IntroMacro 2014 M5 02 Moneygandalf.fee.urv.cat/professors/AntonioQuesada/Curs1314/...3 Money Banking crises, bubbles & the fallacy /1 • Banks extend loans with assets as collateral

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Money wealth• Supose the European Central Bank gives youmillion. Your wealth has apparently increased.

• But what if you had received this money yearsago? Would your euros be wealth then?

• Money is not wealth, but, at most and except forcurrency collectors, a claim on wealth: money is aninstrument to acquire wealth (goods) but notwealth itself (what if you were on a desert island?).

• The purchasing power of an amount of money isthe amount of goods that can be obtained from it.

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Fallacy of composition• If you receive million, your purchasing power(ability to obtain wealth) increases. If everyone inSpain receives million, is Spain wealthier?

• The fallacy of composition holds that what is trueat a certain scale (the individual level) need not betrue at a larger scale (the group, or economy, level).

• A seller reducing prices may sell more products.But if every seller reduces prices, it is not true thatall of them would sell more products. If everybodyleaves home earlier to avoid a traffic jam, the jam isno avoided but merely brought forward.

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Banking crises, bubbles & the fallacy /1• Banks extend loans with assets as collateral. If theborrower cannot service the loan, the bank seizesthe asset (this occurs, for instance, with mortgages).

• Suppose that loans are mainly used to finance thepurchase of real estate. If many banks engage inthat lending, the prices of real estate will tend torise. The expectation of higher prices may attractmore real estate investors.

• More investors lead to a higher demand for loans,probably at a higher interest. The banks would behappy to grant collateralizing loans since the valueof the collateral (real estate) is booming.

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Banking crises, bubbles & the fallacy /2• As the entry of new investors slows down, thevalue of real state tends to fall. This damages thelast round of investors. When they fail to repay theloans, the banks’ lending becomes more prudent.

• The credit contraction reduces the value of realstate further. More default occurs. Banks turn riskadverse to lending. More bankruptcies follow.When banks finally seize the collateral, it is adepreciating asset that risks the banks’ solvency.

• The fallacy: when banks engaged in collateraliza‐tion, each presumed that it does not affect the priceof the collateral asset. This is false in the aggregate.

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Can too much money be harmful?

• For wealth, it appears that the more, the better.Does the same apply to money?

• Intuition: if the amount of wealth grows at a ratesmaller than the amount of money, in proportion,more money corresponds to each unit of goods.

• This means that the money price of goods rise. Byhow much? There can be no limit, as hyperin‐flations testify: in a hyperinflation, the inflation rateis out of control (prices may change every minute).

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trillion

http://stephenlaughlin.posterous.com/buy‐an‐100‐trillion‐zimbabwe‐dollar‐bank‐notehttp://en.wikipedia.org/wiki/Zimbabwean_dollar

http://online.wsj.com/news/articles/SB10001424052748703730804576314953091790360

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Largest denomination banknote

Hungary 1946 ∙ 100 quintillion ( = 1020 ) pengőhttp://en.wikipedia.org/wiki/Hyperinflation

http://www.zimbabwesituation.com/nov14_2008.html#Z2

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Money as a sign of poverty

• Large denomination banknotes (the fuel that feedsthe flames of hyperinflations) are actually a sign ofpoverty not wealth. In Hungary, , pricesdoubled every hours (monthly inflationreached per cent).

• The trillion banknote at some point incould just buy a bus ticket. It circulated a few

months, until the was abandoned as legalcurrency in April . In May , the note wasworth some : it had become a commodity(wealth) for currency collectors and tourists.

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Traditional account of money• Money is everything considered money: money isas money does. It is recognized by three functions.

• Medium of exchange. Goods can be generallyobtained in exchange for money, that is, moneymust can be used to make purchases of goods.

• Store of value. Money has the ability to preserve (atleast part) of its purchasing power in time: it is away of accumulating purchasing power.

• Unit of account. The value of goods is expressed interms of money (the euro from to ).

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Is there a most important function?• Neoclassical economists tend to emphasize themedium of exchange function. Money is a “veil”under which the “true” economy (real sector) ope‐rates. Money just facilitates the exchange of goods.

• Postkeynesians put the emphasis on money asstore of value. The ability to store wealth liesbehind the existence and persistence of the unequaldistribution of wealth.

• Historical evidence points to money as quantifiedreminders of debts, so money served as mere unitof account (D. Graeber ( ): Debt. The first years).

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The textbook myth /1• Textbooks typically explain the story of the pro‐gression from barter to currency (gold and silvercoinage) to credit. The historical evidence suggeststhat things have occurred the other way round.

• Records from Ancient Egypt and Mesopotamia (ca.) show that the development of a credit

system preceded the invention of coinage.

• In Ancient Mesopotamia, prices and debts (rents,fees, loans) were calculated in silver but had not bepaid in silver. Peasants settled their debts mostly inbarley and most transactions were based on credit.

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The textbook myth /2

• So “virtual money” was first. Coins came muchlater, but were unable to completely replace creditsystems.

• Barter is a kind of accidental byproduct of the useof coinage or paper money.

• Most of the cases of barter that are known, involvepeople are familiar with the use of money but, forone reason or another, have no access to currency(shortage of in Argentina, , or rubles inRussia, in the s).

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The credit theory of money• Holds that money is not a commodity (a “thing”)but an accounting tool. Money is a yardstick thatmeasures debt (the same thing as credit). Coins andbanknotes are a promise to pay something (see 15).

• Popular traditional perception: money derived itsvalue from the precious metals of which the coinswere made.

• Credit theory: a sale and purchase is the exchangeof a commodity for credit, so the value of credit ormoney does not depend on the value of any metalor metals, but on the right to get the credit satisfied.

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15http://commons.wikimedia.org/wiki/File:Spain‐franco_bank_notes_0009.jpg

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The commodity theory of money• Holds that money is a commodity whose role is tomake trade easier. The point is to find the mostconvenient commodity to perform that function:one that is durable, easily recognized, divisible,easy to transport… The choice eventually narro‐wed down to the metals (http://mises.org/daily/6122/)

• As with any other commodity, an “excessive”amount of money tends to lower its value. Moremoney should be given for goods, so the prices ofgoods are pushed up. The policy recommendationis to limit the amount of money in circulation.

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Fiat money fiat currency (notes)• Money could be defined as anything generallyaccepted as a payment (in exchange) for goods. Butmoney is accepted for goods because of the beliefthat it will be subsequently accepted for goods.

• The popular view identifies money with currency( “physical money” coins & banknotes), whichwhat is typically used to buy goods. In the past,currency had intrinsic value (were pieces of metal).

• Currency is now fiat money: intrinsically worthlesspieces of paper or metal. More generally, “money”is “legal tender fiat currency originated by a centralbank, the printed version of which is ‘cash’”.

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Modern monetary theory• “Also known as neochartalism, [it] is a descriptiveeconomic theory that details the procedures andconsequences of using government‐issued tokensas the unit of money, i.e., fiat money”.

• “MMT aims to describe and analyze moderneconomies in which the national currency is fiatmoney, established and created exclusively by thegovernment. In MMT, money enters circulationthrough government spending. Taxation and itsLegal Tender power to discharge debt establish thefiat money as currency”.

http://en.wikipedia.org/wiki/Modern_Monetary_Theory

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Our currency: the euro• The euro (sign: ; code: ) is the official curren‐cy of the members of the eurozone (officiallycalled euro area): A, B, C, E, FI, FR, GE, GR, IR, IT,LA, LU, M, N, P, SLA, SLE, and SP.

• The euro was born in Jan. as a unit of accountand became currency on Jan. . It is managedby the Eurosystem: the European Central Bankplus the central banks of the eurozone members.

• It is the second most traded currency in the world,after the . By mid‐ , it surpassed the asthe currency with highest value in circulation.

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http://en.wikipedia.org/wiki/File:Eurozone.svg

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1cCirculation of euro coins (% share, quantity)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html

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Circulation of euro coins (% share, value)

http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html

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Circulation of euro coins (quantity, millions)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html

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Circulation of euro coins

Eurozone (changing composition) ∙ Dec 2013

Low denomi-nation coins

Quantity(millions)

High denomi-nation coins

Quantity(millions)

1 CENT 27,675 26.1%

20 CENT 9,7569.2%

2 CENT 21,620 20.4%

50 CENT 5,4325.1%

5 CENT 17,14416.2%

1 EUR 6,5136.1%

1o CENT 12,72412%

2 EUR 5,0944.8%

http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.htm

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Circulation of euro coins (value, EUR millions)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html

€2

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20c

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Circulation of euro coins


Low denomi-nation coins

Value(EUR millions)

High denomi-nation coins

Value(EUR millions)

1 CENT 2771.1%

20 CENT 1,9518.1%

2 CENT 4321.8%

50 CENT 2,71611.2%

5 CENT 8573.5%

1 EUR 6,51326.9%

1o CENT 1,2725.3%

2 EUR 10,189 42.1%


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Circulation of euro banknotes (quantity, millions)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html

€200

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Circulation of euro banknotes(quantity, millions)

http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html

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Circulation of euro banknotes


Low deno-mination

Quantity(millions)

High deno-mination

Quantity(millions)

5 1,672 10.1% 100 1,850 11.2%

10 2,156 13.1% 200 199 1.2%

20 3,089 18.7% 500 583 3.5%

50 6,963 42.2% TOTAL 16,512


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Circulation of euro banknotes (% share of total banknotes)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html

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Low denomination euro banknotes (% share ∙ Quantity & value)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html

V €20

V €10

V €50

Q €20

Q €50

Q €10Q €5

V €5

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High denomination euro banknotes (% share ∙ Quantity & value)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html

Q €100

Q €200Q €500

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V €500

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Circulation of euro banknotes (value, EUR billions)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html

€500

€100

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€50

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€5

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Circulation of euro banknotes


Low deno-mination

Value(EUR billions)

High deno-mination

Value(EUR billions)

5 8.4 0.9% 100 185 19.3%

10 21.6 2.3% 200 39.8 4.2%

20 61.8 6.5% 500 291.6 30.5%

50 348.1 36.4% TOTAL 956.2


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BANKNOTES

COINS(rightscale)

Circulation of euro banknotes & coins (value, EUR billions)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html

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Circulation of euro banknotes (SPA)

Net circulation (issued returned) ∙ Dec 2013

Low deno-mination

Quantity(millions)

High deno-mination

Quantity(millions)

5 79 100 2410 840 200 1320 1,132 500 81

50 862 Pesetas (EUR millions)

806

http://www.bde.es/webbde/es/estadis/infoest/bolest7.html

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‐1

2006

‐7

2007

‐1

2007

‐7

2008

‐1

2008

‐7

2009

‐1

2009

‐7

2010

‐1

2010

‐7

2011

‐1

2011

‐7

2012

‐1

2012

‐7

2013

‐1

2013

‐7

Circulation of banknotes, Eurozone & Spain (value, EUR billions)http://www.ecb.europa.eu/stats/euro/circulation/html/index.en.html

http://www.bde.es/webbde/es/estadis/infoest/series/be0716.csv

SPAIN

EUROZONE

Mon

ey

43

0

5

10

15

20

25

30

35

40

45

50

55

60

65

70

75

80

85

90

2002

‐1

2002

‐7

2003

‐1

2003

‐7

2004

‐1

2004

‐7

2005

‐1

2005

‐7

2006

‐1

2006

‐7

2007

‐1

2007

‐7

2008

‐1

2008

‐7

2009

‐1

2009

‐7

2010

‐1

2010

‐7

2011

‐1

2011

‐7

2012

‐1

2012

‐7

2013

‐1

2013

‐7

TOTAL VALUE

€50

€500

Circulation of banknotes, Spain (value, EUR billions)http://www.bde.es/webbde/es/estadis/infoest/series/be0716.csv

Mon

ey

44

‐25

‐20

‐15

‐10

‐5

0

5

10

15

20

25

30

35

40

45

50

55

60

65

70

75

80

85

90

2002

‐1

2002

‐7

2003

‐1

2003

‐7

2004

‐1

2004

‐7

2005

‐1

2005

‐7

2006

‐1

2006

‐7

2007

‐1

2007

‐7

2008

‐1

2008

‐7

2009

‐1

2009

‐7

2010

‐1

2010

‐7

2011

‐1

2011

‐7

2012

‐1

2012

‐7

2013

‐1

2013

‐7

TOTAL VALUE

Circulation of banknotes, Spain (value, EUR billions)http://www.bde.es/webbde/es/estadis/infoest/series/be0716.csv

€50

€20

€500

Mon

ey

45

Monetary aggregates

• Monetary aggregates are technical ways of defining(measuring the amount of) money.

= monetary base = high‐powered money = = currency held by the public (cash) = bank reserves = currency in bank vaults thebanks’ deposits at the central bank

(money stock/supply, monetary mass) = deposits = non‐interest‐bearing accounts at banks

savings depositstime deposits others

Mon

ey

46

Technical definitions of money (ECB)• “ : a narrow monetary aggregate that com‐prises currency in circulation [banknotes andcoins] plus overnight deposits held with s[monetary financial institutions] and centralgovernment (e.g. at the post office or treasury).”

• “ : an intermediate monetary aggregate thatcomprises plus deposits redeemable at aperiod of notice of up to and including months(i.e. short‐term savings deposits) and depositswith an agreed maturity of up to and includingyears (i.e. short‐term time deposits) held withs and central government.”

Mon

ey

47

Technical definitions of money (ECB)

• “ is a broad monetary aggregate that com‐prises plus marketable instruments, inparticular repurchase agreements, moneymarket fund shares and units, and debtsecurities with a maturity of up to and includingtwo years issued by s”.

• “These aggregates differ with regard to thedegree of moneyness of the assets included”.

http://www.ecb.europa.eu/pub/mb/html/index.en.htmlhttp://www.ecb.europa.eu/pub/pdf/mobu/mb201401en.pdf

ECB Monthly Bulletin (glossary)

Mon

ey

48

http://www.ecb.europa.eu/stats/money/aggregates/aggr/html/hist.en.html

Technical definitions of money (ECB)

overnight deposits balances which can immediately be converted into currency or used for cashless payment

Mon

ey

49

0

0,5

1

1,5

2

2,5

3

3,5

4

4,5

5

5,5

2013

Dec

2012

Dec

2011

Dec

2010

Dec

2009

Dec

2008

Dec

2007

Dec

2006

Dec

2005

Dec

2004

Dec

2003

Dec

2002

Dec

2001

Dec

2000

Dec

1999

Dec

1998

Dec

1997

Dec

1996

Dec

1995

Dec

1994

Dec

1993

Dec

1992

Dec

1991

Dec

1990

Dec

1989

Dec

1988

Dec

1987

Dec

1986

Dec

1985

Dec

1984

Dec

1983

Dec

1982

Dec

1981

Dec

1980

Dec

CURRENCY

Eurozone (EUR trillions, working day and seasonally adjusted)http://sdw.ecb.europa.eu/browse.do?node=2120791

M1

OVERNIGHTDEPOSITS

Mon

ey

50

0

0,5

1

1,5

2

2,5

3

3,5

4

4,5

5

5,5

6

6,5

7

7,5

8

8,5

9

9,5

2013

Dec

2012

Dec

2011

Dec

2010

Dec

2009

Dec

2008

Dec

2007

Dec

2006

Dec

2005

Dec

2004

Dec

2003

Dec

2002

Dec

2001

Dec

2000

Dec

1999

Dec

1998

Dec

1997

Dec

1996

Dec

1995

Dec

1994

Dec

1993

Dec

1992

Dec

1991

Dec

1990

Dec

1989

Dec

1988

Dec

1987

Dec

1986

Dec

1985

Dec

1984

Dec

1983

Dec

1982

Dec

1981

Dec

1980

Dec

DEPOSITSUP TO 2 YEARS


M1

M2

REDEEMABLEDEPOSITS

Mon

ey

51

0

1

2

3

4

5

6

7

8

9

10

2013

Dec

2012

Dec

2011

Dec

2010

Dec

2009

Dec

2008

Dec

2007

Dec

2006

Dec

2005

Dec

2004

Dec

2003

Dec

2002

Dec

2001

Dec

2000

Dec

1999

Dec

1998

Dec

1997

Dec

1996

Dec

1995

Dec

1994

Dec

1993

Dec

1992

Dec

1991

Dec

1990

Dec

1989

Dec

1988

Dec

1987

Dec

1986

Dec

1985

Dec

1984

Dec

1983

Dec

1982

Dec

1981

Dec

1980

Dec

M2

M1

M3Eurozone (EUR trillions, working day and seasonally adjusted)http://sdw.ecb.europa.eu/browse.do?node=2120791

Mon

ey

52

0

0,5

1

1,5

2

2,5

3

3,5

4

4,5

5

5,5

2013

Dec

2012

Dec

2011

Dec

2010

Dec

2009

Dec

2008

Dec

2007

Dec

2006

Dec

2005

Dec

2004

Dec

2003

Dec

2002

Dec

2001

Dec

2000

Dec

1999

Dec

1998

Dec

1997

Dec

1996

Dec

1995

Dec

1994

Dec

1993

Dec

1992

Dec

1991

Dec

1990

Dec

1989

Dec

1988

Dec

1987

Dec

1986

Dec

1985

Dec

1984

Dec

1983

Dec

1982

Dec

1981

Dec

1980

Dec

M2‐M1

M1

M3‐M2


Mon

ey

53

‐1,5

‐1

‐0,5

0

0,5

1

1,5

2

2,5

3

3,5

4

4,5

5

5,5

6

6,5

7

2013

Dec

2012

Dec

2011

Dec

2010

Dec

2009

Dec

2008

Dec

2007

Dec

2006

Dec

2005

Dec

2004

Dec

2003

Dec

2002

Dec

2001

Dec

2000

Dec

1999

Dec

1998

Dec

1997

Dec

1996

Dec

1995

Dec

1994

Dec

1993

Dec

1992

Dec

1991

Dec

1990

Dec

1989

Dec

1988

Dec

1987

Dec

1986

Dec

1985

Dec

1984

Dec

1983

Dec

1982

Dec

1981

Dec

1980

Dec

M1

Eurozone (monthly rate of change, %)http://sdw.ecb.europa.eu/browse.do?node=2120791

Mon

ey

54

‐3

‐2

‐1

0

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

2013

Dec

2012

Dec

2011

Dec

2010

Dec

2009

Dec

2008

Dec

2007

Dec

2006

Dec

2005

Dec

2004

Dec

2003

Dec

2002

Dec

2001

Dec

2000

Dec

1999

Dec

1998

Dec

1997

Dec

1996

Dec

1995

Dec

1994

Dec

1993

Dec

1992

Dec

1991

Dec

1990

Dec

1989

Dec

1988

Dec

1987

Dec

1986

Dec

1985

Dec

1984

Dec

1983

Dec

1982

Dec

1981

Dec

M1

M2

M3

Eurozone (annual rate of change, %)http://sdw.ecb.europa.eu/browse.do?node=2120791

Mon

ey

55

The textbook model of money creation

• The cash reserve ratio is the amount ofreserves banks must hold per euro of deposit. It isthe percent of deposits banks cannot lend.

• The liquidity ratio is the amount ofcurrency that people hold per euro of deposits.

• The money multiplier is .

• It then follows that , so .Hence, if remains constant, .

Mon

ey

56

The money multiplier

• Calling the money stock , the money multiplierindicates how many units of money stock is

generated by one unit of monetary base.

• In fact, and imply. In addition, , , and

yield . In sum,

• Therefore, (the money stock) is a fixed multipleof (the monetary base).

.

Mon

ey

57

Money creation process /1

• Suppose is increased by million. Forinstance, the central bank buys financial assetsfrom the banks and pays by increasingmillion the reserves of banks on the central bank.

• Since the deposits on banks have not changed,banks have an excess of reserves equal to . Theycan then lend the million to consumers andfirms. Let consumers and firms be always willingto borrow any amount offered by banks.

• The people that borrow the million willspend them buying goods or financial assets.

Mon

ey

58


• The sellers of the goods or the financial assets getmillion. Let , so people hold

cents in cash for each euro deposited on banks.

• People must then allocate the million in cashand deposits to make the increase in cashdivided by the increase in deposits equal to .The equations giving the solution are and or, equivalently, .

As a result, and .

Mon

ey

59


• This means that people deposit million onbanks and hold million in cash. Suppose

. Hence, banks only need to keep as reservesthe of new deposits and can lend the rest. Thefollowing table summarizes the process so far.

• Now the process recommences: people borrow andspend , and those receiving the keep a partin cash ( ) and deposit the rest ( ) on banks.

∆M0 ∆D ∆E ∆R ∆loans ∆D ∆R ∆M1 ∆E ∆D

1 600 600 600

2 500 100 50 450 600

Mon

ey

60


• The following table represents the process.

• Deposits grow continuously:In the limit, the sum converges to .

∆M0 ∆D ∆E ∆R ∆loans ∆D ∆R ∆M1 ∆E ∆D1 600 600 6002 500 100 50 450 6003 375 75 37.5 337.5 4504 281.25 56.25 28.125 253.125 337.55 210.9.. 42.1... 210.9... 189.84... 253.125∙∙∙ ∙∙∙ ∙∙∙ ∙∙∙ ∙∙∙ ∙∙∙

TOTAL 600 2,000 400 200 1,800 2,400

Mon

ey

61

Money creation process /5was initially increased by . What fraction is

finally held in cash? The sum, which converges to .

• Since , . That is,. Thus, . This is also the

value to which the sumconverges (the at round should

not be counted because banks lend this amount:they represented voluntary, not legal reserves).

yields . Asand , : an increase of in

is transformed into an increase of in .

Mon

ey

62


• This suggests that the money multiplier mustbe : generates . In fact,

captures the total effect on the cash held by thepeople and the deposits generated by the process

• This sequence illustrates the interaction betweenthe financial side (deposits and loans) and the realside (purchases of goods).

… deposits loans expenditures revenues deposits loans …

.. .

.

..

Mon

ey

63

CentralBank Banks Consumers

Producers

600600loans

600purchases

E = 100

Banks Consumers450

R = 50

D = 500

Producers

450purchases

E = 75

Banks Consumers337.5

loans

R = 37.5

D = 375

loans

. . .

Summary of the textbook money creation process

Mon

ey

64

The reality of bank lending

• In the model, banks need to receive a deposit tolend. In reality, when a bank makes a loan, themoney lent is not taken from anyone’s account norfrom the bank’s funds: it is created out of thin air.

• As deposits are accounting entries in a computer,the bank creates the money by crediting its custo‐mer’s account with the amount of the loan and ba‐lancing this liability by registering the amount ofthe loan as an asset. The bank is not actually provi‐ding cash but the promise to provide cash. But thatpromise, the account at the bank, counts as cash.

Mon

ey

65

Banking system’s shaky foundations• Problem: the banks promise to deliver somethingthat they cannot deliver, as there is not enoughcash in an economy to cash all bank deposits. In abank run a large number of customers decide towithdraw their deposits simultaneously.

• In slide , deposits worth are created, butthey are backed by only the additional in cash.

• In Spain, the Deposit Guarantee Fund of CreditInstitutions guarantees up to per depositin case of bankruptcy. The fund ended with ashortfall of billion. http://www.fgd.es/en/index.html

Mon

ey

66

Banking business: fraud & catastrophe

• 1/ Banking works as long as everyone believes itdoes. If confidence is lost, the system collapsesbecause it relies on the fiction of unexisting money.

• 2/ The creation of bank money (loans) rests only onthe bank’s belief that the borrowers can repay.

• 3/ Nothing controls the scale/timing of bank len‐ding. Banks lend freely until they fear a default onrepayments. New loans are refused and economicactivity declines: lending, expenditure, pro‐duction, employment, lending.http://www.opendemocracy.net/ourkingdom/oliver‐huitson/uneconomics‐guide‐to‐money‐creation

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