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

Money : Economic functions and crea

tion process

Money: its nature, function and creation process.

Class tests

Just a quick preliminary note on the organisation of the class tests: As outlined previously, they are at the same

time as the French groups’ tests The content will be comparable

1st test: Wednesday 29th of April, 8 -10

2nd test: Friday 29th 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 “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


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 ? 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!) In other words, money is what we decide it

to be as a society 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 Very close to barter, but with the currency-

commodity dominating the exchanges Gold, silver, salt, cigarettes, sea shells,

marbles. Not necessarily intrinsically valuable, but

often so: doesn’t require much trust. 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. 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. 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 Money as a sign, a symbol. It typically has no intrinsic value (except for

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. This is important for financing the economy

In a commodity/token currency system, the money supply is exogenous The price revolution in 16th 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.


The nature of money



The classical and Keynesian functions

The classical functions of money 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

1st function: Means of exchange Simplifies exchange compared to barter: no need

for a double coincidence of wants


2nd function : unit of account Money is divisible, so can be used to measure and

compare the values of different goods (price system)

3rd function: Reserve of value 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)


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 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


Keynes identifies 3 “motives” for demanding money

The transaction motive: money is required for exchange (similar to the

“classical functions”) This demand is a positive function of income

The precaution motive: Holding some liquidity is the best option in the

presence of uncertainty. This is also a positive function of income


The speculation motive: 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:

iYLP

MM d ,


This has lead to an important debate on the effect of money in the economy between: Those who believe that money is neutral (i.e. does

not affect real economic variables) Classical approach, quantity theory approach

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 Money is neutral in the LR, not in the SR


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? 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.


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. 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

nsTransactioPricesVelocityMoneyTPVM


The nature of money



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? 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 actors in this process are :

The agents: Provide deposits to banks and take out loans

The banking system: Which take the deposits from agents and make the

loans to agents 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


Central Bank

Bank A Bank B Bank C

Agents

Interbank market

Deposits and loans

Supplies base money B

(interbank liquidity)

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 !


First, let’s examine the balance sheet of a bank

Liabilities: in the form of the deposits of money made to the bank by agents

Assets: Reserves: held against depositor claims Loans: made to 3rd parties, they earn interest

Bank A

Assets Liabilities

Reserves Deposits

Loans


Creation of money through credit

A bank receives a 1000 € deposit in cash We assume a 20% reserve ratio against deposits

Bank A has to hold 200 € in reserve It can loan 800 €

This 800 € loan is new money, created by the bank!

Bank A

Assets Liabilities

200 € 1000 €

800 €



Assume the 800 € loan is deposited in Bank B Total deposits in the economy are now 1800 € Given the reserve ratio of 20%:

Bank B has to hold 160 € in reserve It can loan 640 €

Bank A

Assets Liabilities

200 € 1000 €

800 €

Bank B

Assets 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%:

Bank B has to hold 160 € in reserve It can loan 640 € 128 € (0.2×640) held as reserves, 512€ re-loaned.

Bank A

Assets Liabilities

200 € 1000 €

800 €

Bank B

Assets Liabilities

160 € 800 €

640 €


Assuming that all of the lending/deposits occur in the same bank, we have :

One can see that the higher the reserve ratio, the smaller the loans that can be made, and the faster the process stops.

Bank A

Assets Liabilities

1000 € 5000 €

4000 €


The simple money multiplierThe reserve/deposit ratio is rdThe money base is B Money supply is

A higher reserve requirement reduces the multiplier

Brd

M s 1


The cash money multiplierSuppose that on top of their deposits in the

bank agents hold cash, with a cash to deposit ratio cd

The bank still has a reserve/deposit ratio rdMoney supply is:Money base is: The multiplier is:

DcdCDM s 1

DcdrdCRB

cdrd

cd

Dcdrd

Dcd

B

M s

11


The money multipliersSimple multiplier:

Cash multiplier:

If rd = 0.2 and cd = 0.1 The simple multiplier is equal to 5 The cash multiplier is equal to 3.66

cdrd

cd

B

M s

1

rdB

M s 1


The interbank market and the central bank

Imagine a customer from bank B buys a 2nd hand computer 200 € from a customer in bank A He writes a 200 € cheque, so his deposit goes down

by that amount The deposits in bank A go up by 200 €

Bank A

Assets Liabilities

200 € 1000 €

800 €

Bank B

Assets Liabilities

160 € 800 €

640 €



Imagine a customer from bank B buys a 2nd hand computer 200 € from a customer in bank A 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 !!

Bank A

Assets Liabilities

200 € 1200 €

800 €

Bank B

Assets Liabilities

160 € 600 €

640 €



Bank A is potentially bankrupt. 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

Bank A

Assets Liabilities

200 € 1200 €

800 €

Bank B

Assets Liabilities

160 € 600 €

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.

Bank A

Assets Liabilities

200 € 1200 €

800 €

Bank B

Assets Liabilities

160 € 600 €

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. It can then pay the 200 € it owes bank A and still meet

its 20% reserve ratio.

Bank A

Assets Liabilities

200 € 1200 €

800 €

Bank B

Assets Liabilities

320 € 600 €

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. 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.

Bank A

Assets Liabilities

400 € 1200 €

800 €

Bank B

Assets Liabilities

120 € 600 €

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. 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.

Bank A

Assets Liabilities

240 € 1200 €

960 €

Bank B

Assets Liabilities

120 € 600 €

480 €


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 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.

Documents

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