The Aim and Scope of Financial System: the Monetary function

Course Introduction to Finance (80753 INTRODUCTION TO FINANCE) (A.Y. 07/8) The Aim and Scope of Financial System: the Monetary function 08

Agenda ) The Monetary Function ) Money and the monetary function 3) The evolution of monetary systems

The Monetary Function The functions of the financial system 3 Monetary function Asset Allocation function Risk Management function The financial system has to provide financial products and services to facilitate payments. Banknotes Credit cards Debit cards Cheques Bank transfers 3

Money and the monetary function Definition Money is a medium that can be exchanged for goods and services and is used as a measure of their values on the market. 4

Money and the monetary function The functions of money Money is 3 a payment tool (Medium of exchange) a purchase power case (Store of value) a financial yardstick (Standard of value) 5

Money and the monetary function The functions of money Money is 3 a payment tool a purchase power case a financial yardstick Money can be used to buy goods and services. It represents the item accepted by the seller as counterpart of the trading agreement. 6

Money and the monetary function The functions of money Money is a payment tool a purchase power case Money allows to postpone (or anticipate) purchase power. 3 a financial yardstick Money can be hold for a period of time and be spent in the future. 7

Money and the monetary function The functions of money Money is 3 a payment tool a purchase power case a financial yardstick Money allows to compare different things by measuring their monetary values. Knowledge about prices (monetary values) is useful even for monitoring values and not just for trading. 8

Money and the monetary function What does it work well like "money"? The main features of an item that works well as money are Standardization The same unit of money must have the same value. 9

Money and the monetary function What does it work well like "money"? The main features of an item that works well as money are Acceptance A large number of users have to accept it as a payment facility. 0

Money and the monetary function What does it work well like "money"? The main features of an item that works well as money are 3 (Low) Holding cost To hold money does not have to be costly.

Money and the monetary function What does it work well like "money"? The main features of an item that works well as money are 4 Flexibilty Money has to work either for big and small payments.

The evolution of monetary systems 3

Barter based economy There is not a social agreement about what works like money. Any trade is an exchange of good Vs good. ( Nothing is money and everything is money at the same time )! A trade happens only when two counterparts are both interested in the goods offered by the counterpart.! Comparison between goods is complicated by a lack of a yardstick. 4

Barter Commodities as money A commodity is used as a standard good for payments. The commodity is accepted as payment because is widely used. 5

Barter Commodities as money A commodity is used as a standard good for payments. The commodity is accepted as payment because is widely used. Example #: Livestocks (sheeps, goats, camels, horses, etc) 6

Barter Commodities as money A commodity is used as a standard good for payments. The commodity is accepted as payment because is widely used. Example #: Livestocks (sheep, goats, camels, horses, etc) You can benefit from their ownership. (milk and meat for sheep and goats, transportation vehicle for camels and horses) 7

Barter Commodities as money A commodity is used as a standard good for payments. The commodity is accepted as payment because is widely used. Example #: Livestocks (sheep, goats, camels, horses, etc) Not all cattle units are equals. (differences in age, health status, etc.) 8

Barter Commodities as money A commodity is used as a standard good for payments. The commodity is accepted as payment because is widely used. Example #: Livestocks (sheep, goats, camels, horses, etc) Livestocks need to be managed. (Animals need to be fed, cleaned, etc to have milk you need to milk them ) 9

Barter Commodities as money A commodity is used as a standard good for payments. The commodity is accepted as payment because is widely used. Example #: Livestocks (sheep, goats, camels, horses, etc) Livestocks are not divisible goods. (You can not pay with half of a cattle ) 0

Barter Commodities as money A commodity is used as a standard good for payments. The commodity is accepted as payment because is widely used. Example #: Salt

Commodities as money Barter A commodity is used as a standard good for payments. The commodity is accepted as payment because is widely used. Example #: Salt You can benefit from their ownership. (Cooking, preserving foods, etc.)

Barter Commodities as money A commodity is used as a standard good for payments. The commodity is accepted as payment because is widely used. Example #: Salt It does not need maintenance costs. (No need to feed ) 3

Barter Commodities as money A commodity is used as a standard good for payments. The commodity is accepted as payment because is widely used. Example #: Salt It is divisible and easy to split. (You can use for large and small trades) 4

Barter Commodities as money A commodity is used as a standard good for payments. The commodity is accepted as payment because is widely used. Example #: Salt It has a low intrinsic value. (In case of large payment you need a lot of salt) 5

Barter Commodities as money A commodity is used as a standard good for payments. The commodity is accepted as payment because is widely used. Example #: Salt Risk of destruction or waste. (When mixed with water it is lost) 6

3 Barter Commodities Precious metals Precious metals are used as a standard tool for payments. Gold (or silver) is accepted as payment because people recognize this metal as valuable. 7

Barter 3 Precious metals Commodities Precious metals are used as a standard tool for payments. Gold (or silver) is accepted as payment because people recognize this metal as valuable. Example: Gold 8

Barter 3 Precious metals Commodities Precious metals are used as a standard tool for payments. Gold (or silver) is accepted as payment because people recognize this metal as valuable. Example: Gold It has a high intrinsic value. (Comparing he same amount of gold and other commodities, gold is more precious) 9

Barter 3 Precious metals Commodities Precious metals are used as a standard tool for payments. Gold (or silver) is accepted as payment because people recognize this metal as valuable. Example: Gold No risk of destruction or waste. 30

3 Precious metals Barter Commodities Precious metals are used as a standard tool for payments. Gold (or silver) is accepted as payment because people recognize this metal as valuable. Example: Gold Low value for use. (Gold is not useful itself: you can not eat, drink, or use as a transportation vehicle ) 3

Barter 3 Precious metals Commodities Precious metals are used as a standard tool for payments. Gold (or silver) is accepted as payment because people recognize this metal as valuable. Example: Gold Risk of fake. (Gold can me mixed with other metals or be completely faked) 3

Barter 3 Precious metals Commodities Precious metals are used as a standard tool for payments. Gold (or silver) is accepted as payment because people recognize this metal as valuable. Risk of fake Example: Gold Certification of gold quality and the standardization of coins size can be assured by a coinage service or authority. The seigniorage is the income received by the coinage authority for the coinage (or the chance to issue coins with a nominal value lower than the intrinsic value). 33

3 4 Barter Commodities Gold Banknotes Banknotes were introduced to solve the problems of a gold-based systems gold can be stolen (thefts, robberies, etc.) large amount of gold is not easy to be managed, transported, etc. 34

3 4 Barter Commodities Gold Banknotes Banknotes were introduced to solve the problems of a gold-based systems Gold coins are deposit in a storage facility ( bank ) that issues a certificate of deposit ( notes ) that can be used as a certificate of properties of gold and be freely traded and used for payments. 35

3 4 Barter Commodities Gold Banknotes Banknotes were introduced to solve the problems of a gold-based systems People accept banknotes just because they represent the right to withdraw gold from the banknotes issuer (the bank). 36

3 4 Barter Commodities Gold Banknotes Banknotes were introduced to solve the gold-based systems People accept the banknotes just because they represent the right to withdraw gold from the banknotes issuer (the bank). 37

3 4 Barter Commodities Gold Banknotes Banknotes were introduced to solve the problems of a gold-based systems The exchange rate between different currencies were related to the different amount of gold related to each unit of money. 38

Barter Commodities 3 Gold 4 Banknotes Banknotes were introduced to solve the The Role of Reputation in the Gold based gold-based monetary systems The issuer of banknotes is aware that until banknotes are accepted as a payment tool, just a small fraction of the gold stock will be claimed and there is the chance to issue new banknotes that are not collateralized by gold. The exchange rate between different currencies In were this scenario related the monetary to the system different is still on balance amount until the banknotes' of gold users have the perception that banknotes are collateralized by gold and related to each unit of money. until people will accept banknotes as a payment tool. The banknotes printed without a relative amount of gold allow to the issuer to benefit from "buying for free". 39

Barter Commodities 3 Gold 4 Banknotes 5 The Bretton Woods Agreement In July 944 the main developed countries signed an agreement where the US Federal Reserve system takes the obligation to pay a fixed amount of gold for any US dollar bill issued 40

Barter Commodities 3 Gold 4 Banknotes 5 The Bretton Woods Agreement while the other countries used US Dollars as collateral for issuing their own currencies. 4

Barter Commodities 3 Gold 4 Banknotes 5 The Bretton Woods Agreement In that manner all the currencies are accepted by the awareness that local banknotes users can claim to the national central banks (the issuers ) for US Dollar, that can be converted in gold by claiming to the Federal Reserve. 4

3 4 5 6 Barter Commodities Gold Banknotes Bretton Woods In 97 the US President Richard Nixon announced that from that point forward the Federal Reserve was no more obliged to pay gold for US Dollar bills. The post Bretton Woods era The Gold standard era was over. 43

3 4 5 6 Barter Commodities Gold Banknotes Bretton Woods After the end of the gold standard the use of banknotes as a money tool is (officially) based on national laws that force people to accept banknotes for payments (the so called fiat money ). The post Bretton Woods era 44

3 4 5 6 Barter Commodities Gold Banknotes Bretton Woods Economic agents will use banknotes as money tool until they think the central bank (the issuer) will preserve the quality of such tool. The post Bretton Woods era The central bank reputation is pivotal and represents the main collateral of a currency. 45

Course Introduction to Finance (80753 INTRODUCTION TO FINANCE) (A.Y. 07/8) The Aim and Scope of Financial System: the Monetary function 08 46