Macroeconomics II

Macroeconomics II by Professor Dr. Paul Bernd Spahnand Dipl.-Volkswirt Jan Werner Faculty of Economics and Business Administration of the Johann Wolfgang Goethe University Frankfurt, 19. April 2004 Introduction and Overview

Structure • Introduction • Functions of money • Historical development of the forms of money • Measuring money • Function and Structure of Financial Markets • Conclusion

Introduction “In a world of certainty ... there is no need for money”. Charles Goodhart • The Walras model assumes full information. • All markets clear perfectly and instantaneously. • Such an economy does not require money, because every good can function as a monetary unit. Charles Goodhart born 1936

Introduction “Money is what money does. Money is defined by its functions.” John Hicks John Hicks 1904-89

Functions of money • Medium of exchange • Unit of account • Store of value • Payment function

Functions of money • Medium of exchange • Indeed, where people are bound together by family, tribal or social ties, there is typically no need for money (kibbutz, monastery). • In a barter economy, any good may take the role of a medium of exchange, but it is required that exchange intentions are mutually consistent = “double coincidence of wants”.

Functions of money • Medium of exchange • One good often serves as a “numéraire”, which reduces the possible exchange relationships. • Money decomposes one act of exchange into two such acts: Good x Money Good y • Money reduces the transaction costs.

Functions of money Moreover the money has to be „equipped“ with the following criteria: • A standardised and well-known value, • Widely accepted, • Easy to divided, • Easy to carry and • “Constant” value, does not erode over time.

Functions of money • Therefore precious metal play an important role as forms of money • Money in his function of Unit of Account also reduces the transaction costs, because the number of prices are dropped. • This function is especially for a complex economy important.

Functions of money • Store of value • Bridging the temporal gap between income flows and expenditures • Many other store of values exist besides money like: • Real estate and properties, • Gold and jewellery, • Antiques, arts and images, • Stocks and bonds

Functions of money • Store of value • Normally, money has the lowest valorisation of all stores of value • Why do individuals hold money without interest? • Money is extremely liquid • In a hyperinflation money loses its liquidity

Functions of money • Payment function • This function allows the granting of credit, the transfer of credits and liabilities, and the redemption of debentures. • The postulate is that credit money will be provided and is accepted in a society. • The payment function can be ditto summarised to the prior functions of money.

Historical development of the forms of money • Commodity money in a barter economy: • “Goods” with a use value like as salt, corn, spices, colours (e.g. indigo), cattle. • “Assets” that are rare and tradeable such as gold, pearls, gems, feathers of rare bird, cowrie shells. • In societies where people are considered “assets”, money could also be slaves, children, or women of marital age.

Historical development of the forms of money • Metal money is a result of the desire store the money and lower transaction costs: • Durable assets = sumptuous metals • Assets with an aesthetic or ideal value such as jewellery, ritual gear and relics • But the inhomogeneity of different forms of money requires a “standard”.

Historical development of the forms of money • In the middelage the nations developed their own currency to strengthen their political power: • Portuguese “escudo”, • French “écu” and • Austrian “Schilling” • „Bullionist Debate“ in 18th century

Historical development of the forms of money • The conception of Credit money / Fiat Money allows to introduce paper currency. • The introduction of checks improved the efficiencey of the payments systems. • Electronic Payment / Credit cards / EC-Card • E-Money

Measuring money • The Quantity theory of money is based on the following equation: P  y = P  T = M  V • The real income y, • The price level P, • The number of transactions T, • The velocity of circulation of money V and • The contraction of the money stock M

Measuring money • The contraction of the money stock M is divided by the central banks (EZB and Fed) in the following money aggregates: • M1 = “narrow money” • M2 = “intermediate” money • M3 = “broad money”

Measuring money

Measuring money Money demand in the Euro-area (end of September 2003)

Function and Structure of Financial Markets • See „The economics of money, banking and financial markets" by Frederic S. Mishkin (2004, 7.edition, Boston, ISBN 0-321-20463-8), page 24.

Function and Structure of Financial Markets Financial Markets can be classified as follow: • Debt Market • Equity Market • Primary Market • Secondary Market • Exchanges Market • Over-the-Counter Market • Money and Capital Market

Function and Structure of Financial Markets Why do Financial Intermediaries exists? • To lower transaction costs • developing expertise and taking advantage of economies of scale • To reduce risk sharing • portfolio diversification • To solve the problems of asymmetric information • adverse selection • moral hazard

Function and Structure of Financial Markets Adverse Selection (before) • Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected. Moral Hazard (after) • Hazard that borrower has incentives to engage in undesirable (immoral) activities making it more likely that won’t pay loan back.

Conclusion • Money is defined by three (alternatively four) functions. • A complex economic requires an efficient form of money. • Money supply can be measured by M1, M2 and M3. • Indirect finance with the conception of Financial Intermediaries can lower the cost and can be more capablethan direct finance.

Macroeconomics II