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Summary Monetary Economics
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Summary of all the important topics for Monetary Economics, based on the lectures slides and the book by Wim Boonstra.
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Chapter 1 – Introduction: why bother about money and banking?The six tasks of a financial system are generally referred to as:
1. Providing a payment system
2. Pooling of funds, or transformation of size
3. Re-allocation of funds, or term transformation and transformation of location
4. Risk transformation
5. Production of information as revealed by prices
6. Reducing information asymmetry
Chapter 2 – Money is a promise
Money is an asset that is generally accepted within a certain community as a medium of exchange,
unit of account, and store of wealth. This definition has five crucial elements: general acceptance,
within a certain community, medium of exchange, unit of account and store of wealth.
When people start to trade, they soon need an asset, a good that is generally accepted as a medium
of exchange. Once people agree to express the value of all tradeable products in one standard
commodity, money is born. An advanced and free society with a high degree of specialization among
its members cannot function properly without money. Economies that function without money are
either subsistence societies, or highly centralised like a command economy without freedom for its
members.
Using money to set prices makes life a lot easier: for keeping accounts, for adapting prices of goods
or services, for estimating future income or losses, etc. And it opens unlimited possibilities for
producing new tradable products.
The preference for precious metals illustrates the first feature that money should have before it is
accepted as such: its appearance should reveal information about its value and that appearance
should be more or less constant. A currency created by the government to provide services to the
public is a wonderful institution, especially if it succeeds in putting into circulation coins that cannot
easily be counterfeited by fraudsters.
Money whose intrinsic value is less than its nominal value is referred to as fiduciary money.
Merchants who had to deal with heavy loads of coins in between trades, would rather have their
coins stored safe by either a mint, a goldsmith or a cashier. They would get proof in return, a receipt,
saying how much gold, silver or copper was stored in the vault on their behalf. Over time, merchants
started using signed contracts of money-stored-elsewhere as money itself.
These bills, or promises, initially were not fiduciary money, as the promises issued by the goldsmith
were 100% covered by the value in the vault, full-reserved as it is called today. However, the
goldsmith realised that merchants would not come and claim their value on a daily basis. So, they
started writing more promises than were actually covered by the gold or other metals in the vault.
They started to move from full-reserve banking to fractional reserve banking, in which the promises
were only partly covered by value in the vaults.
If coins and bills are declared real by something like a government decree, and as such are trusted by
the people to be real, they are forms of fiat money. For fiat money to be accepted, people need to
,believe that its nominal value can indeed be used in trade, or that the amount stated on the
banknote can actually be picked up at the bank that made that promise.
The production of fiat money, which by definition has lower production costs than its economic
value, can be a highly profitable business for the issuer, who can earn seigniorage if they are the first
to spend the new money. Therefore, governments have a vested interest in establishing a monopoly
on the production of fiat money.
A standardised series of precisely defined monetary aggregates makes it possible to compare
monetary developments between countries and it is possible to analyse how changes in a monetary
aggregate affect the economy. The most important aggregates are the following:
- M0 – base money; The monetary base consists of liabilities of the central bank. Its first
component is the volume of all issued banknotes and coins, cash. The second component is
formed by the reserves that commercial banks hold at the central bank.
- M1 – narrow money; Consists of cash in circulation and the balances people hold at their
bank.
- M2 – broad money; Consist of M1 plus secondary liquidities like short-term saving deposits.
These savings are highly liquid and can be converted into M1 at short notice.
- M3 – broader money; Consist of M2 plus repos. Repos are securities issued by money
market funds and bonds with a maximum maturity of two years.
Chapter 3 – Monetary Standards
Precious metals can be stored easily, they do not deteriorate, so they keep their value; they are
dividable, so you can weigh and measure them easily. Ideally, supply conditions should be stable and
predictable, and the money supply should be able to grow more or less in line with economic
activity. Moreover, the daily use of money should incur as little additional cost as possible. Money
should be easy to transport, as this reduces transaction costs.
The gold coin standard
The typical feature of the gold coin standard is that gold has a fixed price. If the supply of gold
increases or decreases and the value of gold thus goes down or up, this will by definition not have
any effect on the price of gold. This is the core of any standard based on precious metals: the price
of the metal cannot change. It is the price of all other tradable goods and services that have to adapt
because the value, but not the price, of gold changes. A sharp increase in the quantity of gold leads
to an overall rise in the price level, inflation. A decline in the quantity of gold leads to an overall drop
in prices, deflation as the purchasing power of the gold increases.
Free monetisation of gold prevents the intrinsic value of the gold from falling permanently below the
nominal value. As more gold is offered at the mint, the money supply increases. As long as the
money supply increases faster than the transaction volume, an upward pressure on prices will be
exerted. Due to the increase in price level, the production costs of the gold also rise, which slows
down output. The system has an automatic regulator.
The advantage of a gold coin standard is that a high inflation rate is unlikely to occur, unless an
exceptionally large gold find is made. Furthermore, it is a pure market mechanism, and the
government is not involved in the volume of the money supply. Debasing money means that its
intrinsic value is eroded by using less and less precious metal in the coins, while at the same time
, keeping the nominal value of the money unchanged. As a result of debasement, the money system is
no longer based on full money and ultimately the intrinsic value of money may even approach zero.
The problem with the gold coin standard is that it is expensive and involves a rather inelastic money
supply. And the gold supply is rather unpredictable.
Parallel standards
It is conceivable that standard gold coins could circulate alongside standard silver coins without a
fixed exchange ratio or price ratio between the two types. Two separate monetary systems operate
side by side are called a parallel standard. Disadvantages are the high information costs as people
have to convert.
In order to overcome the disadvantages of the parallel standard, a government may decide to
establish a fixed exchange ratio between gold and silver standard coins, and thus declare an officially
fixed price ratio between gold and silver. This is referred to as a double standard. However, this
leads to problems as soon as the market values of gold and silver start to change.
The phenomenon which sees relatively overvalued money displace the relatively undervalued
money from circulation is referred to as Gresham’s Law. Note that Gresham’s Law can only apply if
there is an official value ratio between two types of money, while their mutual intrinsic values
diverge.
The gold exchange standard
The central bank of a country must have enough precious metal in its vault to be able to meet
withdrawal requests. It also has to regulate the domestic money supply so that it is not too far out of
balance with the gold supply.
A disadvantage of the gold core standard is that the gold which the central bank has to hold in
reserve does not pay any interest or dividend. That is why some central banks decided not to keep
gold themselves, but instead to buy high-quality liquid assets from countries where the central bank
did hold gold. Then, if necessary, this central bank could quickly and without any risk, turn its
reserves into the currency of the other country, which could be exchanged for gold if desired. That
system is referred to as the gold exchange standard. Note that this is only possible if the mutual
exchange rate of the currencies Is fixed and both countries use the same official gold price.
Commodity standards
In a commodity standard, the money in circulation is not covered by gold, but by a basket of
commodities. Suppose that an economy enters a phase of recession. Savings go up with the interest
rate and spending falls. Prices come under downward pressure. Under the commodities standard,
the government will put extra money in circulation by buying up commodities according to the
official ratio of the fixed-price index and at the official prices. The money goes to the producers of
raw materials who can boost their production as costs fall, giving the economy a new boost.
In an upturn, the mechanism works exactly the other way around.
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