{writeup/Video: http://bit.ly/azGian01A} There is an age-old controversy regarding money. Free market proponents believe that money emerges naturally to facilitate exchange among private parties. State Theorist hold that money is a creation of the state, which acquires value by force of law. Giannini resolves this controversy by showing that both state and market are necessary aspects of money.

1. Giannini: The Age
of Central Banks.
Chapter 1: Money between state and market:
the concept of payment technology

2. Section 1.1:
Introduction

3. What is Money?
A bundle of contradictions
Debates about money spanning centuries.
Unresolved controversies.
Many different theories and schools of thought about
role and function of money within an economy.
QTM: Money does not matter.

4. Does History of Money Matter?
If so, HOW?
Sir John Hicks: “Goal of Monetary Theory should be to
explain the pattern of evolution of money.”
BUT: Later reversed this stand.
One does not need the history of automobiles to
understand how the car engine works.

5. Neoclassical Assumptions Make Money
Irrelevant
If we assume that exchanges are settled and managed
centrally by an omniscient auctioneer and that there is
perfect trust among agents in the economy, the monetary
issue becomes meaningless because there is no need for
any medium of exchange, or quid pro quo, to conclude
transactions.
We can just write IOU notes to each other – everything is
guaranteed to balance in the end. Money plays no role.

6. Uncertainty is KEY to understanding money
• If I accept a payment in Money, what are the chances
of my being able to USE this money to buy things?
• Will those who have commodities I want ACCEPT this
money?
• What are my perceptions of the TRUST in the money,
and the UTILITY of this money, in general public.
EXPECTATIONS about public acceptability of money are
KEY to use of money.

7. What determines Social Expectations about
money?
• Here, HISTORY plays crucial role.
• Past experience with money is central to public trust.
• Money has evolved over time as mechanisms to
improve trust and utility have been devised (or have
collapsed).
• Understanding history is key to understanding money.
• Conversely, having a theory of money will illuminate
the history of evolution of money.

8. Two Functions of History
• Understanding Variations in Levels of Trust
• Understanding evolution of money as methods for
creating Trust.
Monetary Theory should provide us with a theory of
history –
That, it should explain how the role and function of
money has evolved

9. Origins of Money: Two Conflicting Stories
Both go back to Aristotle!
1. Cattalactic (Exchange-Theory): Money facilitates
barter of goods. Double coincidence of wants is not
required.
2. State Theory of Money: Money is created by State
authority, which provides legal framework and
enforcement for use of money.
Sterile Debate carried out over centuries.
Both aspects of money are essential to its operation, as
an institutional analysis shows.

10. Institutional Analysis
Neoclassical narrow focus on prices and exchange throws
out essential elements of economic activity.
Institutions which permit exchange are crucial to the
story.
When people give money, or take money, in exchange for
goods, what they will be able to do with this money is
subject to large amounts of uncertainty.
Institutions are used to manage and reduce this
uncertainty.
These EVOLVE over time, in light of experience.

11. Resolving the State/Exchange Conflict
• The State (or Other Institutional Frameworks) provide
guarantees about usage of money. This creates trust.
• Exchange theory justifies the use of money for many
kind of transactions, provided that trust-creating
mechanisms are available, and historically reliable for
the public.
Both aspects are necessary to understand money.

12. Institutions
• Craft Order
• Mitigate Conflict
• Realize Mutual Gains
Oliver Williamson: Micro Aspects of Institutional Analysis.
1. Look at transactions, not at individuals.
2. Investments needed to finalize transactions
3. Essential incompleteness of contracts, and
mechanisms to cope with this.

13. Methodology of Institutional Approach
1. Market exchange is governed, not just by producers
and consumers, but a host of institutions which
enable and facilitate the market.
2. Economists view of “rationality” is too strong. There
are limits on knowledge, memory, and
computational capabilities.
3. Economies evolve through time, subject to different
kinds of pressures to change. Studying static
equilibria under optimal behavior by all agents does
not provide necessary insights.

14. 1.2 MONEY AS AN
INSTITUTION: THE
CONCEPT
OF PAYMENT
TECHNOLOGY

15. Three Conditions for A Monetary Economy
1. Common measure of value of goods.
2. Procedures for carrying out transactions to completion.
Checks are first step of payment procedure (for example)
3. Means for converting means-of-payment into unit of
account.
These three elements – priced goods, payment procedures,
conversion conventions – are called a Payment Technology.
3: is confusing because prices and means of payment are same
today. But this has not been the case in most of history.
Consider for example goods priced in USD, while means of
payment is in PKR.

16. The key element of a payment technology
is without doubt the possibility to complete an exchange
when there is no ‘double coincidence of wants’ in such a
way that no further legally binding obligations exist after
the exchange is completed.
In other words, the key element is the existence of a
means of payment or, in a word, of money.

17. The 3 x 3 Theorem
Money is not useful if there are only TWO goods – they
can be traded for each other at some suitable exchange
rate.
Money is not useful if there are only TWO people – they
can carry out barter with each other at mutually agreed
terms.
We need THREE goods and THREE people for a monetary
economy.

18. Money is a social convention!
IMPLICATION: Money exchange between A and B is
implicitly built on the assumption that C will be willing to
accept money!
Social Agreement that exchange of Money for Good
extinguishes all social obligations –

19. Money is like a Durable Good, which provides
a flow of services
• Increases in supply of money raise general price level,
and reduce the value of service being provided
• Loss of public confidence in value of money also
reduces the value of service being provided by money.

20. Value of Money: Two Factors
• Rate of Interest on Deposit Accounts Minus Rate of
Inflation.
•  - The Confidence in Stability of Value of Money
across time.
What are the factors the affect ?

21. Guarantees by Producers of Money
Producers of money can destroy value of money by
reckless money creation.
To hold money, public need some assurance that money
creation will be done with responsibility.
For every payment technology there must therefore be a
body of rules, conventions and institutional mechanisms
designed to sustain the confidence of the people using it.

22. Theory of Money
The purpose of a theory of money as an institution is
precisely to study the confidence- creating mechanisms
that evolved in order to support the acceptability of
money as quid pro quo in a world of imperfect
information or, put another way, of potentially fraudulent
agents.
Law – legal enforcements of violations of social
conventions – MUST always be part of the confidence
creating mechanisms. (Except for commodity money).

23. Three Types of Confidence Creating
Mechanisms
1. Commodity Money – something of general value to
public (or socially recognized as such)
2. Producers of Money provide some guarantee,
pledge, legal constraint, binding them to
responsibility in money creation
3. Vertical Integration: Producers and Consumers are
bound together within a single governance structure
assigning rights and responsibilities to all parties.

24. Examples
Type 1: Gold and Silver, but also other commodities
generally recognized by public as being of value.
Type 2: Guarantee of Value (Responsible Behavior)
Guaranteed conversion to gold at fixed rate ensures that
too much money cannot be printed.
Type 3: Vertical Integration. Producers of Money are
Banks. But they are put under control of Central Banks,
answerable to Public.

25. 1.3 PAYMENT TECHNOLOGY COSTS

26. Commodity Money Paradox
(and its resolution)
The paradox is this:
1. Commodity money is highly inefficient (to be demonstrated)
2. Yet, it has persisted for a long time, and across diverse
cultures.
WHY?
Why does an inefficient payment technology show such strength?
Textbooks discuss characteristics of commodity money: portability,
indestructibility, homogeneity, divisibility and recognizability.
But these are of secondary importance, and miss the main point.

27. Disadvantages of Commodity Money
• Costs of Production
• Unavailability of Commodity for other uses.
Giannini estimates above two items, and shows costs are
quite large. We will focus on the following:
• Inflexibility: inability to adapt the quantity of money
according to the requirements of the economy.

28. Deflationary Bias
If amount of money – like gold stock – is fixed, and
economy is expanding, then prices must fall to
accommodate all transactions.
Generally speaking, prices are sticky downwards. This is
because one needs to make economy wide coordinated
reductions in prices. This involves huge transaction and
information costs (ignored by neoclassicals)
With sticky prices, the economy will fall into recession or
depression – Volume of transactions will be reduced
below what is possible, because of insufficient money.

29. Vulnerability to Exogenous Money Shocks
History of Middle Ages provides MANY examples of gold-
induced recessions.
Standard method of handling was to use “coinage” where
the actual gold content would be less than the official
value. But such subterfuge would result in crises, with
regularity. The economy required price adjustments
which were hard.
On the other side, influx of gold could lead to inflations,
causing other kinds of damage to the economy.
Maladaptation costs.

30. Paradox Resolved
Fiat Money has been known since antiquity. However, the
relatively inefficient commodity money persisted for a
very long time, across a very broad geographic region.
WHY?
Fiat money requires confidence creating mechanisms. It
was not possible to create sufficient levels of trust by
public to allow for use of fiat money.
Neoclassical ignores confidence, trust, uncertainty, and
therefore leads to this pseudo-paradox.

31. Characteristics of Commodity Money
• Should lend itself to alternative, non-monetary, uses
without much adaptation.
• Should have a rigid, or fixed and predictable, supply
schedule, preventing exogenous supply shocks which
destroy the stability of value of money.
“Partial” commodity money: minted gold coins: face
value of coin may be greater than gold content. Reducing
gold weight solves adaptation to market problem, but
creates confidence problems.
Central monetary problem of Middle Ages: discrepancies
between face value and actual value.

32. Tension Between Efficiency & Confidence
governs evolution of money

33. Fundamental Tension:
Adaptability versus Confidence
To make money adaptable to needs of economy, producers of
money must be given power to flexibly create and destroy
money.
This power can be ABUSED.
To create confidence, money supply must be subjected to strict
rules of creation.
Milton Friedman’s rule of fixed rate of increase of money –
based on neoclassical assumptions of quick and costless
adjustment of prices to equilibrium.
Advocates of Government Control of Money favor flexibility
but discount the confidence required for use of money.

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