Paper Money Prof. Dariusz Filar

Fiat money Fiat means „let there be” in Latin, and hence by „decree”. During the period of twenty years between the two world wars ( ), almost all the countries of the world abandoned the gold standard; their currencies were thus no longer convertible into gold. Paper money (fiat money) that is not convertible into anything valuable derives its value from its acceptability in exchange. Richard G.Lipsey K. Alec Chrystal

Fiat money, sometimes called token money Most people take the ability to use money for granted. People simply take it for granted that they can walk into practically any store or restaurant or boutique or gas station and buy whatever they want, as long as they have enough little pieces of paper. But stop and ask yourself: „How is it that a shop owner is willing to part with a loaf of bread that I can eat in exchange for some pieces of paper that are intrinsically worthless?” The actual value of a one-, a ten-, or a fifty-dollar bill itself is basically zero. Why would anyone agree to use worthless scraps of paper as money? Karl E. Case Ray C. Fair

Paper currency, fiat money The contemporary monetary systems are based entirely on inconvertible paper currency, or fiat money. Fiat money is a medium of exchange or store of value that cannot be redeemed for anything other than a replica of itself. A fiat dollar can be exchanged only for another dollar. The general acceptability of paper currency does not depend on either its intrinsic market value (as, for example, was the case with rock salt in parts of the ancient Roman Empire), or its redemption value (as was the case with gold certificates). It depends entirely on people’s confidence in its continued usefulness in trade. Dennis Placone

Money is a contract Money is a contract – the freest, most gorgeous of them all. Money is somebody else’s promise to pay, to give me what I want, when I want it. (…) Modern money is a contract with (1) parties unknown for the (2) future delivery of (3) pleasures undecided upon. David Bazelon

The Value of Money Why does money have value? Dollars in bank accounts cannot have intrinsic value – they are just figures on paper. Furthermore, the dollar’s value is not based on some kind of „gold backing” – there is no such thing. Contrary to popular belief, the government no longer holds gold in Fort Knox to back the dollar. Only until 1971, the government was required to hold $ 0.25 in gold for every dollar outstanding. Although it may seem a little like magic, confidence in its general acceptability is the stuff money is made of. Hence the value of money ultimately depends on an unwritten social agreement that it is valuable. Richard B. McKenzie

Functions of Money Money as a Medium of Exchange, or Means of Payment Money as a Unit of Account Money as a Store of Value

Money as a Medium of Exchange, or Means of Payment Under a monetary system, money is exchanged for goods and services when people want to buy things Goods and services are exchanged for money when people sell things No one ever has to trade goods for other goods directly (barter) Money is a lubricant in the functioning of a market economy – it facilitates trade and contributes to national production

Money as a Unit of Account All prices are quoted in monetary units; a standard unit of account is extremely useful when quoting and comparing prices Money is a kind of common denominator in which the relative values of other goods and services can be expressed No one has to posses money physically to compare prices of various goods and services

Money as a Store of Value Money could be used to „transport” purchasing power from one period of time to another One could keep some of his/her earnings in the form of money until such time as he/she wants to spend it Money is very easy to exchange for goods and services; economists call this the liquidity property of money. Other stores of value (diamonds or antique paintings for example) are characterised by „stickness” (it is not so easy to exchange them for something else)

The overall demand for money The overall demand for money in the economy is the sum of all individual demands for money by the people in the economy. People decide how much money to hold in currency and how much in bank deposits The overall demand for money (Md) is equal to the sum of currency plus deposits

The Demand for Money Transaction demand for money: the desire to hold money balances in order to carry out anticipated purchases of goods and services Precautionary demand for money: the desire to hold money balances in order to finance unexpected or emergency purchases of goods and services Speculative demand for money: the desire to hold money balances in anticipation of a decrease in the price of other assets and in anticipation of future profits

Determining the Supply of Money There are two types of money: CURRENCY – or cash in circulation - coins and bills that could be used for transactions DEPOSITS – funds hold at accounts in commercial banks Commercial banks keep as RESERVES some of the funds they receive in the form of deposits Money Supply is cash in circulation plus deposits

Central Bank – the high-powered money, or the monetary base The central bank money is sometimes called high-powered money (Hd) or the monetary base. The high-powered money consists of issued currency (total amount of bills and coins) and of deposits held by commercial banks with the Central Bank To the Central Bank the high-powered money is a liability

The Balance Sheet of Central Bank Assets Government Bonds (mainly FX bonds) Other securities Liabilities Currency (all bills and coins in circulation) Required reserves of commercial banks Own capital

High-powered money and the economic system The Central Bank gets high-powered money into the economic system simply by buying securities. It pays for these purchases of securities with newly issued currency. Hence, in creating additional high-powered money, the Central Bank is expanding both sides of its own balance sheet. At the same time as it increases its liabilities, it purchases assets of equal value.

Money multiplier The overall supply of money depends on the amount of central bank money (high-powered money; monetary base) Increases in Hd lead to more than one-for-one increases in the overall money supply The overall supply of money is, therefore, equal to central bank money times the money multiplier

Understanding the money multiplier (1) Suppose central bank buys 100 units worth bonds. To pay the seller (call him Seller 1), central bank creates 100 units in central bank money. Seller 1 (if he doesn’t want to hold any currency) deposits the 100 units in a deposit at his bank – call it Bank A. This leads to an increase in deposits of 100 units.

Understanding the money multiplier (2) Here is the beginning of the work of the Money Multiplier: Bank A keeps 100 units x 0,1 (reserves ratio) = 10 units in reserves and buys bonds with the rest (100 – 10 = 90) from the Seller 2 Seller 2 deposits 90 units in a deposit at her bank – call it Bank B. This leads to an increase in deposits of additional 90 units.

Understanding the money multiplier (3) Bank B keeps 90 units x 0,1 = 9 units in reserves and buys bonds with the rest (90 – 9 = 81). It pays 81 units to the seller of those bonds – call him Seller 3 Seller 3 deposits his 81 units at a account in his bank – call it Bank C. This leads to an increase in deposits of 81 units. And so on …