THE RISE AND FALL OF MONEY

Chapter 2

MONEY AS TECHNOLOGY

Specialization and Exchange

• • • In a varied economy, producers will specialize in production of certain goods, yet consume a diverse set of goods which presents of problem of allocation of goods. Barter – Cumbersome. Difficult to overcome the double coincidence of wants. Anthropologists find no evidence of barter based economies.

Gift-giving Ritualized voluntary exchanges. Informal debts. I give you a stone axe today under the presumption that you will give me a club tomorrow. Informal debts.

Problem with Informal Debts

• As tribe gets bigger and economy becomes more complex, hard to keep track of value of people’s obligations.

• Exchange of tokens of value can help people hold record obligations. “Money as memory.” • Primitive moneys usually objects of some value (often decorative).

Necessary Characteristics of Money

• • • • • Acceptable (Usable by most traders) Standardized Quality Durable Valuable Relative to Weight Divisible By 2500 BCE, precious metal rings were being used as money in Egypt. British Museum

Evolution of Money:

Money is a technology that has advanced in sophistication over time. • Governments began minting coins for standardization (ca. 700 B.C.). According to Herodotus, ancient kingdom of Lydia had first coins made of electrum Oldest Coins

•

Paper Money

Coins in China are traditionally made of bronze which are heavy relative to value. Tang dynasty merchants deposited coins at pawn shops and traded in receipts (900 AD).

• In 12 th century, Song empire gov’t takes over money printing system and issues first national paper currency. Oldest Paper Money, 1375

Fiat Money

• Fiat Money intrinsically worthless item that can be used as money by government declaration that it is legal tender. • Government settles contracts, can declare a contract settled if fiat money payment is made.

• Tax bills are settled when fiat money payment is made.

• Currency can be used for trade since it will have future value. • Money during Yuan dynasty not backed by precious metals, only Khan’s decree.

Self Interested Government may have incentives to increase money supply

.

• Government generates revenues by printing new fiat money (referred to as seignorage). • Yuan and Ming Dynasty printed money overly rapidly dissipating its value. • “ in 1380, one guan was worth 1000 copper coins, in 1535, one guan valued merely 0,28 copper coin!” • Paper money became unpopular and was discontinued

Silver dollar

• Paper money introduced in China due to shortage of metals. • After Spanish conquest of Mexico/South America & Philippines, trans-Pacific trade introduced large quantities of silver to China.

• Spanish dollar and later Mexican dollar became trading standard in 18 th & 19 th century Asia (and USA!). • Initially, 1 Yuan = 1 Yen = 1 Mexican dollar

Hong Kong Dollar

Link • • • • Hong Kong mint began officially coining dollar equivalent in 1860’s. Standard “British Trade Dollar” defined in 1895 by act of Parliament. Straits Settlements begin coining their own currency in 1903 so British Trade dollar becomes Hong Kong Dollar.

In 1934, US gov’t begins heavy buying of silver leading to shortage of coins in Asia. Currency Board: Sterling backed Notes of HSBC, Mercantile Bank [later merged w/ HSBC], Standard Chartered [and later Bank of China] were defined as legal tender in 1935.

Evolution of Money

In more advanced societies with sophisticated banking systems, broad money may be used for transactions. • Checks: Paper promises to pay definitive money on demand. • Electronic Transfers: Funds can be transferred from account to account in banking system. • Debit Cards and ATM Cards can be used to transfer funds to definitive money or in direct exchange for goods.

MEASURING MONEY IN THE MODERN WORLD

Defining Money

• Many financial assets and transaction flows.

• What precisely is Money? • Money has three distinct aspects. • In practice, money is defined as cash plus certain bank accounts.

Aspects of Money

1.

2.

3.

Medium of Exchange

a payment for goods.

– Token that can be offered as

Unit of Account

– All goods will have a value in money and, thus, can be used to measure all goods

Store of Value

– If money is to be accepted for goods today it must have durable value. (Money is an Asset).

•

Categories of Money

1. Definitive Money

Definitive Money (sometimes known as monetary base): Money that can be used to finalize transactions.

•

Currency+ Reserves

• • Banks keep reserve accounts at central bank in HK these are called Clearing Balances.

When check/electronic transfer requires payment from one bank to another, the transaction is finalized with a debit of one banks account and a corresponding credit to another.

Central Bank Balance Sheet Monetary Liabilities

• Currency: Paper Money is typically issued by central bank. Coins are sometimes (as in HK) • Currency Held by Non Bank Public • Currency Held by Banks aka “Vault Cash”: includes money ATM machines.

• Deposits of Banks: Banks keep accounts at the central bank to facilitate payments and meet regulatory requirements.

An average of 4.6% of currency in circulation in USA is vault cash. In HK, 7.5%

Categories of Money

2. Broad Money

Broad Money: A set of assets, typically some form of bank deposit, which can be used for transactions through some process.

•

Checking Accounts,

•

Savings Accounts

•

Liquid Time Deposits and CD’s

19

Categories of Broad Money

M1 M2 M3 M1 Currency + Checking Acct.

M2 M1 +Savings Acct.

+ “More Liquid” Time Deposit M3 M2 + “Less Liquid” Time Deposit

Hong Kong Monetary Aggregates 1.

2.

3.

Overwhelming quantity of funds held by fully licensed banks and are counted as M2.

Restricted License Banks & Deposit Taking Companies deposits are in incremental M3 but are small.

Only about 6% of M2 is currency. Legal tender notes and coins in hands of public 323,137 M1 1,081,475 Demand deposits with licensed banks 758,338 M1 1,081,475 Savings deposits with licensed banks 2,126,496 Time deposits with licensed banks 1,817,200 NCDs issued by licensed banks and held by public 115,110 M2 5,140,282 Deposits with RLBs & DTCs 10,838 M2 5,140,282 NCDs issued by RLBs & DTCs and held by public 0 M3 5,151,120 HKMA Statistics HK$Millions

Money Supply vs. Monetary Base

Monetary Base * Money Multiplier = Money Supply

Money Multiplier

• The money multiplier can be derived by the ratio of money to the monetary base.

Money Base



Cash



Cash



Deposits Reserves Cash Deposits

 1 

Cash Deposits



Reserves Deposits

• As long as the reserve ratio is less than 1, the money multiplier is greater than 1. • Multiplier is decreasing in reserve-deposit ratio and decreasing in cash-deposit ratio.

Fractional Reserve Banking

• Banks keep only a fraction of any deposits they receive on hand in the form of vault. The rest is used to acquire other assets, especially loans.

• Regulatory Requirements – Some regulatory regimes have minimum reserve levels.

• Most developed economies have either rr= 0 (e.g. HK) or modern banking techniques make them non binding.

Reserve Ratio = Required Reserves Ratio + Excess Reserves Ratio (Reserves/Deposits) = rr + ER/Deposits

Monetary Policy China PBoC uses frequent changes in rr to manage liquidity in the banking system. China's Evolving Reserve Requirement, BIS

WHY DID WE CARE ABOUT MONEY AND WHY DID WE STOP

Money and Inflation

• Money is a tool for transactions and like all tools has been subject of technological advance (from beads to Octopus cards).

• However, degree to which society can take advantage of this technology depends on policy choices particularly regarding inflation.

Great Inflation of the 70’s & 80’s

CPI Inflation, % Annual Rate 35 30 25 20 15 10 5 0 -5 19 61 19 65 19 69 19 73 19 77 19 81 19 85 19 89 19 93 19 97 20 01 20 05 20 09 OECD East Asia Subsaharan Africa Latin America

28

Quantity Theory

• Simplest monetary theory is the Quantity

Theory of Money.

• Purchasing power of money is equal to the quantity of money (M

t

) times the speed of circulation (V, # of

transactions)

• Purchasing power means # of goods (Y

t

) multiplied by price per good (P

t

)

M t * V t = P t * Y t

Rule of Thumb

• Rule of Thumb The growth rate of product is approximately equal to the sum of the growth rates of the elements of a product.

Z t



t

 

t g t Z



g t X



g t Y g t Z



Z t



Z t

 1

Z t

 1

Money and Inflation

• Assuming stable velocity

g t M



g t Y

 

t



t



g t P

• Inflation occurs when money growth speeds ahead of output growth. The unbounded creation of fiat money leads to inflation which ultimately will make the money worthless.

Money & Inflation: 1975-1994

Inflation & Money OECD Countries

0.2

0.18

0.16

0.14

0.12

0.1

0.08

0.06

0.04

0.02

0 0 0.02

0.04

0.06

0.08

0.1

Average Money Growth

0.12

0.14

0.16

0.18

Monetary Targets

During the battle against inflation, many central banks would set targets for the growth of money.

1 0 5 4 3 2 10 9 8 7 6

Bundesbank Money Growth Rate Target

Lower Bound Upper Bound Bundesbank targeted Base 1975-1988, target M3 from 1988-1998 Link

34

Money Target Transmission Mechanism

• Breakdown in stable relationship between money supply and the economy has made this approach less popular in developed economies.

Unpredictable relationship between bank reserves and total money supply. Multiplier is volatile.

?

Unpredictable relationship between total money supply and economic activity. Velocity is volatile

?

Money Monetary Base GDP

Link

Link

Quantitative Targets •

37

Link Back

Money Free World

• New payment mechanisms make paper less important.

• If money is memory, why do we need money when the internet remembers everything.

• Currency: September 4, 2014 345,817 million Pop. 7.15 million • About 50k per man, woman and child. How much is in your wallet? • Money is anonymous.