Here is a clip from Seinfeld that I use when teaching Behavioural Economics. It seems rational that Jerry gives Elaine $182 for her birthday but it really is inappropriate. Cash replaces social norms by market norms and ruins the feelings usually evoked by a typical non-cash birthday gift. The deadweight loss of giving is the loss of efficiency that occurs when the value of the gift to the recipient is less than the cost of the gift to the giver. In this case, economists argue that cash would be a more efficient gift.
On the 8th November last year India’s Prime Minister, Narendra Modi, announced that all 500 and 1000 rupee notes could no longer be used as a medium of exchange – this accounts for 86% of cash in circulation. These notes could be exchanged for new ones by the end of the 2016.
Why did they outlaw the use of 500 and 1000 rupee notes?
- The main motivation was to remove the country of shadow economy millionaires hoarding of illegal cash. It is estimated that the shadow economy accounts for 20% of India’s GDP.
- Demonetisation increases the use of electronic banking allowing better tracking by tax authorities.
- The printing of new denomination money would hopefully inflate away the value of illegal cash in the shadow economy.
- Encourage people to deposit cash in the bank where it would earn interest
- Greater tax revenue for the government by firms declaring their earnings. This additional money could be used for infrastructure projects as well as tax incentives for companies.
What have been the problems?
- The Reserve Bank of India hasn’t been able to print the new money fast enough to replace the $207bn in rupees. There has been almost no new cash in rural banks and therefore keeping millions of farmers deposits that total $46bn. With limited cash in rural areas prices have collapsed.
- Factories in some cities have closed as employers can’t pay their workers although some have resorted to giving supermarket coupons to keep workers on the job.
- A dentist in an affluent part of Delhi has found a 70% fall in business since the cash ban.
- Outside the major cities cash transactions are very common and not recognising 500 and 1000 rupee notes provides a significant monetary shock for those areas
- Not all the shadow economy can move to a more legal environment with demonetisation and this represents a potential loss of economic activity.
- A shortage of cash has led to small businesses having to shut down.
In the long-run the forced priming of bank accounts and the switch to electronic payments will mobilize more money for lending and taxes.
Venezuela also became a country mostly without cash on December 16, sparking scattered protests and looting around the country as people fumed at having their already limited purchasing power cut off almost entirely.
As the nation’s most widely used banknote went out of circulation, the higher-denomination bills that were supposed to replace the 100-bolivar note had not yet arrived at banks or ATMs. That forced people to rely on credit cards and bank transfers or to try to make purchases with bundles of hard-to-find smaller bills often worth less than a penny each. The government was forced to delay the withdrawal of the 100-bolivar banknote until January 2. The graphic shows the volume of bank notes that are required to make $10m – Venezuela needs 14 sizable trucks to carry the 100-bolivar banknotes.
Source: The Economist – December 3rd 2016
Money has taken various forms over the ages – whether it be tokens on a tree made of pewter (soft metal which comes from Malaysia) to the stone currency from the island of Yap in Micronesia. There was a problem with the stone currency in that one of the essential characteristics of money is portability and a 5 meter high stone with a hole in it doesn’t fit the bill let alone the wallet. Money that comes in small coins and notes became a much more efficient medium of exchange and facilitates more transactions but it still gives you a sense that you are spending it as your wallet becomes lighter and less bulky.
Today the vast majority of transactions are done without cash and there is a tendency not to feel the cost of the transaction, by physically taking money out of your wallet, when paying by credit card. This ease of payment encourages us to spend more. Research has shown that credit cards make people spend 12-18% more, on average, than they would using cash. But lets go further, you can now wave your card over the credit card terminal with no need for a security pin number or a signature. In fact a smartphone is able to carryout a similar transaction which further erodes the sense of parting with money. I recently received an updated airpoints card from a national airline which enables you to accumulate points that can be redeemed for flights. However reading the letter I was interested to see that the card was also offering me $10,000 credit limit. Credit was also offered from a petrol station and a supermarket card – the means of a deferred payment is a popular function.
For the AS level course remember the following:
The Functions of Money
There are 4 traditional functions of money.
1. Medium of exchange.
This is very important in a specialised economy as barter would be very inefficient. It also makes possible a great extension of the principle of specialisation.
The desirable qualities of money are as follows:-
- Acceptable: Must be sure somebody will accept your money for goods & services
- Scarce: Should be, if there’s too much, then no one would value it, hence gold was always good money.
- Portable: Convenient to carry around
- Divisible: Can be divide up into different denominations
- Durable: Money (physical) that can last
2. Unit of Account
A unit of account is a way of placing a specific value on economic goods and services. Thus, as a unit of account, the monetary unit is used to measure the value of goods and services relative to other goods and services. It thus enables individuals to compare, easily, the relative value of goods and services. A firm uses money prices to calculate profits and losses: and a typical household budgets its regular expenses daily using money prices as its unit of account.
3. Store of Value.
Once a commodity becomes universally acceptable in exchange for goods and services, it is possible to store wealth by holding a stock of this commodity. It is a great convenience to hold wealth in the form of money. Consider the problems holding wealth in the form of wheat. It may deteriorate, it is costly to store, must be insured, and there will be significant handling costs in accumulating and distributing it.
4. Standard of Value/Standard of Deferred Payment.
An important function of money in the modern world, where so much business is conducted on the basis of credit, is to serve as a means of deferred payment. When goods are supplied on credit, the buyer has immediate use of them but does not have to make an immediate payment. The goods can be paid for three, or perhaps six, months after delivery.
Cows in India, which number 280m, have been seen as a poor investment when you consider the return the Indian farmer gets. Cattle are expensive to keep and the cost of feed for one cow per year is approximately US$160 a year. Some research has suggested the return on a cow is -64%
So the question The Economist asked is why do households in India buy them?
Households may prefer to produce high-quality milk at home, even if doing so costs more.
Only 7% of Indian villages have a bank branch. That means people lack a formal savings mechanism for their spare cash. And although there are informal ways to save—joining a local savings club, for example, or simply stuffing money under the mattress—owning a cow may be a better option. With the liquid nature of money people find it easier to spend money which they sometimes regret. This is referred to by economists as “myopia”. As the cow is quite illiquid (not easy to instantly turn into cash) it is therefore less myopic which means immediate spending is more difficult.
In future the idea of commitment savings accounts in developing countries has been raised whereby people forgo their right to withdraw funds until they reach a specified level.
Thanks to AS student Carlos McCoy for some information on Bitcoin. BITCOIN, the world’s “first decentralised digital currency”, was launched in 2009 and unlike traditional currencies, which are issued by central banks, Bitcoin has no central monetary authority. Instead it is underpinned by a peer-to-peer computer network made up of its users’ machines, akin to the networks that underpin BitTorrent, a file-sharing system, and Skype, an audio, video and chat service. However in today’s environment it does maintain a good store of value relatively speaking when you look at alternative currencies. Below is Max Keiser with some very good points.
Just published on their website, the Reserve Bank of New Zealand has prepared a short video explaining inflation. The video, featuring the Bank’s Head of Economics, John McDermott, explains how inflation is measured and how it manifests itself in everyday life. It also explains the importance of maintaining price stability. Well worth a look.
The recent LIBOR crisis that hit the headlines last week has shown that once again banks which were once reknowed for their prudence and considered boring have now been replaced by greed and reckless risk-taking. According to the WSJ, in the early years of banking an institution needed to attract deposits from the public and therefore cultivated prudence and integrity and publicised this to potential investors. Lets face it being boring was potentially a selling point for bankers. During the 20th century this changed and you only need to look no further than the pre-crisis advertising in which the rhetoric wasn’t one of care and honesty but a willingness to lend to anyone.
However in today’s environment do depositors care so much about the prudent and trustworthiness of banks? Do they actually benefit from this? When you have a situation that the banks become “too big to fail” and are bailed out by the government there seems to be nonchalant attitude amongst depositors to the integrity of banks. This then means that the banks have little incentive to care either. It seem that banks gain little advantage over their competitors from being prudent. In fact depositors can gain from the banks making risky uses of their money. As the government will guarantee their money they then can profit from higher rates of interest by the banks being prepared to make riskier investments. This has encouraged investors to favour risk-taking banks.