Money

In any society, money is the commodity or token that serves as a medium of exchange.

• gold coins (in medieval Europe)
• cowrie shells (in West Africa)

The major historical types of money are

• Commodity moneys
  • metallic coin
  • other commodities
• Fiat money
• Fiduciary money
  • bank notes
  • checking accounts

We say traditionally that money has four major functions. It is a

• medium of exchange
• unit of account
• standard of deferred payment
• store of value

Credit Cards

What is a credit card account? It is a line of credit, that is, a contract between you and a lender by which the lender will lend you money at fixed terms whenever you want to borrow.

Lines of credit can be very useful from many points of view, but they are not money.

• Fred, as a goldsmith, he has a strong vault.
• He stores the gold owned by other citizens for a small fee. (A business that stores money in its vaults for a fee is called a bank of deposit.)
• Fred gives his customers receipts for their deposits.
• After a while, some of Fred's customers use receipts for the gold they have deposited to make payments and settle debts.

Fred's receipts have become "banknotes" and the Bank of Fred is now a "Bank of Issue."

One day Ronald the Peasant comes in to ask for a loan. Ronald is doing pretty well, and wants to buy a second ox so he can use a two-ox team to cultivate a larger field. Fred doesn't have any gold to loan -- so he writes out some bank-notes and gives them to Ronald the Peasant as a loan. The ox-seller accepts the bank-notes in payment for the ox, and at the end of the year, Ronald sells some of his crop for bank-notes, and uses those bank-notes to repay the loan with interest. Fred has created money out of nothing (but trust)! And creating money is a profitable business.

If many customers want to redeem their bank notes at once, the bank will not be able to comply. This is a "run" on the bank. The Bank of Fred will then be unable to redeem its notes, faith in them will collapse, and the bank-notes will cease to be money.

Fred has to be careful to keep enough gold coins in reserve to avoid this danger. Suppose experience has taught Fred that he needs to keep one Florin in the vault for every three banknotes he has issued. That is, Fred has adopted a reserve ratio -- a ratio of reserves to money issue -- of 1/3.

This determines how much money Fred can issue. If Fred has 1,000 Florins in the vault, then he can issue 3,000 Florins of bank-notes. If someone deposits another 100 Florins, Fred would then be able to issue 300 new bank-notes. Fred would give 100 to the new depositor as receipts for his deposits, but the other 200 Florins would be available for Fred to loan out and so increase his profits.

So much for the story. How true is it?

Among the real early bankers were the Medici, who started out as medical doctors, and ended as monarchs, and the Fuggers, who owned a silver mine.

But it gives an accurate portrayal of the workings of a bank of issue in a system of fiduciary money. The Bank of Fred is a good example of a bank of issue.

By the 1700's, bank notes (called "fiduciary money") circulated widely in Western Europe, along with metallic coins. However, the Napoleonic Wars created problems.

After the war, the government brought in a consultant -- gentleman-economist David Ricardo. Ricardo designed a new, somewhat more streamlined monetary system.

In the new monetary system, paper Pound notes were the main medium of exchange. They would be issued only in proportion to gold bullion held by the Bank of England, and redeemable for bullion in large quantities, mostly for international trade. This is the "classical" gold standard of the nineteenth century -- strictly speaking, not a gold coin system but a paper money system with the paper (fiduciary) money exchangeable for gold bullion.

During the 19th century, then, Britain was "on the gold standard." America was not. America was never on any very consistent monetary standard at all. In 1913, Congress established the Federal Reserve System (the "fed") to be the American central banking system -- the "bankers' bank" and main control on the monetary system.

The Federal Reserve system consists of 12 Banks for 12 districts in different parts of the country.

The federal reserve banks are also bankers' banks. By controlling the amount of reserves, and regulating the reserve ratio, the Federal Reserve System controls the American Money Supply.

Something similar could be said about most developed economies. In the modern world, money is not a commodity but a service provided by banks.

This causes some concern. People worry about whehter money is "based on" some commodity, and what commodity. But why worry?

The answer comes in two stages.

• From many points of view, the effectiveness of the monetary system requires a fairly stable average price level. As we have seen in a previous chapter, inflation can and sometimes has destroyed the purchasing power of a monetary unit very rapidly.
• The danger of inflation was seen as being connected to the quantity of money in circulation by way of the "quantity theory of money."

Many economists rely more on a broader concept of money known as M2, which includes savings deposits, small time deposits (a lot like savings deposits) and money market fund balances. Table 2 shows the makeup of M2 in June, 1996:

There are other, still broader concepts of money, that include other kinds of bank obligations, but we shall not go into more detail here.

• Checking accounts are money, fiduciary money created by banks
• Creation of fiduciary money is limited by the supply of bank reserves
• Bank reserves are obligations of the Federal Reserve, including deposits and vault cash
• Checks are "cleared" by the Federal Reserve by transferring deposits from the bank that issued the check to the bank that deposits it
• A bank that has excess reserves may be able to create money and loan it, by establishing a checking account in the amount of the loan
• Nevertheless, banks have to limit their lending to allow for "clearing" through the Federal Reserve.
• An increase in reserves, for example by importing currency from abroad, increases the total money supply by a multiple of the increase in reserves
• The multiple is the inverse of the required reserve ratio.

Increasing the Money Supply

1. The FOMC buys bonds.
2. It pays for the bonds with a check on the Fed.
3. The check is an addition to bank reserves.
4. With more reserves, banks create more money.

Decreasing the Money Supply

1. The FOMC sells bonds.
2. The check written to pay for the bonds is cleared through the Fed.
3. This reduces bank reserves.
4. With less reserves, banks must cut back on money creation.

p = M*V/RDGP

This is illustrated by Figure 1

An increase in the money supply is shown below:

Figure 2: Increasing the Money Supply

The new money supply is shown in light green. We have an increase in the money supply, and the result is that the price level rises from p to p'.

Interest and the Demand for Money

Another word for the convenience of money is "liquidity." The more convenient, safe and flexible an asset is, as a means of payment, the more "liquid" we say it is. Money is the most "liquid" of assets.

Modern central banks, like the American Fed, base their operations on the idea that the demand for liquidity rises when the interest rate (on non-liquid assets like bonds) drops.

The Liquidity Preference Curve

Con: On the other hand, gold is not perfect as a monetary system either. Historically, new discoveries have propelled vast inflations. Governments have clipped and adulterated the coins, and (in more modern history) have adopted the gold standard only to drop it when it is no longer politically convenient. If we have a government with enough self-discipline to stick to a rigorous gold standard, it will probably do equally well with a managed bank-money system. Finally, a real cost of a gold coin system is the resource cost of "digging it up in Nevada to bury it again in Fort Knox." While a managed bank money system has costs too, at least the costs of digging are avoided.

• Modern money is a token, not a commodity with a value in non-monetary use. The value of money is what it will buy -- and as modern money will buy a range of goods gold coins could not have bought, it is, in that sense, far more valuable.
• Modern money is a mixture of fiduciary money and fiat money.
• Fiduciary money is a service produced by banks, so-called "banks of issue."
• These banks create money at some multiple of the reserves they have available to pay claims.
• The quantity theory of money teaches us that it is important that the quantity of money be controlled and not increase too fast.
• In our system, money creation is controlled and managed by the central banks, such as the Federal Reserve System.
• The Central Banks control the creation of money by regulating bank reserves and controlling the amount of reserves available.