THE RISE AND FALL OF MONEYChapter 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 12th 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 18th & 19th 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 MoneyIn 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 Money1. Medium of Exchange – Token that can be offered as

a payment for goods.2. Unit of Account – All goods will have a value in

money and, thus, can be used to measure all goods3. Store of Value – If money is to be accepted for

goods today it must have durable value. (Money is an Asset).

Categories of Money1. Definitive MoneyDefinitive 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.

• 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.

Central Bank Balance SheetMonetary Liabilities

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

Categories of Money2. 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 Currency + Checking Acct.

M2 M1 +Savings Acct.+ “More Liquid” Time Deposit

M3 M2 + “Less Liquid” Time Deposit

M1

M2

M3

Hong Kong Monetary Aggregates1. Overwhelming

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

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

3. Only about 6% of M2 is currency.

Legal Demandtender notes deposits

and coins within hands licensedof public banks M1323,137 758,338 1,081,475

NCDsSavings Time issued bydeposits deposits licensed

with with bankslicensed licensed and held

M1 banks banks by public M21,081,475 2,126,496 1,817,200 115,110 5,140,282

NCDsissued by

RLBsDeposits & DTCs

with RLBs and heldM2 & DTCs by public M3

5,140,282 10,838 0 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.

• 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.

1CashMoney Cash Deposits Deposits

Cash ReservesBase Cash ReservesDeposits Deposits

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

-5

0

5

10

15

20

25

30

35

1961

1965

1969

1973

1977

1981

1985

1989

1993

1997

2001

2005

2009

OECD East Asia Subsaharan Africa Latin America

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Quantity Theory• Simplest monetary theory is the Quantity Theory of Money.• Purchasing power of money is equal to the quantity

of money (Mt) times the speed of circulation (V, # of transactions)

• Purchasing power means # of goods (Yt) multiplied by price per good (Pt)

Mt * Vt = Pt * Yt

Rule of Thumb

Z X Yt t t t t tZ X Y g g g

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

1

1

Z t tt

t

Z Zg

Z

Money and Inflation

M Y Pt t t t tg g g

• Assuming stable velocity

• 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

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

0.18

0.2

0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18

Average Money Growth

Ave

rag

e In

flat

ion

Rat

e

Monetary TargetsDuring the battle against inflation, many central banks would set targets for the growth of money. 1975

19771979

19811983

19851987

19891991

19931995

19970

1

2

3

4

5

6

7

8

9

10

Bundesbank Money Growth Rate Target

Lower BoundUpper 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.

Monetary BaseMoney

GDP

?

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

Unpredictable relationship between total money supply and

economic activity. Velocity is volatile

Link

Link

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Quantitative Targets

•

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.