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
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 ? 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.
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 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
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)
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 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: 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 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:
iYLP
MM d ,
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
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.
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
nsTransactioPricesVelocityMoneyTPVM
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? 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 :
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
The creation of money
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 !
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
Bank A
Assets Liabilities
Reserves Deposits
Loans
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!
Bank A
Assets Liabilities
200 € 1000 €
800 €
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 €
Bank A
Assets Liabilities
200 € 1000 €
800 €
Bank B
Assets Liabilities
800 €
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.
Bank A
Assets Liabilities
200 € 1000 €
800 €
Bank B
Assets Liabilities
160 € 800 €
640 €
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.
Bank A
Assets Liabilities
1000 € 5000 €
4000 €
The creation of money
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 creation of money
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 creation of money
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 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 €
Bank A
Assets Liabilities
200 € 1000 €
800 €
Bank B
Assets Liabilities
160 € 800 €
640 €
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 !!
Bank A
Assets Liabilities
200 € 1200 €
800 €
Bank B
Assets Liabilities
160 € 600 €
640 €
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
Bank A
Assets Liabilities
200 € 1200 €
800 €
Bank B
Assets Liabilities
160 € 600 €
640 €
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.
Bank A
Assets Liabilities
200 € 1200 €
800 €
Bank B
Assets Liabilities
160 € 600 €
640 €
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.
Bank A
Assets Liabilities
200 € 1200 €
800 €
Bank B
Assets Liabilities
320 € 600 €
480 €
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.
Bank A
Assets Liabilities
400 € 1200 €
800 €
Bank B
Assets Liabilities
120 € 600 €
480 €
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.
Bank A
Assets Liabilities
240 € 1200 €
960 €
Bank B
Assets Liabilities
120 € 600 €
480 €
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.