Paul Bernd Spahn, Goethe-Universität Frankfurt/Main1 Lecture 2 Modern Concepts of Money

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main 1

Lecture 2

Modern Concepts of Money


What is money ?

• Money is typically defined by describing its functions.

• Important functions are: – the easing of transactions of goods and services

(medium of exchange); – unit of account– the store and transfer of value (wealth).

• The functions of money are embedded into a historical process.

• The definition of money is thus evolving.


Historical forms of money

• Commodity money in a barter economy:– “Goods” with a use value such as salt,

corn, spices, colors (e.g. indigo), cattle;– “Assets” that are rare and tradeable

such as gold, perls, gems, feathers of rare bird, cowrie shells; even stones

– In societies where people are considered “assets”, money could also be slaves, children, or women of marital age.


Stone “money” of the island of Yap


What is money ?

“Money is what money does. Money is defined by its functions”

(John Hicks).

Money is an information processing technology that aims at

reducing uncertainty and establishing trust.

John Hicks 1904-89


Medium of exchange

• In a barter economy, any good may take the role of a medium of exchange, but it is required that exchange intentions are mutually consistent

• One good often serves as a “numéraire” (which reduces n*(n-1) possible exchange relationships to (n-1) )

• Money decomposes one act of exchange into two such acts: Good x Money Good y


Medium of exchange

• The decomposition of exchange acts renders a modern economy based on labor sharing possible

• But this requires the existence of a social consensus, according to which money is accepted as a general medium of exchange

• A legal provision can facilitate such acceptance, but it cannot necessarily be enforced


Medium of exchange: Lack of confidence

• Where there is lack of confidence in a legal tender, there could be escape into “substitute currencies” (= “hard” currencies or commodity money --> such as cigarettes, butter)

• Such “monies” circulate forcibly as media of exchange, but they are unsuitable as a store of value (Gresham’s “Law”):

Bad money replaces good money!


Medium of exchange: Gresham’s Law

„TO THE Right Honourable the Lords Commissioners of His Majesty's Revenue. May it please your Lordships.

... If Things he let alone 'till Silver Money be a little scarcer, the Gold will fall of itself; for People are already backward to give Silver for Gold, and will in a little Time, refuse to make Payments in Silver without a Premium, as they do in Spain; and this Premium will be an Abatement in the Value of the Gold: And so the Question is, Whether Gold shall be lowered' by the Government, or let alone 'till it falls of it self, by the Want of Silver Money ? ...

All which is humbly submitted to your Lordships great Wisdom. Mint-Office, Sept 21, 1717. Isaac Newton.“


Store of value

• The prerequisite for storing values and the creation of net worth is the existence of an order on property rights

• Net worth possesses two kinds of merits. It is useful:– Directly: By providing consumption services

(real estate, jewellery, antiques, totems, relics)– Indirectly: By bridging the temporal gap

between income flows and expenditures


• To the extent that assets may have monetary characteristics, money can produce returns (interest income)

• Normally, money is held interest-free

• The question is: Why do individuals hold money without interest?

• This brings us to the notion of

Ability to pay or “liquidity”

Store of value


Payment function

• This function permits the granting of credit, the transfer of credits and liabilities, and the redemption of debentures

• The prerequisite is that credit money will be provided and is universally accepted within a society


Credit money: A historical review

1. Stage : Emergence of bank certificates (covered trade bills)

2. Stage : Lending of deposits against debentures

3. Stage : Emergence of “book money” or “credit money” (which is not necessarily covered at 100 %)

New appearance of money: Paper money (to the extent that it is “securitized”)


Credit money: Bullionist Debate

• In18th century‘s England, banknotes, which circulated as money, were issued by private banks. These bearer notes were claims on gold held by the bank.

• In Scotland, banknotes often had a clause that allowed the bank to suspend convertibility. Although banks were legally required to pay the bearer in gold bullion, they could temporarily suspend that conversion.

• Suspension was to respond to the „bullying“ trick whereby banks would hold back notes issued by one bank, and then collectively unload the notes upon that bank to ruin it.



• The Bullionist argument: If banks are not required to convert notes into gold, they will be tempted to issue notes in excess of the gold in their vaults. This will lead to an excess supply of money and hence, a cheapening of the price of money, i.e. inflation.

Henry Thornton 1760-1815

David Ricardo1772-1823



• The Anti-Bullionist argument: It refers to the „Real Bills“ doctrine of John Law and Adam Smith who argued that banknotes are issued only in exchange for merchants' bills of exchange.

• As long as the repayment of these bills is credible („real bills“), the demand for banknotes by commerce is limited by the „needs of trade“; hence even without convertibility, there will never be excess note issue.

Robert Torrens1780-1864


Critique of the Real Bills doctrine

• Thornton (1802) provided the following critique of the Real Bills Doctrine. He asked

– Who guarantees that the demands of commerce were limited?

– Suppose actual capital yields returns are higher than the rate of interest (or discount) charged by the banks: Would not merchants demand an interminable amount of notes - however „real“?

• Bills offered for exchange into notes might not readily be „limited“ as the Real Bills advocates argued. Inflation must thus ensue. Thornton's analysis formed the germ for the later „cumulative process“ of Knut Wicksell (1898).


The Currency-Banking Controversy

The Bullionist debate re-emerged during 1840-50.

• England’s financial system was based on means of payment in the form of gold coins and notes of the Bank of England (founded 1694) and of commercial banks outside London (after 1844 insignificant).

• There were no demand deposits or checks, but there were trade bills and credit on the books of account.


Currency School (George W. Norman, Bank of England, J. Pennington und S. J. Lloyd)

Money = Coins + Notes

Sir Robert Peel (1844): “If I use the word money, it only means the coins of the Kingdom and promissory notes which have to be redeemed, upon request, in gold. With the word paper money I mean exclusively such promissory notes. It does not include commercial papers or bills, nor bankers’ acceptances, nor any other form of paper credits.”

Sir Robert Peel (1788-1850)


Currency School: Motives

• The representatives of this school chose a narrow definition of money (bank notes of commercial banks can only be created if covered by notes of the Bank of England that are covered by gold).

• Although the amount of credit money was = 4 x (notes + coins), its pace of development was seen as being more or less proportional to the expansion or contraction of central bank money.

• There was need for a maximum amount of note issue (as under the gold standard) or else inflation would result.


Quantity theory of money

P y = M V• With real income y fixed and the velocity of

circulation of money V being constant, the expansion or contraction of the money stock M will determine the price level P.

• Thus the Bank of England (and especially the “country banks”) could be rendered responsible for cylical variations of the price level.

• It also provided an argument in favor of a central bank monopoly.


Banking School (John Stuart Mill, John Fullarton und Thomas Tooke)

Why shouln’t “first-class”

commercial bills be as good as money or function at least as

money substitutes? John Stuart Mill1806-73


Banking School

Thomas Tooke: “The greatest part of the country’s wholesale transactions is effected through credit, of which commercial bills function as the visible proof ...”

Consequence: The price level is determined by expenditures (including those effected via credit finance). Monetary policy as interpreted by the quantity theory of money is ineffective.

Thomas Tooke 1774-1858


Ending the debate: Peel’s Act (1844)

• The Bank of England (Issue Department) obtains the monopoly for emitting currency.

• Circulating money of about £14,000,000 has to be “covered” by gold to one third of its value.

• New emissions of currency have to be covered by gold at 100 %.

• The Currency School dominated monetary constitutions all over the world until the beginning of World War I.


Currency-Banking Controvery: Essence

• The controvery is re-ignited in the 20th century with Lord Keynes’ “General Theory”.

• The Neo-currency school emphasizes the function of money as a means of payment and adheres basically to some interpretation of the quantity theory of money.

• The Neo-banking school stresses the function of money as a store of value where the interest rate mechanism comes to bear (Keynes).


Keynes’ basic philosophy

• Money is part of a portfolio of assets and competes with real assets, other financial assets (such as bonds, commercial papers), and human capital.

• Any change in the stock of money will have to lead to a portfolio adjustment which affects the price structure of the portfolio.

• If M > M*, PFA, r, K, since K*(r).


“Quasi-money”

• Close substitutes to money (such as short-term financial assets) can function as a store of value, hence bear interest, and still be “liquid”.

• Such “quasi-money” can be converted into money without high transactions costs.

• The consequence is:It is not sufficient to control the money supply alone; liquidity as a whole has to be monitored.


Liquidity

• The question is, how to define “liquidity”.

• Milton Friedman proposes an “ideal” definition:

• Liquity =

i Ai * wi,

where wi is the “degree of moneyness” of asset Ai. Milton Friedman

1912-Nobel Prize 1976


Empirical definition of money

• Friedman’s approach had an important influence on the empirical and operational definition of money

• The definition of “quasi-money” includes not only central bank money and demand deposits, but also time deposits and savings according to their “degree of moneyness”.


Liquidity as a technology of exchange

• Liquidity depends on social conventions which establish confidence among potential trading partners and facilitate exchange.

• Disobeying to the rules is costly, so money reduces transactions costs and gets an own “intrinsic” value or price.


Liquidity as a technology of exchange

• James Tobin: “Money is like language. English is useful only to the extent that you also understand English”.

James Tobin1918-2002

Nobel Prize 1981


Understanding transactions costs

• Attempts to formalize the transactions motive for holding money interest-free start with an analysis of the transactions costs that occur if financial assets are less liquid.

• The conversion of “quasi-money” into money produces costs that a rational individual tends to minimize.

• But: there are situations, where people would accept “illiquid assets” as a means of payment.


Understanding transactions costs

• In order to obtain a positive value of cash, it is sufficient to prove that cash can purchase goods more cheaply than “quasi-money”.

• In a next step, we could analyze the costs of non-mediated exchange, and the impact of technological change on the value of cash.

• As technology progresses, “quasi-money” will become ever more liquid, i.e. money will become interest-bearing (e.g., CDs in the US).


Evolution of the payment system

• Commodity money

• Fiat money

• Electronic money– Debit cards (EC card, ATM card)– Stored-value card (“money card”)– Electronic cash/checks

• Are we moving to a cashless society?


Money aggregates in Germany

• Two major monetary aggregates:

– Cash– Demand

deposits

Demand deposits

Circulating Cash


Cash and liquidity effect in the Euro area


Measuring money demand

• M1= “narrow money”

• M2= “intermediate” money

• M3= “broad money”


Components of M3

• Repurchase agreement: it is an arrangement whereby an asset is sold but the seller has a right and an obligation to repurchase it at a specific price on a future date or on demand.

• Such an agreement is similar to collateralized borrowing, but differs in that ownership of the securities is not retained by the seller.

• Repurchase transactions are included in M3 in cases where the seller is a Monetary Financial Institution (MFI) and the counterparty is a non-MFI resident in the euro area.


Components of M3

• Money market funds: they are collective investments – which are close substitutes for deposits – and which primarily invest in money

market instruments and other transferable debt instruments with a residual maturity up to one year,

– or in bank deposits which pursue a rate of return that approaches the interest rates on money market instruments.


Money demand in the Euro-area (end of August 2002)

Billion euros In pc of currency in circulation

Currency in circulation

300 100

M1 = “narrow money”

2268 756

M2 = “inter-mediate” money

4766 1589

M3 = “broad money”

5567 1856


The money supply process

• There are four players in the money supply process

– The central bank (ECB, Federal Reserve)– Depository institutions (banks)– Depositors (individuals and institutions)– Borrowers (individuals and institutions)

• The central bank conducts monetary policy to gear the supply of “base money”


The supply of “base money”

• The central bank creates money of highest liquidity: “high-powered” money or “base money”

• She “monetizes” assets by acquiring them and issuing central bank money

• Such assets are gold, foreign exchange, and selected securities

• We assume for a moment, “base money” = currency in circulation


Balance sheet of a central bank

Assets Liabilities

Base money (we simplify:

only cash)

Gold

Forex

Securities


Central bank assets

• Gold and SDR certificates. The latter are issued by the IMF to settle international debt.

• Foreign exchange.– Claims denominated in foreign currency– Claims against foreigners denominated in euros

• Securities of euro area residents. They are denominated in euros (treasury bills and banker’s acceptances).

• Intra-Eurosystem claims.


The Eurosystem

• It comprises the European Central Bank (ECB) and the national central banks (NCBs) of the Member States which have adopted the euro in Stage Three of the Economic and Monetary Union

• There are currently 12 NCBs in the Eurosystem

• The Eurosystem is governed by the Governing Council and the Executive Board of the ECB


The ECB Council

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The Executive Board of the ECB

Meeting of the Executive Board


Eurosystem’s international reserves

• The reserve assets of the euro area consist of the Eurosystem’s reserve assets:– the reserve assets of the ECB– the reserve assets held by the national central banks

(NCBs) of the participating Member States.

• Reserve assets must be under the effective control of the relevant monetary authority

• They consist of highly liquid, marketable and creditworthy foreign currency-denominated claims on non-residents of the euro area, plus gold, SDRs and reserve positions in the IMF


Official reserves (excluding gold) 2001

• Japan and China have accumulated the largest reser-ves in the world

• The Euro-area follows third


Intra-Eurosystem claims or liabilities

Intra-ESCB balances of the participating NCBs with the ECB

(except for the capital of the ECB and positions resulting from the transfer of foreign reserve assets to the ECB)

are described as Intra-Eurosystem claims or liabilities.

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Paul Bernd Spahn, Goethe-Universität Frankfurt/Main1 Lecture 2 Modern Concepts of Money