Money Economic functions and creation process Money

Money : Economic functions and creation process Money: its nature, function and creation process.

Class tests ¢ Just a quick preliminary note on the organisation of the class tests: l l As outlined previously, they are at the same time as the French groups’ tests The content will be comparable ¢ 1 st test: Wednesday 29 th of April, 8 -10 ¢ 2 nd test: Friday 29 th of May, 15: 45 – 17: 45

Money : function and creation process ¢ ¢ ¢ We now move on to examining equilibrium in the money market. Next week: we will look at the money market equilibrium, CB intervention, etc. Before that, it is important to spend a session examining money itself l ¢ “Modern” money has several counter-intuitive properties: it is intrinsically worthless and it can be created from nothing. The money market cannot really be understood if these are not explained properly beforehand

Money : function and creation process The nature of money The classical and Keynesian functions of money The creation of money by the banking system

The nature of money ¢ What is money ? l l ¢ In other words, money is what we decide it to be as a society l l ¢ It is whatever a given society at a given time agrees to use as a means of exchange Do not confuse money and wealth (see the Spanish “price revolution” vs. Adam Smith!) It is a social institution Its existence is therefore always based on the level of trust within a society There are several types of currency

The nature of money ¢ ¢ Commodity money A situation where a commodity serves as currency l Very close to barter, but with the currencyl ¢ commodity dominating the exchanges Gold, silver, salt, cigarettes, sea shells, marbles. Not necessarily intrinsically valuable, but often so: doesn’t require much trust. l l The commodity is usually rare (limited supply) Has desirable properties: divisible, fungible

The nature of money ¢ ¢ Token money: A situation where the currency is officially backed on a commodity. l ¢ The commodity itself is not exchanged, instead tokens representing units of the commodity are exchanged (ex: bank notes in the Gold Standard) This requires a higher level of trust, as the intrinsic value of the token is much less than the face value. l The tokens can always be converted into the commodity on demand (the token is an IOU)

The nature of money ¢ ¢ Fiat money: Where money exists simply by law (an act of government): it must be accepted in repayment of all debts l Money as a sign, a symbol. l It typically has no intrinsic value (except for l ¢ pennies!) Its face value is backed entirely by the state’s credibility This requires a high level of trust in the institution that creates it.

The nature of money ¢ Most countries nowadays use fiat currency, because money supply can be controlled. l ¢ In a commodity/token currency system, the money supply is exogenous l l ¢ This is important for financing the economy The price revolution in 16 th century Europe (New world gold arriving in Spain) Restricted money supply during WWI, which caused most countries to temporarily abandon it. In a fiat system, the supply can be adjusted as necessary.

Money : function and creation process The nature of money The classical and Keynesian functions of money The creation of money by the banking system

The classical and Keynesian functions ¢ The classical functions of money l l l ¢ Also called the Aristotelian functions. Aristotle was intrigued by the problem of commensurability: how can intrinsically different goods have an exchange value? His conclusion : exchange can only occur if the goods are equal in a given comparable measure 1 st function: Means of exchange l Simplifies exchange compared to barter: no need for a double coincidence of wants

The classical and Keynesian functions ¢ 2 nd function : unit of account l ¢ Money is divisible, so can be used to measure and compare the values of different goods (price system) 3 rd function: Reserve of value l l Payments made in money do not lose their value over time, unlike barter or payments in kind Money allows the conservation of values through time (discounting inflation)

The classical and Keynesian functions ¢ ¢ Keynes’ “General theory of employment, interest and money ” introduced more functions, leading to a debate about the role of money in the economy The central argument is the existence of a preference for liquidity in agents l l l With uncertainty, agents will prefer to hold liquidities as away of adapting faster to the risky environment Money is the most liquid and least risky way of holding assets: it is always accepted in transactions Money will be demanded for its intrinsic properties

The classical and Keynesian functions ¢ ¢ Keynes identifies 3 “motives” for demanding money The transaction motive: l l ¢ money is required for exchange (similar to the “classical functions”) This demand is a positive function of income The precaution motive: l l Holding some liquidity is the best option in the presence of uncertainty. This is also a positive function of income

The classical and Keynesian functions ¢ The speculation motive: l l l ¢ This motive embodies the trade-off between holding liquidities and assets. Liquidity is preferred, but does not pay interest. Assets pay interest, but are not as liquid Therefore the interest rate is the opportunity cost of holding liquidity : as it increases people will hold less liquidity This leads to an overall demand for money of the following form:

The classical and Keynesian functions ¢ This has lead to an important debate on the effect of money in the economy between: l Those who believe that money is neutral (i. e. does not affect real economic variables) § Classical approach, quantity theory approach l Those who believe that money is not neutral (it can affect real variables) § This is due to the role of the interest rate on money demand ¢ The debate is not closed yet, but has moved to a short-term/long-term debate l Money is neutral in the LR, not in the SR

The classical and Keynesian functions ¢ ¢ The Keynesian argument for non-neutral money will be shown in greater detail in the next few weeks (IS-LM) What about the “classical” approach? l l l It is grounded in the Quantity Theory of Money (QTM) Classical dichotomy : nominal variables and real variables are independent Money is only used for transactions, therefore only the “classical” functions apply.

The classical and Keynesian functions ¢ ¢ It is based on the Cambridge equation QTM states that velocity V (the number of times a given € is used in a given time period) and the volume of transactions T are exogenous with respect to money M. l l ¢ Therefore increases in M lead to proportional increases in P Inflation is a purely monetary phenomenon But Keynesians argue this holds only in the LR: in the SR, increasing M can change real variables because of the liquidity preference

Money : function and creation process The nature of money The classical and Keynesian functions of money The creation of money by the banking system

The creation of money ¢ ¢ Most of the money is created by banks through the process of credit (lending) What is the purpose of a bank? l l To hold the short term deposits of money by agents And make them available as long term loans to other economic agents (which earn interest) This funds economic activity (investment projects, consumer durable purchases) In the process, this also creates money for transactions in the economy

The creation of money ¢ The actors in this process are : l The agents: § Provide deposits to banks and take out loans l The banking system: § Which take the deposits from agents and make the loans to agents l The central bank: § Regulates the banking system (prudential regulations) § Provides “base money” to the banking system § Acts as the lender of last resort to banks

The creation of money ¢ Central Bank Supplies base money B (interbank liquidity) Interbank market Bank A Bank B Deposits and loans Agents Bank C Supplies money M to the economy ¢ The amount of money M supplied by the banks is larger than the base money B supplied by the central bank M>B There is a net creation of money !

The creation of money ¢ First, let’s examine the balance sheet of a bank Bank A Assets Liabilities Reserves Deposits Loans ¢ ¢ Liabilities: in the form of the deposits of money made to the bank by agents Assets: l l Reserves: held against depositor claims Loans: made to 3 rd parties, they earn interest

The creation of money ¢ Creation of money through credit Bank A Assets Liabilities 200 € 1000 € 800 € ¢ ¢ A bank receives a 1000 € deposit in cash We assume a 20% reserve ratio against deposits l l ¢ Bank A has to hold 200 € in reserve It can loan 800 € This 800 € loan is new money, created by the bank!

The creation of money ¢ Creation of money through credit Bank B Bank A Assets Liabilities 200 € Assets 1000 € Liabilities 800 € ¢ ¢ ¢ Assume the 800 € loan is deposited in Bank B Total deposits in the economy are now 1800 € Given the reserve ratio of 20%: l l Bank B has to hold 160 € in reserve It can loan 640 €

The creation of money ¢ Creation of money through credit Bank B Bank A Assets Liabilities 200 € 1000 € 160 € 800 € ¢ ¢ ¢ 640 € Assume the 800 € loan is deposited in Bank B Total deposits in the economy are now 1800 € Given the reserve ratio of 20%: l l l Bank B has to hold 160 € in reserve It can loan 640 € 128 € (0. 2× 640) held as reserves, 512€ re-loaned.

The creation of money ¢ Assuming that all of the lending/deposits occur in the same bank, we have : Bank A Assets Liabilities 1000 € 5000 € 4000 € ¢ One can see that the higher the reserve ratio, the smaller the loans that can be made, and the faster the process stops.

The creation of money ¢ The simple money multiplier The reserve/deposit ratio is rd l The money base is B l Money supply is l l A higher reserve requirement reduces the multiplier

The creation of money ¢ The cash money multiplier Suppose that on top of their deposits in the bank agents hold cash, with a cash to deposit ratio cd l The bank still has a reserve/deposit ratio rd l Money supply is: l Money base is: l The multiplier is: l

The creation of money ¢ The money multipliers l Simple multiplier: l Cash multiplier: l If rd = 0. 2 and cd = 0. 1 § The simple multiplier is equal to 5 § The cash multiplier is equal to 3. 66

The creation of money ¢ The interbank market and the central bank B Bank A Assets Liabilities 200 € 1000 € 160 € 800 € ¢ 640 € Imagine a customer from bank B buys a 2 nd hand computer 200 € from a customer in bank A l l He writes a 200 € cheque, so his deposit goes down by that amount The deposits in bank A go up by 200 €

The creation of money ¢ The interbank market and the central bank B Bank A Assets Liabilities 200 € 160 € 600 € 800 € ¢ Imagine a customer from bank B buys a 2 nd hand computer 200 € from a customer in bank A l l ¢ 640 € He writes a 200 € cheque, so his deposit goes down by that amount The deposits in bank A go up by 200 € Now Bank A’s balance sheet is unbalanced !!

The creation of money ¢ The interbank market and the central bank B Bank A Assets Liabilities 200 € 160 € 600 € 800 € ¢ Bank A is potentially bankrupt. l l ¢ 640 € It claims 200 € asset compensation from Bank B (through the clearing house) Bank B has enough assets, but not enough liquidity (in the form of reserves) It needs to liquidate some assets

The creation of money ¢ The interbank market and the central bank B Bank A Assets Liabilities 200 € 160 € 600 € 800 € ¢ 640 € Bank B goes to either to the Central Bank or on the Inter-bank market and swaps 160 € worth of loans against base money.

The creation of money ¢ The interbank market and the central bank B Bank A Assets Liabilities 200 € 1200 € 320 € 600 € 800 € ¢ 480 € Bank B goes to either to the Central Bank or on the Inter-bank market and swaps 160 € worth of loans against base money. l It can then pay the 200 € it owes bank A and still meet its 20% reserve ratio.

The creation of money ¢ The interbank market and the central bank B Bank A Assets Liabilities 400 € 120 € 600 € 800 € ¢ 480 € Bank B goes to either to the Central Bank or on the Inter-bank market and swaps 160 € worth of loans against base money. l l It can then pay the 200 € it owes bank A and still meet its 20% reserve ratio. Both banks are now balanced. Bank A can buy from the CB the 160 € worth of assets that Bank B sold.

The creation of money ¢ The interbank market and the central bank B Bank A Assets Liabilities 240 € 120 € 600 € 960 € ¢ 480 € Bank B goes to either to the Central Bank or on the Inter-bank market and swaps 160 € worth of loans against base money. l l It can then pay the 200 € it owes bank A and still meet its 20% reserve ratio. Both banks are now balanced. Bank A can buy from the CB the 160 € worth of assets that Bank B sold.

The creation of money ¢ ¢ In theory, with the central bank always ready to lend if a bank needs it, the system is secure However: credit & money creation are not the only form of financing the economy l l ¢ A lot of financing now occurs directly (agents investing), and banks mediate this through trusts and subsidiaries that are “off the balance sheet”. This activity is not “banking”, however, so is not regulated the same way. The problem is that the lack of prudential regulations on this “off balance sheet” activity has caused the financial problems we are in.