Money : Economic functions and crea tion process

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

2. 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

3. 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

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

5. 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

6. 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

7. 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)

8. 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.

9. 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.

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

11. 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

12. The classical and Keynesian functions • 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)

13. 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 liquidityin 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

14. The classical and Keynesian functions • 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

15. The classical and Keynesian functions • 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:

16. The classical and Keynesian functions • 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

17. 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? • 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.

18. 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. • 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

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

20. 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

21. The creation of money • 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

22. The creation of money • 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 ! Central Bank Supplies base money B (interbank liquidity) Interbank market Bank A Bank B Bank C Supplies money M to the economy Deposits and loans Agents

23. The 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

24. The creation of money • 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!

25. The creation of money • Creation of money through credit • 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 €

26. The creation of money • Creation of money through credit • 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.

27. The creation of money • 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.

28. The creation of money • The simple money multiplier • The reserve/deposit ratio isrd • The money base is B • Money supply is • A higher reserve requirement reduces the multiplier

29. 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 • The bank still has a reserve/deposit ratio rd • Money supply is: • Money base is: • The multiplier is:

30. The creation of money • The money multipliers • Simple 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

31. The creation of money • 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 €

32. The creation of money • 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 € • Now Bank A’s balance sheet is unbalanced !!

33. The creation of money • The interbank market and the central bank • 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

34. The creation of money • The interbank market and the central bank • Bank B goes to either to the Central Bank or on the Inter-bank market and swaps 160 € worth of loans against base money.

35. The creation of money • The interbank market and the central bank • 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.

36. The creation of money • The interbank market and the central bank • 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.

37. The creation of money • The interbank market and the central bank • 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.

38. 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 • 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.