MONEY AND MONETARY POLICY

DISCOVERING CONNECTIONS

1. What do you know from the history of money?

2. Can you give any examples of things that were used as money in the previous societies?

3. Do you see any advantages of a barter system?

4. What functions does money serve in modern societies?

5. What body is responsible for monetary policy in the country?

READING

Text 1

As you read the text, focus on the types and functions of money.

Money and its Functions

Historically, many commodities, ranging from precious metals to cigarettes, have been used as money. In prisoner-of-war camps, cigarettes served as money. In the nineteenth century money was mainly gold and silver coins. These are examples of commodity money, ordinary goods with industrial uses (gold) and consumption uses (cigarettes) which also serve as a medium of exchange. In most modern societies, however, commodities are rarely used as money because they are expensive. Instead, they use fiat money, that is mainly paper currency issued by governments and deposits in checking accounts that are accepted as a means of payments for goods and services. Fiat money is sometimes called token money. By collectively agreeing to use fiat money, society economizes on the scarce resources required to produce money as a medium of exchange. The essential condition for the survival of fiat money is the restriction of the right to supply it. Private production is illegal.

Society enforces the use of fiat money by making it legal tender. The law says it must be accepted as a means of payment.

In modern economies, fiat money is supplemented by IOU (I owe you) money. IOU money is a medium of exchange based on the debt of a private firm or individual. A bank deposit is IOU money because it is a debt of the bank. When you have a bank deposit the bank owes you money. Bank deposits are a medium of exchange because they are generally accepted as payment.

Although the crucial feature of money is its acceptance as the means of paymentormedium of exchange, money has three other functions. It serves as a unit of account, as a store of value, and as a standard of deferred payment. We discuss each of the four functions of money in turn.

Money, the medium of exchange, is used in one-half of almost all exchanges. Workers exchange labour services for money. People buy or sell goods in exchange for money. Money is the medium through which people exchange goods and services.

To see that society benefits from a medium of exchange, imagine a barter economy. A barter economy has no medium of exchange. Goods are traded directly or swapped for other goods. In a barter economy, the seller and the buyer each must want something the other has to offer. Each person is simultaneously a seller and a buyer. There has to be a double coincidence of wants.

Trading is very expensive in a barter economy. People must spend a lot of time and effort finding others with whom they can make mutually satisfactory swaps. The use of money – any commodity generally accepted in payment for goods, services, and debts - makes the trading process simpler and more efficient.

The unit of account is the unit in which prices are quoted and accounts are kept. In Britain prices are quoted in pounds sterling; in America in dollars. It is usually convenient to use the units in which the medium of exchange is measured as the unit of account as well. However there are exceptions. During the rapid German inflation of 1922-23 when prices in marks were changing very quickly, German shopkeepers found it more convenient to use dollars as the unit of account. Prices were quoted in dollars even though payment was made in marks, the German medium of exchange.

Money is a store of value because it can be used to make purchases in the future. To be accepted in exchange, money has to be a store of value. Nobody would accept money as payment for goods supplied today if the money was going to be worthless when they tried to buy goods with it tomorrow. But money is neither the only nor necessarily the best store of value. Houses, stamp collections, and interest-bearing bank accounts all serve as stores of value. Since money pays no interest and its real purchasing power is eroded by inflation, there are almost certainly better ways to store value.

Finally, money serves as a standard of deferred payment or a unit of account over time.

Vocabulary Focus

Ex. 1.Match the words from A with their synonyms from B.

Ex. 2.The text contains a number of common verb-noun partnerships (e.g. to store money, to make purchases... ).Match up the verbs and nouns below to make common collocations.

Ex. 3. Match the Russian word-combinations with their English equivalents.

Comprehension

Ex. 1. Complete the sentences.

1. Commodity money is…

2. Fiat money is …

3. In modem economies, fiat money is supplemented by …

4. Money is the medium through which…

5. The unit of account is the unit in which…

6. Money is a store of value because…

7. A standard of deferred payment or a unit of account…

8. In a barter economy, the seller and the buyer each must want something…

Ex. 2.Choose the correct answer:

1. A direct exchange of fish for corn is an example of:

a. storing value.

b. a modern exchange method.

c. barter.

d. a non- coincidence of wants.

2. Which of the following is a store of value?

a. Money market mutual fund share.

b. Repurchase agreement.

c. All of the above are a store of value.

d. None of the above are a store of value.

3. Anything can be money if it acts as a:

a. unit of account.

b. store of value.

c. medium of exchange.

d. all of the above.

Ex. 3.Say whetherthe following is true or false.

1. Money eliminates the need for barter.

2. Any item can successfully serve as money.

3. Money is said to be liquid because it is immediately available to spend for goods.

Ex. 4. Answer the questions.

1. What example of commodity money is given in the text?

2. What is fiat money?

3. What is fiat money supplemented by in modern economies?

4. In what way does society enforce the use of fiat money?

5. Why can a bank deposit serve as an example of IOU money?

6. How are goods exchanged in a barter economy?

7. Why is trading expensive in a barter economy?

8. What else can be used instead of money as a store of value?

9. What are the four functions of money? What do they imply?

Text 2

Read the text and and think of a proper title for it.

Monetary policy is a central government policy with respect to the quantity of money in the economy, the rate of interest and the exchange rate.

Let us consider the demand and supply for money.

Why do people hold (demand) currency and checkable deposits (M1), rather than putting their money to work in stocks, bonds, real estate, or other nonmoney forms of wealth? John Maynard Keynes, in his 1936 work entitled The General Theory of Employment, Interest, and Money, gave three important motives for doing so: transactions demand, precautionary demand, and speculative demand.

The transactions demand for money is the stock of money people hold to pay everyday predictable expenses. The desire to have "walking around money" to make quick and easy purchases is the principal reason for holding money. Without enough cash, the public must suffer forgone interest.

People have a second motive to hold money, called the precautionary demand for money. The precautionary demand for money is the stock of money held to pay unpredictable expenses. This is the "mattress money" people hold to guard against those proverbial rainy days.

The third motive for holding money is the speculative demand.The speculative demand for money is the stock of money held to take advantage of expected future changes in the price of bonds, stocks, or other non-money financial assets. It is the so called “betting money.

As the interest rate falls, the opportunity cost of holding money falls, and people increase their speculative balances.

Money supplycomes in many forms, including currency, demand deposits, time deposits, and plastic money.

The narrowest commonly used measure of money M1 consists of currency (bills, coins, money orders and travelers checks) and current accounts (AmE -checking accounts).

A broader measure M2 includes M1 plus saving accounts.

When the money supply increases,people have more money to spend, and demand for goods and services increases. As demand increases, businesses hire additional workers to increase output. This is an economic growth scenario. But, if output does not keep pace with demand, prices increase. When prices rise continuously, inflation results. This tends to cause problems for people whose incomes do not increase at a rate consistent with inflation.

Ex. 1.Match the Russian word combinations in with their English equivalents.

Ex. 2.Match the kind of demand for money in A with the stock of money people hold B and the definitions that follow.

1. The stock of money people hold to pay unpredictable expenses.

2. The stock of money people hold to take advantage of expected future changes in the price of bonds, stocks, or other non-money financial assets.

3. The stock of money people hold to pay everyday predictable expenses.

Ex. 3.Choose the correct answer.

1. The stock of money people hold to pay everyday predictable expenses is the:

a. transactions demand for holding money.

b. precautionary demand for holding money.

c. speculative demand for holding money.

d. store of value demand for holding money.

2. The stock of money people hold to take advantage of expected future changes in the price of bonds, stocks, or other nonmoney financial assets is the:

a. unit-of-account motive for holding money.

b. precautionary motive for holding money.

c. speculative motive for holding money.

d. transactions motive for holding money.

3. Which of the following statements is true?

a. The speculative demand for money at possible interest rates gives the demand for money curve its upward slope.

b. There is an inverse relationship between the quantity of money demanded and the interest rate.

c. According to the quantity theory of money, any change in the money supply will have no effect on the price level.

d. All of the above.

Ex. 4.Discuss the following questions with your parner.

1. Why do people hold (demand) currency and checkable deposits (M1), rather than putting their money to work in stocks, bonds, real estate, or other nonmoney forms of wealth?

2. What’s the main reason for having ‘walking around money’?

3. What are the consequences of lacking cash?

4. What is the precautionary demand for money based on?

5. What do precautionary balances help to avoid?

6. What is the speculative demand for money held for?

7. Why do people prefer to invest in stocks and bonds when the interest rate is high?

8. What happens to the opportunity cost of holding money when the interest rate falls?

9. What does a demand for money curve represent?

10. What does the money supply of the U.S. consist of?

11. What measures can be taken to regulate the money supply?

12. What may happen if output does not keep pace with demand?

Text 3

Read the text and compare the macroeconomic theories of different schools of economic thought. Explain the difference between the Keynesian and the monetarist views on how an increase in the money supply causes inflation. Note the similarity between the classical and the monetarist schools.

Classical Economics

The dominant school of economic thought before the Great Depression was classical economics. The basic theory of the classical economists, introduced by Adam Smith in The Wealth of Nations, was that a market-directed economy will automatically correct itself to full employment. Consequently, there is no need for fiscal policy designed to restore full employment.

A key assumption of classical theory is that, given time to adjust, prices and wages will decrease to ensure the economy operates at full employment. A decrease in the aggregate demand curve causes a temporary surplus, which, in turn, causes businesses to cut prices and, in turn, causes more goods to be purchased because of the real balances effect. As a result, wages adjust downward, and employment rises. Classical economists therefore view the economy as operating in the long run along a vertical aggregate supply curve originating at the full-employment real GDP.

Keynesian Economics

The Great Depression challenged the classical prescription to wait until markets adjust and full employment is automatically restored. As the unemployment rate rose to 24.9 percent in 1933, people asked how long it takes for the market mechanism to adjust. John Maynard Keynes responded with this famous saying, "In the long run we are all dead." Keynes and his book, The General Theory, attacked classical theory and in the process revolutionized macroeconomic thought.

Using fiscal policy to affect aggregate demand is a cornerstone of Keynesian economics. While Keynesians believe monetary policy is often not very powerful, especially during a downturn, they perceive fiscal policy as their "top banana." However, Keynesians recognize that one of the potential problems of fiscal policy is the crowding-out effect. Financing a federal deficit by borrowing competes with private borrowers for funds. Given a fixed money supply, the extra demand from the federal government to finance its deficit causes the interest rate to rise. As a result, businesses cut back on investment spending and offset the expected increase in aggregate demand. The Keynesian view, however, is that the investment demand curve is not very sensitive to changes in the interest rate and therefore only a relatively small amount of investment spending will be crowded out. Thus, the decline in investment only slightly counteracts or offsets an increase in aggregate demand created by a deficit.

Conclusion: Keynesians view the shape of the investment demand curve as rather steep or vertical, so the crowding-out effect is insignificant.

Monetarism

Monetarists are iconoclasts because they attack the belief in the ability of either the Fed or the federal government to stabilize the economy. They argue that fiscal policy is an essentially useless tool, having little or no impact on output or employment because of a total crowding-out effect. Suppose the money supply remains fixed and the federal government borrows to finance its deficit. The intended goal is to increase aggregate demand and restore full employment. According to the monetarists, financing the deficit will drive up the interest rate and crowd out a substantial, not a small, amount of investment spending. The reason is that the monetarists view the investment demand curve as sensitive to changes in the interest rate, and therefore, greater amounts of investment spending will be crowded out. As a result, the net effect is no increase in aggregate demand and no reduction in unemployment.

Conclusion: Monetarists view the shape of the investment demand curve as less steep or more flat, so the crowding-out effect is significant.

Although the monetarists do not trust the Federal Reserve to use discretionary monetary policy, they are quick to point out that only money is important. Changes in the money supply, the basic lever of monetary policy, have a powerful impact. Instead of ineffectual government deficit spending to cure unemployment, an increase in the money supply would definitely stimulate the economy based on the quantity theory of money. In short, changes in the money supply directly result in changes in real GDP.

Notes:

1.top banana n slang – главный, наиболее важный фактор;

2.crowding-out effect – эффект вытеснения;

3. iconoclast n – борец с предрассудками.

Ex. 1.Choose the correct answer.

1. The quantity theory of money of the Classical economists says that a change in the money supply will produce a:

a) proportional change in the price level.

b) wide variation in the velocity of money.

c) less than proportional change in the price level.

d) greater than proportional change in the price level.

2. According to Keynesians, an increase in the money supply will:

a) decrease the interest rate, and increase investment, aggregate demand, prices, real GDP, and employment.

b) decrease the interest rate, and decrease investment, aggregate demand, prices, real GDP, and employment.

c) increase the interest rate, and decrease investment, aggregate demand, prices, real GDP, and employment.

d) only increases prices.

3. Which of the following is true?

a) Keynesians advocate increasing the money supply during economic recessions but decreaseing the money supply during economic expansions.

b) Monetarists advocate increasing the money supply by a constant rate year after year.

c) Keynesians argue that the crowding-out effect is rather insignificant.

d) Monetarists argue that the crowding-out effect is rather large.

e) All of the above.

4. How is modern monetarism different from Keynesianism?

a) Monetarists believe that inflation is caused by excessive growth in the money supply, based on the equation of exchange, while Keynesians believe that inflation is caused by excessive growth in aggregate demand.

b) Monetarists believe that the velocity of money is predictable, while Keynesians believe it is unstable.

c) Monetarists believe that wages and prices are flexible, while Keynesians do not.

d) Monetarists believe that crowding-out negates any positive impact of fiscal policy, while Keynesians see a clear impact of fiscal policy on aggregate demand.

e) All of the above.

WRITING

Ex. 1.While reading the text below define the key word-combinations for describing each instrument of monetary policy. Put them down on separate sheets of paper so that to exchange the notes with your partners in class. Ask your partners to define the kind of instrument the word-combinations refer to.

Ex. 2.Read the text again and write its summary using the following questions as a plan:

1. What are the main instruments of monetary policy?

2. In what way does the rise in interest rate influence the lending provided by commercial banks?

3. What happens in the situation when the level of reserves in commercial banks increases?

4. Comment on the situation when the central bank sells bills or government bonds.

5. Why does central bank require the commercial banks to hold a percentage of their deposits as reserves?

6. What happens if the central bank increases/decreases the required reserve ratio?

7. What is monetary base?

8. How has the amount of cash changed in last decades? Why do we still need cash?

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