ECON120 Study Guide

Unit 2: The Hierarchy of Money

2a. Identify the mathematical works that introduced modern accounting to Europe 

  • What knowledge did Fibonacci bring to Europe from Northern Africa, India, and Islamic Spain?
  • How did accounting affect the monetary system?
  • What was the focus of Pacioli's writings?
  • How did double-entry accounting affect the monetary system?
  • How is credit issued thanks to double-entry accounting?

In 1202, Leonardo da Pisa, popularly known as Fibonacci, published a book called Liber abaci (Book of Calculation) that brought the Hindu-Arabic numeral system to Europe. These accounting techniques were the foundation of double-entry accounting. Fibonacci's work spawned a new type of merchant class: the banker.
Mathematician Luca Pacioli published Summa de arithmetica, geometria, proportioni et proportionalita (Summary of arithmetic, geometry, proportions and proportionality) in 1494, which gave Pacioli the nickname "the father of accounting and bookkeeping". He formalized the "Venetian Way" of double-entry accounting, a system still utilized by most business entities today.
To review, see Modern Accounting.

2b. describe a two-layered monetary hierarchy between the gold florin and bills of exchange 

  • What is monetary hierarchy?
  • How does a layered-money framework compare to a "hierarchy of money" framework?
  • What is the relationship between assets and liabilities?
  • How did the florin contribute to a layered money system?
  • What is a bill of exchange and how was it used as a credit instrument?
  • What are the advantages and disadvantages of first-layer money?
  • What are the advantages and disadvantages of second-layer money?

Bills of exchange were a way to send money from one place to another and simultaneously convert it to the recipient's desired currency. They were letters written by bankers promising payment. By the fourteenth century, bill of exchange issuers denominated at least one side of most transactions in gold florin. Florins were the international business balance sheet denomination of choice and the world's first reserve currency.
To review, see Layered Money.

2c. Explain the importance of counterparty risk and default risk 

  • What type of risks did bills of exchange carry?
  • How has the word "cash" evolved?
  • What is credit elasticity and how does its extension affect counterparty and default risk?
  • How was money velocity affected by the counterparty risk of bills of exchange?

The gold coin is first-layer money and the form of final settlement. The piece of paper only exists because of the gold it represents; it's second-layer money, created as a liability on somebody's balance sheet. Second-layer money has counterparty risk, or the risk that comes with holding a promise made by a counterpart.
Bills carried default risk by the issuer because they were a form of deferred settlement. Default risk is the risk that the actor between money layers cannot or will not fulfill the promise to pay.
Cash is defined as anything we use as a form of money that others accept at face value, even if it's paper with counterparty risk and no guarantee of final payment. For something to work as cash, people have to trust the issuer or whoever has made the promise to pay.
To review, see Layered Money.

2d. Summarize how fractional reserve lending works 

  • How does fractional reserve lending work?
  • Why does the issuance of credit rely on fractional reserve lending?
  • What is the difference between full reserve banking and fractional reserve banking?

Assume a goldsmith's deposits gain credibility and start circulating as cash because people trust that they are redeemable for gold. He then issues gold deposits to himself without reserving the corresponding gold in his vault and spends these deposits as cash into circulation. The goldsmith will then default if ever faced with a full redemption request. This type of activity is called fractional reserve banking, as opposed to full reserve banking, which is when all deposits have corresponding gold in a vault.
To review, see Layered Money and Traveling Between Layers of Money.

2e. Explain the advantages and disadvantages of a layered money system

  • What are the advantages of fractional reserve lending?
  • What are the disadvantages of fractional reserve lending?
  • How does a layered money system affect economic potential?
  • How does a layered money system affect the risk of financial panic?
  • What were some early advantages to the rise in second-layer monetary instruments?
  • What were their problems?

The hierarchy of money is dynamic. When credit expands, the money pyramid expands as the second layer grows in size. A gold coin and a gold deposit have almost no observable difference when confidence is high. People freely accept gold certificates as money because they trust the issuer's ability to satisfy redemption. Contractions can result in redemption requests, called bank runs, and eventually financial crises.
To review, see Traveling Between Layers of Money.

2f. Explain cash, clearance, and liquidity in monetary systems 

  • Why were bills of exchange not involved in a clearance process?
  • How is liquidity defined within monetary science?
  • What is the importance of liquidity?

Clearance is the process of settling transactions. Liquidity is the ability to exchange an asset for cash. Early on, cash and coins were synonymous, meaning that the only form of money considered to function as cash were precious metal coins themselves. Bills of exchange didn't readily convert to precious metal unless presented to the appropriate underwriters upon their maturity date.
To review, see Traveling Between Layers of Money.

Unit 2 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • bank run
  • bill of exchange
  • cash
  • clearance
  • counterparty risk
  • default risk
  • fractional reserve banking
  • full reserve banking
  • liquidity