Winter Term 2004/05
Institute for Law and Finance
Johann Wolfgang Goethe-Universität
Frankfurt am Main
Lecture 1
INTRODUCTION AND OVERVIEW
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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What is money ?
• Money is typically defined
by describing its functions.
• Important functions are:
– the easing of transactions of goods and services
(medium of exchange);
– unit of account
– the store and transfer of value (wealth).
• The functions of money are embedded
into a historical process.
• The definition of money is thus evolving.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Historical forms of money
• Commodity money in a barter economy:
– “Goods” with a use value such as salt, corn,
spices, colors (e.g. indigo), cattle;
– “Assets” that are rare and tradeable
such as gold, perls, 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.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Historical forms of money
• Store and transaction of value requires
– Durable assets (precious metals)
– Assets with an esthetic or ideal value
such as jewellery, ritual gear, relics, standards
• Problem: Inhomogeneity of different forms
of money requires a “standard”.
• From “standards” derives “standardized money”
(Portuguese “escudo”, French “écu”, Austrian “Schilling”)
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Why do we need money ?
• “In a world of certainty ... there is no need for
money” (Charles Goodhardt).
• Such an economy does not require money,
because every good can function as a monetary
unit (numéraire).
• If there is no time constraint, the same is true in
the case of uncertainty, because all uncertain
outcomes could be rendered negotiable as
„contingent claims“ (claim of good x for y, if
state of the world z occurs).
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Why do we need money ?
• As in the case of certainty, all decisions on
the allocation of resources over time could
still be collapsed into the original period -whatever path the economy takes
(certainty-equivalent economy).
• With markets for contingent claims,
no money is needed, because everyone
would know all relative prices in advance.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Do we really need money ?
• Indeed, where people are bound together
by family, tribal or social ties, there is
typically no need for money (khibbuzz,
monastery).
• More importantly, most economic activities
are performed without a conforming flow of
money (e.g. the work performed by an
employee, meal service in a restaurant).
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Where do we need money ?
Money is needed where there is
– uncertainty and/or a lack of trust;
– a time contraint to processing all information
required to establish a complete set of contingent
prices for all states of the world; and
– there is no other mechanism to overcome a lack of
trust (agreement, custom, threat).
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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What is money ?
“Money is what money does.
Money is defined by its functions”
(John Hicks).
Money is an information
processing technology that aims at
reducing
uncertainty and establishing trust.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
John Hicks
1904-89
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Functions of money
• Unit of account
• Medium of exchange
• Store of value
• Payment function
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Unit of account
• It requires a standardized form of money
• It is also necessary that money is divisible in
subunits of account
• Money must also be durable and should not
erode its value over time
For these reasons, precious metal play
an important role as forms of money
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Medium of exchange
• 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
• One good often serves as a “numéraire”
(which reduces n*(n-1) possible exchange
relationships to (n-1) )
• Money decomposes one act of exchange
into two such acts: Good x  Money 
Good y
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Medium of exchange
• The decomposition of exchange acts renders
a modern economy based on labor sharing
possible
• But this requires the existence of a social
consensus, according to which money is
accepted as a general medium of exchange
• A legal provision can facilitate such
acceptance, but it cannot necessarily be
enforced
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Medium of exchange: Lack of confidence
• Where there is lack of confidence in a legal
tender, there could be escape into “substitute
currencies”
(= “hard” currencies or commodity money
--> such as cigarettes, butter)
• Such “monies” circulate forcibly as media of
exchange, but they are unsuitable as a store of
value (Gresham’s “Law”):
Bad money replaces good money!
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Store of value
• The prerequisite for storing values
and the creation of net worth is the
existence of an order on property
rights
• Net worth possesses two kinds of
merits. It is useful:
– Directly: By providing consumption services
(real estate, jewellery, antiques, totems, relics)
– Indirectly: By bridging the temporal gap
between income flows and expenditures
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Store of value
• To the extent that assets may have
monetary characteristics, money can
produce returns (interest income)
• Normally, money is held interest-free
• The question is: Why do individuals hold
money without interest?
• This brings us to the notion of
Ability to pay or “liquidity”
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Payment function
• This function permits the granting of credit,
the transfer of credits and liabilities, and the
redemption of debentures
• The prerequisite is that credit money will be
provided and is universally accepted within
a society
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The features of money
• In order to comply with the four
prerequisites mentioned,
money has to be
–
–
–
–
homogenous
divisible
durable, and
“rare”.
• Forms of money are
– Commodity money, metal money,
and credit money
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Credit money: A historical review
1. Stage : Emergence of bank certificates
(covered trade bills)
2. Stage : Lending of deposits against debentures
3. Stage : Emergence of “book money” or “credit
money” (which is not necessarily covered at 100 %)
New appearance of money: Paper money
(to the extent that it is “securitized”)
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Credit money: Bullionist Debate
• In18th century‘s England, banknotes, which circulated
as money, were issued by private banks. These bearer
notes were claims on gold held by the bank.
• In Scotland, banknotes often had a clause that allowed
the bank to suspend convertibility. Although banks were
legally required to pay the bearer in gold bullion, they
could temporarily suspend that conversion.
• Suspension was to respond to the „bullying“ trick
whereby banks would hold back notes issued by one
bank, and then collectively unload the notes upon that
bank to ruin it.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Credit money: Bullionist Debate
• The Bullionist argument:
If banks are not required to
convert notes into gold, they
will be tempted to issue
notes in excess of the gold
in their vaults. This will lead
to an excess supply of
money and hence, a
cheapening of the price of
money, i.e. inflation.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
Henry Thornton
1760-1815
David Ricardo
1772-1823
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Credit money: Bullionist Debate
• The Anti-Bullionist argument:
It refers to the „Real Bills“ doctrine of
John Law and Adam Smith who argued
that banknotes are issued only in
exchange for merchants' bills of
exchange.
• As long as the repayment of these bills
is credible („real bills“), the demand for
banknotes by commerce is limited by
the „needs of trade“; hence even without
convertibility, there will never be excess
note issue.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
Robert Torrens
1780-1864
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Critique of the Real Bills doctrine
• Thornton (1802) provided the following critique of the Real Bills
Doctrine. He asked
– Who guarantees that the demands of commerce were limited?
– Suppose actual capital yields returns are higher than the rate of
interest (or discount) charged by the banks:
Would not merchants demand an interminable amount of notes
- however „real“?
• Bills offered for exchange into notes might not readily be „limited“ as
the Real Bills advocates argued. Inflation must thus ensue.
Thornton's analysis formed the germ for the later „cumulative
process“ of Knut Wicksell (1898).
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The Currency-Banking Controversy
The Bullionist debate re-emerged during 1840-50.
• England’s financial system was based on means
of payment in the form of gold coins and notes of
the Bank of England (founded 1694) and of
commercial banks outside London (after 1844
insignificant).
• There were no demand deposits or checks, but
there were trade bills and credit on the books of
account.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Currency School
(George W. Norman, Bank of England, J. Pennington und S. J. Lloyd)
Money = Coins + Notes
Sir Robert Peel (1844):
“If I use the word money, it only means the
coins of the Kingdom and promissory
notes which have to be redeemed, upon
request, in gold. With the word paper
money I mean exclusively such promissory
notes. It does not include commercial
papers or bills, nor bankers’ acceptances,
nor any other form of paper credits.”
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
Sir Robert Peel
(1788-1850)
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Currency School: Motives
• The representatives of this school chose a narrow
definition of money (bank notes of commercial banks can
only be created if covered by notes of the Bank of England
that are covered by gold).
• Although the amount of credit money was
= 4 x (notes + coins), its pace of development was seen as
being more or less proportional to the expansion or
contraction of central bank money.
• There was need for a maximum amount of note issue (as
under the gold standard) or else inflation would result.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Quantity theory of money
Py=MV
• With real income y fixed and the velocity of
circulation of money V being constant, the
expansion or contraction of the money stock M
will determine the price level P.
• Thus the Bank of England (and especially the
“country banks”) could be rendered responsible
for cylical variations of the price level.
• It also provided an argument in favor of a central
bank monopoly.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Banking School
(John Stuart Mill, John Fullarton und Thomas Tooke)
Why shouln’t
“first-class” commercial
bills be as good as
money or function at
least as money
substitutes?
John Stuart Mill
1806-73
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Banking School
Thomas Tooke:
“The greatest part of the country’s
wholesale transactions is effected
through credit, of which commercial bills
function as the visible proof ...”
Thomas Tooke
1774-1858
Consequence: The price level is
determined by expenditures (including
those effected via credit finance).
Monetary policy as interpreted by the
quantity theory of money is ineffective.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Ending the debate: Peel’s Act (1844)
• The Bank of England (Issue Department) obtains
the monopoly for emitting currency.
• Circulating money of about £14,000,000 has to be
“covered” by gold to one third of its value.
• New emissions of currency have to be covered by
gold at 100 %.
• The Currency School dominated monetary
constitutions all over the world until the beginning of
World War I.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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