Money and Banking

An International Text

Robert Eyler

• Publisher: Routledge
• Year: 2009
• ISBN:
  9781135283025
• Edition: 1
• Topic: Betriebswirtschaft
• Subtopic: Business allgemein

This book focuses on the core issues in money and banking. By using simple applications for anyone that understands basic economics, the lessons in the book provide any student or reader with a background in how financial markets work, how banks as businesses function, how central banks make decisions, and how monetary policy affects the global economy.

Money and Banking is split into sections based on subject matter, specifically definitions and introductions, financial markets, microeconomic issues, macroeconomy policy, and international finance. It also covers:

- derivative and currency markets

- the microeconomics of banking

- trade and currency movements

- asymmetric information and derivative markets

- the future of financial markets and their participants

By providing a mix of microeconomic and macroeconomic applications, focusing on both international examples and open economy macroeconomics, this book reduces the minutiae seen in competing books. Each chapter provides summaries of what should be learned along the way and why the chapter's topic is important, regardless of current events. For undergraduate business, economics or social science students otherwise, this book is a concise source of information on money, banking and financial markets.

1
Understanding money

Introduction

Money has been identified as the root of all evil, something that talks, and the ether upon which commerce takes place. In the modern world economy, money in a cash form has become less important. But money itself continues to symbolize power, authority and an ability to consume. This text has three major goals. To enhance the reader’s financial and economic literacy is the first and foremost goal. Financial crises come and go, and have depths that are sometimes shallow and other times deep and very depressing. They are natural occurrences of markets gone wrong, of business cycles becoming disrupted by unforeseen events, and of bad policies. Understanding why policy takes place, how the markets are formed in the first place and why equilibrium is a natural pull for human interactions is important to understanding the economy from all angles.

The second goal is to understand the importance and necessity of developed economies to embrace less-developed ones. While this is not a text about economic development, it is one of how economies interact with each other financially. International finance takes place in global markets, connecting diverse institutions and economies to each other because of comparative advantage. The natural tendency to trade delivers a natural tendency to provide financing. This connection provides readers and students of money and banking with the tools to analyze both domestic and international events as economists do.

The third is to illuminate the importance of economics. Economists are generally physicists trapped in the body of a historian, political scientist, sociologist or psychologist. As a result, economists tend to put mathematical formulae and geometric figures to almost all human interactions and thoughts. Concepts of opportunity cost, insurance, central banking, net interest margin, spreading versus hedging risk, the difference between fiscal and monetary policy, and international finance are interconnected and make the world go round. This text begins with defining money and ends with the future of the markets for money, including central banking and monetary policy.

The essence of money

Money, for all of its pundits and pursuers, is the ether upon which commerce flows. It is critical to understand the origins of money and why it is used in economic transactions to fully understand economics as a science. Money’s genesis follows the beginnings of civilization. Regardless of money’s state as coinage, commodity or otherwise, the use of money provides efficiencies in trade. The logical alternative is barter, an economic system where two parties agree to make a transaction from a double coincidence of wants. The classic example is Jack and the Beanstalk: Jack trades two cows for three magic beans. While Jack may agree that two cows are worth three magic beans, he may be the only one of that opinion beyond the owner of the magic beans. Think of how inefficient that is in the aggregate! In a barter system, markets are made with every single transaction, as time is wasted determining the value of a good or service in each trade. When money is used as a medium of exchange, two cows may seem far superior in value than the three beans to a market full of buyers. What happens if Jack throws those beans into the ground and nothing comes up?

In a monetary economy, the double coincidence of wants is eliminated, and market activity determines prices for all goods in terms of how much money the seller asks in exchange for the good and how much money the buyer is willing to pay, a classic interaction of supply and demand from economic principles. A seller asks for certain prices, thinking about other goods to be purchased with revenue from the sale; the buyer pays only what he feels the goods are worth, and naturally does this by comparison to alternatives. The idea of opportunity cost, the cost of the best forgone alternative, is a major part of understanding why barter does not work as efficiently and why money is a much better medium for exchange. There is an additional cost of barter which does not exist with money. But money also has its costs, and those help shape the definition of what is accepted for all debts public and private.

The definition of money

Money is, at its foundation, a medium of exchange. This text uses a definition of money that also eliminates certain financial assets from being considered money. To be considered money, an entity must have the following four characteristics simultaneously:

• Medium of Exchange: money eliminates the double coincidence of wants under barter;

• Unit of Account/Standard of Value: all goods, services, and financial assets within an economy are priced in terms of the currency;

• Store of Value: money is an asset because money has value or explicitly earns income; and

• Standard of Deferred Payment: all debts, public and private, are priced in terms of the currency.

The medium of exchange characteristic is specific to being the lubricant between buyers and sellers, eliminating barter. Monetary economies came from a natural evolution of society. We will see later that differences between currencies around the world, and sometimes within an economy unified politically otherwise, were at one time set to a certain value of gold such that the relative prices of goods were basically the same in any country. Economists still consider “barter terms of trade”, or the relative export to import volumes of goods exchanged between two countries. Karl Marx discussed an economy without money as a “natural economy”. Marx suggested that a barter economy is not necessarily distinct from a monetary economy, simply a part of it. A coincidence of wants is still needed, but money allows for the use of credit to facilitate transactions. Both goods and credit can be priced in the same terms when a monetary economy is present. We will see soon how important credit markets are to economies and why money also makes those markets more efficient.

The unit of account function is tied directly to the medium of exchange function. All goods, services, and financial assets inside the economy should be priced in terms of that currency. This provides consistent, up-to-date information about prices to markets. This function also eliminates the guesswork in determining the value of goods in trade, either domestic or international. The supply and demand for cows determines cattle prices; the supply and demand for magic beans determines their price. Both are priced in terms of the local currency. With money, they now trade for each other using the accepted medium of exchange: Jack sells his cows, uses money from the proceeds to buy the magic beans. In modern economies, the unit of account function also regulates the domestic money supply. As more money enters the economy, via the economy’s central bank, the more currency it takes to buy the same goods, reflected in increasing prices; this characteristic provides a natural barrier to the central bank printing currency without limits.

The store of value characteristic is not the most newsworthy, but in fact could be considered the most important. It is here where the difference between debit and credit cards shows its face. Both are media of exchange and both represent standards of value. Your debit card may be considered money in that funds are transferred directly from your checking account to the grocery store account where you purchased items. When you use your credit card as a medium of exchange, you create a liability, a debt to be paid later. Your credit card company pays the store, and then you pay the credit card company when your bill arrives. The beauty of a credit card is that it saves money on lost income earned from having to constantly use interest-bearing accounts to make purchases, if used correctly.

Finally, the standard of deferred payment function is a simple extension of the unit of account function to also cover debts. If you buy a car using a loan, the loan should be paid back in terms of the local currency. Both the lender and borrower know the financial terms of paying back the loan. The interest rate then becomes the dominant factor in debt repayment, as the interest payments are also in terms of the local currency. When paid this way, the lender does not take any chances in losing value simply by currency exchange, or through a barter-style transaction.

Measuring money

Once you understand the definition of money, a natural question may be: what types of assets are considered to be money, given this definition? The US Federal Reserve defines money in the following three ways, with a fourth measure for close money substitutes or Domestic Non-Financial Debt (DNFD) or sometimes symbolized as L.

M₁ is the label for cash and its closest substitutes. These include currency in circulation, bank reserves held at the central bank and in bank vaults as cash, checking accounts that do not bear interest and those that do, traveler’s checks, and money orders. The monetary base is equal to currency (cash in your pocket, e.g.) and bank reserves. This measure has some history concerning monetary policy.

M₂ includes M₁ and adds interest-bearing accounts that are highly liquid. These additions include individually held savings, money market mutual fund, and Certificates of Deposit (CD) accounts under $100,000 in value, and what are known as overnight ForDom (foreign checking accounts denominated in domestic currency) accounts and overnight repurchase agreements. A repurchase agreement is a contractual, short-term loan of cash from one bank to another where securities flow as collateral. The repurchase takes place when the borrowing bank buys back the securities for more than their original amount. Because these assets are generally cash or cash equivalents, these repurchase agreements include interest-bearing cash held in this form.

M₃ includes M₂ and larger, institutionally held accounts. Savings, money market mutual fund and CD accounts held by institutions or worth more than $100,000 held by individuals are M₃ accounts. Also, ForDom accounts that are savings rather than checking accounts and repurchase agreements that conclude after one day are also M₃ specific accounts. There is a difference in liquidity between M₂ and M₃ accounts that goes back to the idea of the interest rate as an opportunity cost; in general, the differences between each of the above monetary measures is based on liquidity differences. In 2006, the tracking of M₃ was abandoned by the Federal Reserve, who claimed that the cost was too large to continue collecting the data.¹

These monetary aggregates are the main measures of money used by central banks. Since the late 1970s, the United States and most of the larger economies of the world have concentrated on M₂ for policy-making purposes.

The market for money

Markets are defined by supply and demand. If you have not taken an economics course for some time, this section should act as both a brief review and an introduction to how the market for money works. The supply of money is typically seen as an upward sloping “curve”, defining all the combinations between the price and quantity of money. Supply is the willingness and ability to produce a good or service. Money supply comes from the central bank of an economy first and foremost. A question that is often asked is: don’t banks supply money as well? In fact, they do. Banks do so in such a way that makes an upward supply curve intuitive and analogous to the supply of any other good. Banks supplying more money occurs as a movement along the supply curve: when the interest rate increases due to increases in demand, banks have larger incentives to release more funds for use because profits rise. That is contrasted with a shift of the supply curve, which is a parallel movement of the supply such that there is more money supplied at every price.

• Banks change the quantity of money available at each interest rate, given a money supply.

• The central bank changes the amount of money supplied, regardless of the current rate of interest.

The central bank also functions as the regulator of financial markets in most countries. Because the central bank controls both the supply of money and key interest rates, regulating the financial markets provides further oversight and consumer protection against problematic practices or potential financial crises.² The demand for money is where the interest rate acts as the “price” of money. When the rate of interest falls, the quantity of money demanded increases, which is a movement along the demand curve. The basic idea, which will be expanded on later in the book, is that when interest rates fall as a result of monetary policy changing money supply, consumers face a lower opportunity cost of holding cash. As a result, theory suggests that consumers will hold more cash. Policy can then change incentives toward holding cash and toward the consumer choosing to make pur...