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					             Lecture 2




Modern Concepts of Money




Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   1
             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.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main             2
           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.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main        3
             Stone “money” of the island of Yap




Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   4
              What is money ?



   “Money is what money does.
 Money is defined by its functions”
          (John Hicks).                                John Hicks
     Money is an information                             1904-89
processing technology that aims at
             reducing
uncertainty and establishing trust.


 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main                5
             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

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   6
               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


  Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   7
                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!
   Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   8
             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.“

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main             9
             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

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main            10
             Store of value

  • 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”

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   11
             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


Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   12
              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”)



 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main                   13
              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.


 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main       14
               Credit money: Bullionist Debate

• 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                                   Henry Thornton   David Ricardo
                                                           1760-1815      1772-1823
  hence, a cheapening of
  the price of money, i.e.
  inflation.
  Paul Bernd Spahn, Goethe-Universität Frankfurt/Main                                15
                  Credit money: Bullionist Debate
• 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               Robert Torrens
  note issue.                                                1780-1864




     Paul Bernd Spahn, Goethe-Universität Frankfurt/Main                    16
                 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).
    Paul Bernd Spahn, Goethe-Universität Frankfurt/Main        17
                 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.

    Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   18
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                         Sir Robert Peel
                                                                 (1788-1850)
 does not include commercial papers
 or bills, nor bankers‟ acceptances,
 nor any other form of paper credits.”

    Paul Bernd Spahn, Goethe-Universität Frankfurt/Main                          19
                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.
   Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   20
                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.

   Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   21
           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 Mill
                                                                     1806-73




Paul Bernd Spahn, Goethe-Universität Frankfurt/Main                                 22
                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
Thomas Tooke
                                            (including those effected via credit
  1774-1858                                 finance). Monetary policy as
                                            interpreted by the quantity theory
                                            of money is ineffective.
   Paul Bernd Spahn, Goethe-Universität Frankfurt/Main                         23
             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.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   24
              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).

 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   25
              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).


 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   26
              “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.



 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   27
              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



 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main                      28
              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”.

 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   29
              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.


 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   30
              Liquidity as a technology of exchange

• James Tobin:
  “Money is like
  language.
  English is useful
  only to the
  extent that you
  also understand                                       James Tobin
                                                         1918-2002
  English”.                                            Nobel Prize 1981



 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main                      31
              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.




 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main           32
              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).




 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main       33
               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?



  Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   34
              Money aggregates in Germany

                                                       Circulating Cash

• Two major
  monetary
  aggregates:                                          Demand deposits
     – Cash
     – Demand
       deposits


 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main                      35
             Cash and liquidity effect in the Euro area




Paul Bernd Spahn, Goethe-Universität Frankfurt/Main       36
                  Measuring money demand



• M1= “narrow
  money”
• M2=
  “intermediate”
  money
• M3= “broad
  money”




     Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   37
              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.


 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main        38
              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.

 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   39
Money demand in the Euro-area (end of August 2002)

                                                  Billion euros   In pc of currency
                                                                    in circulation
Currency in                                           300               100
circulation
M1 = “narrow                                          2268              756
money”
M2 = “inter-                                          4766             1589
mediate” money
M3 = “broad                                           5567             1856
money”


Paul Bernd Spahn, Goethe-Universität Frankfurt/Main                                   40
              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”

 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   41
              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



 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   42
Balance sheet of a central bank


         Assets                                         Liabilities


     Gold
                                              Base money (we simplify:
                                                       only cash)
    Forex


 Securities


 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main                     43
              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.




 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main    44
              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

 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   45
             The ECB Council




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                                                              benötigt.




Paul Bernd Spahn, Goethe-Universität Frankfurt/Main                                46
              The Executive Board of the ECB

Meeting of the Executive Board




 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   47
              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



 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main                  48
              Official reserves (excluding gold) 2001



• Japan and China
  have accumulated
  the largest reser-
  ves in the world
• The Euro-area
  follows third


 Paul Bernd Spahn, Goethe-Universität Frankfurt/Main    49
             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.

Paul Bernd Spahn, Goethe-Universität Frankfurt/Main   50

				
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