Chapter 12

Chapter 12 - Chapter 12 - Money and the Banking System We...

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Chapter 12 - Money and the Banking System We will now switch from fiscal policy to monetary policy in the next two chapters. We first look at Money and the Banking System and then focus on monetary policy in the next chapter. WHAT IS MONEY? Unlike gold or silver, modern money has no intrinsic value - green paper - but everyone wants more of it. Why? Because of what it will buy. Money is an asset that performs three functions: 1. Medium of exchange - used as a means of final payment. We use dollars to pay for goods and services. Increases efficiency of trade and exchange. Without money, we would have a barter economy, trade goods for goods, or services for goods, etc. Barter is inefficient because it relies on the "double coincidence of wants." For example, to get food, you would have to find a farmer who has what you want and you would have to have exactly what he/she wants. To get medical service, the farmer would have to find a doctor who wants a cow or milk, etc. Barter is extremely inefficient. Compared to barter, money is extremely efficient. The farmer can sell a cow for money, and then go out and buy whatever he/she wants with the cash - medical services, electricity, etc. Money eliminates the "double coincidence of wants." When is barter efficient? - baseball card convention, coin/stamp trading, etc. Market for dating/sex/marriage. Russia - Pepsi/Stolys. To avoid high taxes. Or during hyperinflation. 2 . Money is used as a unit of account. In the US, everything is priced in dollars, so we have a unit of measurement. Money is a measuring rod of value. By having a common unit of account, unit of measurement, we can compare prices/values easily. Everything is priced in a common unit of measurement, US dollars. A barter economy is inefficient because there is no standard unit of measurement. Makes comparison shopping very difficult. Thousands of terms of trade or trading ratios. 5 goods - A, B, C, D and E. In a barter economy, there are ten trading ratios.
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With a common unit of account, there are only 5. 3. Store of value/wealth - money is used as a financial asset to transfer purchasing power from one period to another period in the future. You can put $100 bills under your mattress. Advantages of money as an asset (vs. stocks, bonds, real estate): a. completely liquid - the degree to which an asset can be converted to cash quickly without loss of value. No transaction costs like with stocks and bonds. b. fixed nominal value - unlike stocks/bonds/real estate. c. anonymous Disadvantages of money as an asset: a. pays no interest b. loses value if inflation is positive c. anonymous In most cases, the same currency is used for the unit of account, the medium of exchange and a store of value. We price everything in dollars, we use dollars for final pmt. and we use dollars to store wealth. Not always the case: a. Israel - unit of account was dollar. Med of exchange was shekl. To avoid menu costs. b. Russia, S. America, etc - local currency is not used as a store of value, people hoard
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Chapter 12 - Chapter 12 - Money and the Banking System We...

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