Transcript Nature of Money

Prof. Dr. John JA Burke
 Recognise the Functions and
Properties of Money
 Distinguish between Monetary and
Non-Monetary Economic Systems
 List the benefits and drawbacks of
the Gold Standard
 Money is used to buy goods and
services
 Requires stability of value
 i.e., control over inflation
 Instability of currency leads to loss
of confidence
 Panic: consumers purchase what they do
not need
 Flight of capital by investors
 May take years to repair damage





PROPERTIES
Durability
Portability
Divisibility
Standardised measure of value
 FUNCTIONS
 Traditional Definition in Economic
Texts
 Form of Payment/Medium of
Exchange [Means of Payment]
 Standard of Value [Store of Value]
 Zero inflation is goal
 Standard of account
 Unit of account
 Quote prices and debts in
common unit
 Fiat Money
 Egypt as example
 Something [can be anything] becomes
money by command
 Pharaoh decrees that white stones are
money
 White stones lack intrinsic value; they
derive value by command [fiat]
 Benefits:
 Enjoy faith and credit system of Egypt
 Used to buy goods and services
 Problem:
 No standardisation
 Anyone who found “white rocks” could
claim to be wealthy
 Solution
 Back fiat money with something scarce
and desirable
 Gold, Silver
 Products exchanged for products or
services
 E.g., 4 chairs [Carpenter] for 4 pigs
[farmer]
 Problems
 Lack of portability
 Lack of divisibility
 Lack of standardized measure of
value
 Lack of durability
 Cost of care if Carpenter wants metal
 Waste of time to search for person
willing to exchange metal for farm
animals
 But note: barter is still used today
effectively in some situations
 Currency [Fiat money] of most
Nations convertible into Gold
 Rates of exchange between
Nations are fixed against a specific
price of gold
 John can turn $1 to the US
Treasury in exchange for 1/20th of
an ounce of Gold
 Ian can turn 1 pound Sterling Note
to the British Treasury for ¼ ounce
of Gold
 It follows that John can exchange
$20 for I ounce of Gold; Ian can
exchange 4 BPS notes for 1 ounce
of Gold
 Therefore exchange rate between
USD and BPS is $5 to 1£
 Proponents argue that economies
that adhere to the Gold standard
enjoy low inflation. However, the
fact remains that the gold standard
does not have the flexibility
governments and national
economies require
 Argument persists to this day:
Return to the Gold standard
 Gold standard kept exchange rates
fixed
 Countries unable to control their
money supplies
 Flow of gold determined the
amount of money in an economy
 Production and discovery of gold,
and international politics, affected
monetary policy
 1870
 Gold production was low
 Money supply grew slowly
 Failure to keep pace with economic
growth
 Result: deflation [Falling price levels]
 Devaluation occurs when a country
formally lowers the fixed ratio
between its money and gold
 US devalued the $ in 1934 to
1/35th of an ounce of Gold from
1/20th of an ounce of Gold
 Devaluation reflected depression
economics
 In 1999 and 2009, RoK devalued
the KZT against the $: Why?
 Gold was discovered in Alaska and
South Africa
 Money supply and price levels
grew quickly
 Result: Inflation until World War I
 Trade disruptions caused by World
War I led to collapse of the Gold
Standard
 Countries were unable to convert
their currencies into Gold
 Recall assumption of fixed
exchange rate between USD and £:
5-1
 Suppose value of £ rises above 5$,
and suppose American company
wants to import British tea
 100£ of tea costs $500
 But if £ rises against USD, then the
use of currency becomes costly
 Importer is better off trading in
dollars for Gold and shipping Gold
to London to pay for tea
 But this is impractical, risky, and
burdensome
Post-World War II Exchange Rate System
 Established a new economic order
(Keynes and White were
architects)
 Responsible for development of
contemporary international
banking models in US, Europe and
Japan
 Three major institutions emerging
were: IMF, WBG, and GATT; BIS
already existed
 System, but not principles, brought
to an end in 1971 when US went
off gold standard
 Fixed Exchange Rate System, the
value of which may occasionally be
changed
 Famous Example: Bretton Woods
1945-1973
 Countries agreed to use dollars and
gold as foreign reserve currencies
 Each country fixed its exchange
rate against the Dollar
 Every country had to hold dollar reserves
and stand ready to exchange its own
currency for dollars at the fixed exchange
rate
 The price of Gold was fixed in
Dollars
 Initial rate was 35$ per ounce
 Currencies were convertible
against dollars or gold that
together formed foreign exchange
reserves
 IMF managed the system
 At fixed exchange rate, Central
Banks were committed to buy or
sell domestic currency for foreign
exchange reserves
 Central banks intervened in the
Forex market to defend the
exchange against the Dollar
 Unlike gold standard, Dollar
standard did not require 100%
Forex reserve backing for domestic
currency
 Governments could print as much
money as they wished
 Discretion to print money created
two problems
 Architects of Bretton Woods felt
that Gold supply would not
increase to support post-war
prosperity and a rising demand for
money
 Giving governments discretion to
print money led to two problems
 1. Discretion to print money [problematic]
 2. World of sustained inflation
 Explanation of First Problem
 Undercut the concept of the gold standard
that required governments to adjust money
supply based on gold holdings
 E.g., countries with a Balance of Payments
deficit lost gold and domestic money supply
fell accordingly
 This had effect of lowering prices and
increasing competitiveness of country
 Under Dollar standard, countries with a
payments deficit could print more money
 This lowered unemployment but raised
prices defeating the objective of
competitiveness
 Devaluation
 If balance of payments deficit persisted,
countries would run out of foreign exchange
reserves
 Result: devaluation to raise
competitiveness and wipe out imbalance
in international payments
 Speculative pressure
 Speculators always bet on devaluation of
currency
 Countries lost reserves not only from
current account deficits but also from
capital account outflows
 Architects of Bretton Woods Made
Private Capital Flows Illegal
 Designed to fight against speculation
 Rules were relaxed in 1960s
 Second Problem
 Dollars were world’s medium of exchange
 US payments deficit financed by printing
more dollars
 Because of Vietnam War, deficit spending
increased producing more dollars
 Supply of dollars raised world’s money
supply and led to inflation throughout the
trading world
 Countries refused to adopt the same rate
of inflation as the US
 The enormous US deficit
 The gap between the price of gold
on the open market and the initial
peg of 35$ per ounce of gold
 Devaluations of the peg from 35 to 38 and
eventually to 44 failed to work
 Open market price of gold was $70 in
1972
 In 1973 ,Nixon declared that US would
abandon the Bretton Woods system and
would allow the dollar to float
 The Bretton Woods System
succeeded to a system of floating
currency exchange
 Q1. A US International Balance of
Payments deficit forces other
nations to accept:




A) More Gold
B) More dollars
C) Inflation
D) Rising interest rates
 Q2. Much like fiat currency, a fiat
economy:




A) Operates through centralized control
B) Operates as a free market
C) Operates as a free trade system
D) Operates as a limited-market system
 Q3. Countries A and B share a fixed
exchange rate. Country A’s
currency the Blot, is pegged at 4
Blots = 0,5 ounce of gold. Country
B’s currency the Zlot, can be
exchanged for Blots at a rate of 5
Zlots = 1 Blot. What is the
exchange rate for the Zlot with
gold?




A) 5 Zlots = 0,5 ounce gold
B) 20 Zlots = 0,5 ounce gold
C) 10 Zlots = 0,5 ounce of gold
D) 40 Zlots = 0,5 ounce of gold
 Q4. Globally, money is tight and
prices are rising. What happens to
the money supply and to prices if
South Africa releases a huge
amount of gold on the market?
 A) Money loosens up; prices continue to
rise
 B) Money remains tight; prices drop
 C) Money loosens up; prices stabilise,
then drop
 D) Money remains tight; prices continue
to rise
 Q5. National economic decisionmakers like the gold standard
because:
 A) It removes much of the uncertainty
from international trade
 B) It steadies national interest rates
 C) It stabilises prices
 D) It tends to push up the money supply