EC3115 :: L.1 : The basics of money Almaty, KZ :: 4 Sep 2015 EC3115 Monetary Economics Lecture 1: The basics of money Anuar D. Ushbayev International School of Economics Kazakh-British Technical University https://anuarushbayev.wordpress.com/teaching/ec3115-2015/ Tengri Partners Merchant Banking & Private Equity a.ushbayev@tengripartners.com www.tengripartners.com Almaty, Kazakhstan, 4 September 2015
EC3115 :: L.1 : The basics of money - 2 / 24 - Relevant reading Book treatment B. McCallum. (1989). Monetary Economics, Chapter 2. L. Randall Wray. (1998). Understanding Modern Money, Chapters 3 & 7. Must-read articles N. Kiyotaki and J. Moore. (2001). Evil is the Root of all Money, Clarendon Lecture series, Lecture 1. N. Kiyotaki and J. Moore. (2001). Liquidity, Business Cycles, and Monetary. Policy, Clarendon Lecture series, Lecture 2. M. McLeay, A. Radia and R. Thomas. (2014) Money in the modern economy: an introduction, Bank of England Quarterly Bulletin, Quarter 1.
EC3115 :: L.1 : The basics of money - 3 / 24 - Must-read articles (cont.) N. Kocherlakota. (1998). Money is Memory, Journal of Economic Theory, Vol. 81, No. 2, pp. 232-251. R. Radford. (1945). The Economic Organisation of a P.O.W. Camp, Economica, New Series, Vol. 12, No. 48, pp. 189-201 A. Mitchell Innes. (1913). What is Money?, The Banking Law Journal, May 1913, pp. 377 408.
EC3115 :: L.1 : The basics of money - 4 / 24 - What is money? Section 1 What is money?
EC3115 :: L.1 : The basics of money - 5 / 24 - What is money? Why study monetary economics? Modern societies live in monetary, as opposed to barter, economies 1. This means that the study of money, and the effects of monetary operations on economic variables such as prices, wages, interest rates, employment, consumption and production is of utmost importance to economists. A capitalist economy [...] [is] an integrate production, trading, and wealth owning system, with a structure of financial claims and commitments, [that] operates through real world and irreversible time. Hyman Minsky, (1983), Pitfalls due to financial fragility, In Weintraub, S. and M. Goodstein (eds.) Reaganomics in the Stagflation Economy, University of Pennsylvania Press. 1 In fact, there is very little by way of evidence to support the standard textbook theories that barter economies with many different commodities exchanging hands as media of exchange have ever existed naturally (cf. Wray (1998)).
EC3115 :: L.1 : The basics of money - 6 / 24 - What is money? Lack of trust as a necessary condition for the existence of money The bank s IOU is used by me and the dentist to lubricate our transaction. Why? Because the bank s IOU can freely circulate around the economy. Like blood, it is liquid. In fact, it is functionally equivalent to cash. But, unlike cash, it doesn t come from outside the private system, it comes from inside. For this reason, bank debt is called "inside money". Quantitatively, inside money dwarfs outside money, by a ratio of around 30:1 in Britain today, depending on how you measure it. That is, circulating private debt is extremely important, much more important than cash. Nobuhiro Kiyotaki and John Moore, (2001), Evil is the Root of all Money, Clarendon Lecture series, Lecture 1.
EC3115 :: L.1 : The basics of money - 7 / 24 - What is money? Lack of a record of all transactions as a necessary condition for the existence of money Memory is defined as knowledge on the part of an agent of the full histories of all agents with whom he has had direct or indirect contact in the past. Money is defined as an object that does not enter utility or production functions, and is available in fixed supply. The main proposition is that any allocation that is feasible in an environment with money is also feasible in the same environment with memory. Depending on the environment, the converse may or may not be true. Hence, from a technological point of view, money is equivalent to a primitive form of memory. Narayana Kocherlakota, (1998), Money is Memory, Journal of Economic Theory, Vol. 81, No. 2, pp. 232-251.
EC3115 :: L.1 : The basics of money - 8 / 24 - What is money? A monetary economy is characterized by agents trading with each other by creating and exchanging IOUs. With more depth and sophistication, the exchange of IOUs becomes the dominating element of the process, while redemption gives up significance. In a monetary economy, the IOUs themselves i.e. money are just a way of keeping the score. Traditional economic analysis, unfortunately, made a leap from the above fact to the assertion that money is neutral, i.e. that changes in the money supply do not affect the real economy (production, trade and consumption), but only the nominal quantities (prices, wages, interest and exchange rates). The view was that while a change in the quantity of money can affect the economy in the short run, eventually it will settle at the same long term equilibrium as if the quantity of money didn t change. This, of course, almost disregards the effects of disturbances to the monetary conditions on economic activity.
EC3115 :: L.1 : The basics of money - 9 / 24 - What is money? It is easy to see that this is absurd when taken to extreme: if money was indeed neutral, then the real economy would operate equally well, regardless of whether it was on a gold standard or in a hyperinflation. The economy is supposed to levitate to a true equilibrium despite short-term shocks. However, as Irving Fisher put it in his famous Debt-deflation theory of Great Depressions (1933): equilibrium is seldom reached and never long maintained. In real life, we observe that disequilibrium states (i.e. states where systemic variables exhibited markedly off-equilibrium values) and behaviour are not only entirely possible, but are even common.
EC3115 :: L.1 : The basics of money - 10 / 24 - What is money? In real situations, a monetary disturbance such as Friedman s famous helicopter drop (to which will return in detail later on in this course) will, with a high probability, affect economic agents perceptions and expectations. These agents will then adjust their patterns of economic activity based on these changes to perceptions, pulling the economy away from the old equilibrium trajectory. This justifies short-term non-neutrality of money. The effects, however don t simply stop there, once we acknowledge the existence of path-dependent properties of economic and social processes, i.e. that history matters 2. 2 If you re interested, read Paul Davidson s work on ergodicity in economics e.g. Ergodicity and Non-Ergodicity in Economics, or ask me during the break.
EC3115 :: L.1 : The basics of money - 11 / 24 - What is money? If the additional money balances generated by the positive changes to the money supply are invested into the economy based on agents altered perceptions, then capital goods, that otherwise would not have been created, can be created thus changing the long-term equilibrium itself. This observation gains even more importance once we realize that banks, commonly modeled in traditional economic analysis as simple intermediaries that take money from John and lend it to Peter, are in fact able to create money and purchasing power ex nihilo, without any meaningful consideration to the level of bank reserves 3. 3 We will return to this particularly important aspect of the modern banking system later in this course.
EC3115 :: L.1 : The basics of money - 12 / 24 - What is money? Coming back, exactly what is money? In theory, anything can be money. Your food, cigarettes, cars, perhaps your socks. In reality, few things are. As the famous American economist Hyman Minsky some of whose insights we will try to cover in later parts of this course once put it in his great book Stabilizing an Unstable Economy (1986), everyone can create money, the problem is to get it accepted There are several layers of money: coins, notes and the reserve balances at the central bank are creatures of the state, all other money comes from the private sector. Unlike in the mainstream macro models, most money is thus endogenous (as opposed to exogenous, e.g. Friedman s helicopter drop), and is created in the course of normal operations of a capitalist economy.
EC3115 :: L.1 : The basics of money - 13 / 24 - What is money? To quote Minsky (1986) again: Money is unique in that it is created in the act of financing by a bank and is destroyed as the commitments on debt instruments owned by banks are fulfilled. Because money is created and destroyed in the normal course of business, the amount outstanding is responsive to the demand for financing. This is the reality of modern monetary economies, and it is drastically different to the envisaged myths such as the money multiplier, to which we will return later. Of course, different types of money are have different liquidity. In Kazakhstan, the most liquid asset is the national currency 4 issued by the National Bank of Kazakhstan the tenge. It is followed by financial claims generated by the government (e.g. bonds) and by the private sector (e.g. bank deposits). 4 being cheeky here as the most liquid asset is, sadly, the US Dollar.
EC3115 :: L.1 : The basics of money - 14 / 24 - What is money? Functions and hierarchy of money Money has several functions: a medium of exchange; a unit of account; a store of value. Money has a hierarchical architecture: currency is a promise to pay gold (or to extinguish tax liabilities); deposits are promises to pay currency; securities are promises to pay deposits. To quote economists at the Bank of England, state-backed monies receive their value from the fact that states retain the power to fix the nominal meaning of their unit of account and can choose to accept only claims denominated in that unit of account in discharge of tax obligations 5. 5 http://bankunderground.co.uk/2015/08/21/monies-joining-economic-and-legalperspectives/.
EC3115 :: L.1 : The basics of money - 15 / 24 - What is money? A prince, who should enact that a certain proportion of his taxes should be paid in a paper money of a certain kind, might thereby give a certain value to this paper money. Adam Smith, (1776), An Inquiry into the Nature and Causes of the Wealth of Nations, Oxford University Press, p. 328.
EC3115 :: L.1 : The basics of money - 16 / 24 - What is money? The modem state can make anything it chooses generally acceptable as money... It is true that a simple declaration that such and such is money will not do, even if backed by the most convincing constitutional evidence of the state s absolute sovereignty. But if the state is willing to accept the proposed money in payment of taxes and other obligations to itself the trick is done. Everyone who has obligations to the state will be willing to accept the pieces of paper with which he can settle the obligations, and all other people will be willing to accept these pieces of paper because they know that the taxpayers, etc., will accept them in turn. Abba Lerner, (1947), Money as a Creature of the State, American Economic Review, Vol. 37, No. 2, pp. 312-17.
EC3115 :: L.1 : The basics of money - 17 / 24 - What is money? [T]he public demands the government s money because that is the form in which taxes are paid. It is not a coincidence that the modem state uses the same valuta money in its apocentric payments that it accepts in epicentric payments it uses taxes as a means of inducing the population to supply goods and services to the state, supplying in return the money that will be used to retire the tax liability. In the modem economy, it appears that taxes are paid using bank money, but analysis of reserve accounting shows that tax payments always lead to a reserve drain (that is, reduce central bank liabilities), so that in reality only the government s money is definitive (finally discharging the tax liability). Randall L. Wray, (1998), Understanding Modern Money.
EC3115 :: L.1 : The basics of money - 18 / 24 - What is money? Quick test Money is: A) anything that is generally accepted in payment for goods and services or in the repayment of debt. B) a flow of earnings per unit of time. C) the total collection of pieces of property that are a store of value. D) always based on a precious metal like gold or silver. The difference between money and income is that: A) money is a flow and income is a stock. B) money is a stock and income is a flow. C) there is no difference money and income are both stocks. D) there is no difference money and income are both flows.
EC3115 :: L.1 : The basics of money - 19 / 24 - What is money? Of moneys three functions, the one that distinguishes money from other assets is its function as a A) store of value. B) unit of account. C) standard of deferred payment. D) medium of exchange. Increasing transactions costs of selling an asset make the asset A) more valuable. B) more liquid. C) less liquid. D) more moneylike.
EC3115 :: L.1 : The basics of money - 20 / 24 - Quick glance at failures of mainstream macro Section 2 Quick glance at failures of mainstream macro
EC3115 :: L.1 : The basics of money - 21 / 24 - Quick glance at failures of mainstream macro As we noted last time, in traditional analysis real money balances were simply added to the utility function ad hoc and basically never mentioned again. This failure to understand and model money adequately had implications for many macroeconomic predictions e.g. by the RBC school after the 2008 crisis: 1. Increases government borrowing would lead to higher interest rates on government debt because of crowding out". 2. Increases in the money supply would lead to inflation. 3. Fiscal stimulus has zero effect in an ideal world and negative effect in practice (because of decreased confidence). Let s see how that played out.
EC3115 :: L.1 : The basics of money - 22 / 24 - Quick glance at failures of mainstream macro Govt. borrowing vs. interest rates
EC3115 :: L.1 : The basics of money - 23 / 24 - Quick glance at failures of mainstream macro Monetary base vs. inflation
EC3115 :: L.1 : The basics of money - 24 / 24 - Quick glance at failures of mainstream macro Fiscal multipliers