasoning for the invention of money.
• Wray (1990) argues that money naturally develops in a capitalist economy where property is privately owned and production is enabled by property-less workers.
• Conversely, orthodox economics maintains that all economic activity, including exchange, could emerge without money, attributing the presence of money to its efficiency in facilitating exchange.
• An explanation of why barter is inefficient centers on the concept of the double coincidence of wants.
• For example, a person who catches fish must find a pot maker who wants fish at the same time for an exchange to happen, leading to significant search and information costs.
• This inefficiency results in people spending excessive time on exchanges that could be better utilized in producing more goods and services.
• The opportunity cost of barter exchange systems is notably high.
• Acknowledging these inefficiencies, it is recognized that more efficient barter systems can exist.
• Fairground barter occurs when a fair is held for selling a particular good at regular intervals, simplifying exchanges for sellers and buyers.
• A common example is the horse fair in Europe, where those with horses know they can find buyers easily.
• Trading post barter involves setting up a trading post where specific goods are bought and sold, providing advertised hours for potential customers.
• This allows people to find buyers or sellers conveniently, thereby significantly reducing search costs in the exchange process.
• Today, similar concepts are found in car boot sales and trade fairs, showing that these organizational methods apply to both barter and monetary exchange.
• The narrative of barter’s development illustrates its inherent inefficiencies effectively.
• Another argument against barter emphasizes the complexity of relative prices in exchange.
• In a barter system, exchanges involve price ratios, such as how many fish equal one pot or how much maize equals one cow.
• With two goods (fish and pots), there is one price ratio; with three goods (fish, pots, maize), there are three price ratios.
• As shown by Visser (1974), the number of price ratios increases dramatically with additional goods.
• The formula for calculating price ratios is 12n(n−1)\frac{1}{2}n(n-1)21​n(n−1), where $n$ is the number of goods and services.
• In an economy with four goods, there are six price ratios; with 100 goods, there are 4,950 price ratios; and with 1,000 goods, 499,500 price ratios.
• This clearly demonstrates that barter is a highly inefficient system for handling transactions.
• It is improbable that any society would remain in a barter system for long without attempting to reduce the number of price ratios.
• The adoption of one good as a unit of account allows prices of other goods to be expressed in a single metric, leading to the emergence of money.
• The significant reduction in information costs from using a unit of account (money) enables individuals to dedicate more time to producing goods and services, enhancing their standard of living.
• Information costs in barter can be categorized into two types, as explained by Clower (1971):
  • Transactions costs: The costs incurred during the process of exchange.
  • Waiting costs: These include storage costs, foregone interest on delayed purchases, and subjective costs associated with the absence of goods or services.
• While we have an understanding of money as a unit of account, it doesn’t explain why money needs to change hands as a means of payment.
• Goodhart (1989a) identifies an informational problem in market exchanges regarding the trustworthiness and creditworthiness of trading partners, highlighting the necessity of money.
• If all market participants were fully trustworthy, exchanges could be conducted on credit, eliminating the need for money.
• However, the reluctance of traders to extend credit or accept goods as payment necessitates the use of money, creating a liquidity or cash-in-advance constraint.
• Visser (1974) notes the etymology of terms like “pecuniary” (from Latin pecus, meaning cattle) and “rupee” (from Sanskrit roupya, also related to cattle), hinting at the commodity origins of early forms of money.
• Money historically took various forms, leading to the concept of commodity money.
• Certain characteristics make commodities suitable as money, including:
  • Durability: It should last over time.
  • Easily transportable: It should be convenient to carry.
  • Easily divisible: It should be simple to break into smaller units.
  • Standard value: It should represent a consistent value.
• Additionally, the supply conditions of the commodity should be stable; sudden increases in supply could devalue the money, making people hesitant to accept it.
• The costs of using the commodity as payment should be low.
• These characteristics explain why commodity money often took the form of coins made from precious metals.
• A challenge with coinage was the temptation to reduce the metal content by shaving coins, known as “sweating the coinage.”
• This practice allowed individuals to exchange coins for more goods than the intrinsic value of the metal would warrant, resulting in a discrepancy between the face value of coins and the metal’s worth.
• This discrepancy led to seigniorage, the profit from the difference between a currency’s face value and its production cost, benefiting currency issuers.
• For instance, the Bank of England produces notes with a face value of £20, which may cost only a few pence to produce, creating significant profit for the authorities.
• Sweating the coinage was facilitated by the existence of multiple competing mints before state control, leading to issues with coin quality and trust.
• Galbraith (1975) cites a 1606 manual listing numerous silver and gold coins in circulation in the Dutch Republic, illustrating the complexities merchants faced with coin quality and the practicality of weighing coins in trade.
• People hoarding coins tend to favor those with a higher metal content, using lower-weight coins for transactions, thus ensuring that these coins remain in circulation.
• The practice of “sweating” coins allowed a fixed amount of issued currency to buy more goods, increasing the velocity of money.
• This profit incentive led to the establishment of public banks in the 17th century, particularly in the Netherlands, to ensure coin value by weighing and evaluating their metal content.
• As nation-states rose in significance, governments assumed control over minting, reducing the diversity of coins in circulation.
• Financial intermediaries began issuing notes as receipts for gold and coin deposits, initially ensuring these notes were backed by a corresponding amount of gold.
• Over time, banks recognized that their notes were accepted in trade, allowing them to lend out deposited gold, leading to the development of the modern fractional reserve banking system.
• The issuance of notes became the responsibility of the central bank, which managed official gold reserves.
• The primary monetary policy debate in the 19th century revolved around how much the central bank’s note issue should be backed by gold:
  • The Currency School favored 100% gold backing to prevent inflation.
  • The Banking School argued for flexibility in note issuance to support economic activity, advocating the use of liquid assets as additional backing to gold.
• The monetary system has evolved, with paper money becoming irredeemable for gold and bank deposits now comprising the main element of money.
• Despite changes, the core of the debate remains:
  • Modern Currency School proponents are concerned with inflation and the money supply, often distrustful of government policies that may cause inflation.
  • Modern Banking School economists emphasize the importance of credit in the economy, focusing on the role of profit-seeking banks and the potential negative impacts of high interest rates on economic activity.
• This narrative transitions from commodity money to fiat money:
  • In a commodity money economy (gold coins and fully backed banknotes), the money supply might seem exogenous if commodity supply is stable.
  • However, since money is a social construct, it evolves to meet social needs.
  • If demand for goods and services is limited by the inability to obtain money for transactions, new money forms may arise, or transactions may increasingly occur on credit.
• Therefore, it’s challenging to argue that the money supply is ever truly exogenous in the long term, especially in a modern economy where the money supply is intricately linked to broader economic dynamics.

Summary

• Monetary economics is crucial in modern economies due to the significant impact of monetary policy decisions on individuals and businesses.
• There is considerable disagreement within the field, partly due to the lack of a universally accepted definition of “money.”
• The term “money” often refers to wealth in everyday language, but in monetary economics, it denotes only the portion of wealth that is generally accepted in exchange for goods and services.
• The definition of money is complicated by:
  • A wide range of assets that can function as money.
  • The social determination of what constitutes money, which varies by location and changes over time.
• The definition of “exchange” is also problematic:
  • At an individual level, exchange is limited by the lack of wealth or borrowing capacity rather than by the absence of money.
  • At the aggregate level, the quantity of money in an economy may be significant.
• However, it remains uncertain whether monetary authorities can or will effectively control the money supply.
• The amount of money may serve merely as an indicator of economic activity rather than a direct driver.
• The common narrative surrounding the development of money suggests it emerged to reduce information costs and time involved in exchanges.
• This narrative is historically inaccurate and biases the discussion towards the notion that money operates independently of real economic activity, reinforcing the idea that money is neutral.