Very thorough summary of all the six lectures for the course Global Finance and Growth. I typed information during the lectures and added lecture slide information/tables etc and additional drawings. Summary of the course in year
Balance Sheets
The financial system connects deficit and surplus units. Money is not a thing but a relation between
creditor and debtor. Therefore, it can appear and disappear ‘out of nothing’. This is not worrying.
- Anyone can issue liabilities on himself, but this is not all money. Banks are licensed to create
money by issuing liabilities on themselves. This increases the money supply, which is needed
for economic growth.
- Balance sheets help you to distinguish buying/selling from investment and to keep track of
assets and liabilities.
- Financial interactions are interactions through balance sheets.
- A balance sheet connects, one persons’ liabilities are another ones’ assets and vice versa.
- A persons’ net worth is the difference between assets and liabilities. Tells you if you are solvent.
- The nature of the assets and liabilities tells you something about liquidity.
National Financial Systems
National financial systems are characterized by the answers to three questions:
1. Who has the power to issue the country’s money?
a. Governments and central banks.
b. Commercial banks issue their own liabilities denominated in the governments and
central banks money.
c. Historically, government, who licensed it exclusively to banks (money creation
monopoly) Control by the government: ‘seignior age’: the power to issue money =
free purchasing power.
2. How will the amount of money increase?
d. Lending by banks
3. How to balance the demands of money issuers and takers of money?
e. Through double-entry book keeping and the legal system around it (accountants and
auditors; reporting standards; valuation rules; bankruptcy procedures; ...)
The Natural Hierarchy of Money
Hierarchy; because there is a structure to the many financial assets around us. Anyone can issue a
liability but the problem is to get it accepted. The more acceptable a liability is, the higher it is in the
hierarchy of money.
- Gold: at the top but not relevant today anymore.
- Money/currency is a financial asset, is universal acceptable around us. It is a note that banks gave
you or an electronic note. Universal claim on goods and services.
- Currency; central banks liability
- Deposits: private bank liabilities
- Credit: treasury bills
(government debt), derivatives.
- Moneyness of an asset is not
fixed, financial assets are
widely accepted in the
financial systems. In times of
a crisis, everyone wants ‘real’
money.
- What is money on one level is
credit on the next. A bank
account is a promise to pay
currency, currency is a
promise to pay gold.
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, Global Finance and Growth Lectures
- Lower ‘moneys’ are settled in higher money, but not vice versa.
- Therefore, the money system is hierarchical (not by law)
- The dynamics of the system are flattening and steepening of the hierarchy.
Government and Money
Banks that manage financial affairs within a country and it is central banks that communicate across
countries. Central banks are part of the state but are now politically independent.
The broad ways in which government policy changes amount of money in the hands of firms and
households:
- Fiscal policies: taxes and subsidies. Raise taxes: more money flows out of the economy to the
government or lower taxes and let more money flow into the economy.
o Governments can create money: subsidies (pay unemployment benefits) and pumps it into
the economy.
- Monetary policy (not government but central bank): by setting interest rates, regulate bank credit.
o Increase interest rates: making it more expensive to borrow so the growth of money
will be slower.
o If you lower interest rates, encourage lending and borrowing and the money supply
will grow.
The ECB wouldn’t have to decrease their interest rates so much if only the governments would spend
more as that would stimulate the economy.
Balance Sheets
<-
Lending
= money
creation
Payment
= money
transfer ->
How are international transactions different?
Domestic transactions change the domestic money supply, but international transactions do the same
thing but also change international reserves (exclusive for the international financial system). By
reserves we don’t mean banks reserves (the reserves that commercial banks have bat central banks)
but we mean international reserves; what central banks use to settle with each other.
- If we have savings we can choose to put them into stocks of bonds but not all because you need
stuff to pay the payment obligations (Euros).
- Banks also invest in stocks and bonds etc. but need a reserve ratio.
- Central banks also need enough reserves to pay each other; central bank reserves, typically in
US Dollars (T-bills is the international reserves for the rest of the world). US government debt is
the public debt of the US, to finance the US but also the international reserves of the rest of the
world. Can be done with other treasury bills but the US ones are most popular as the US is the
issuer of the money of the world.
In the gold standard era gold were the reserves. Nowadays it is just called central bank reserves.
Example Dutch and Kenyan Firms
The Dutch firm loses money and gains shares. The Kenyan firm obtains the money and adds liabilities
(obligation to pay future profit).
- The money amount in Kenya has gone up.
- It is the Dutch that decide how much money there will be in Kenya, they can increase the money
supply.
1. If everyone invests in Kenya, more money will flow to Kenya, this could lead to inflation in Kenya.
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, Global Finance and Growth Lectures
2. Everyone needs reserves if you want to meet your payments. Things might get dangerous for
the Dutch central bank if there is a lot of capital outflow.
Inflow of investment and after a few years the money will be invested in another country. All the arrows
will go in reverse and the Kenyan central bank will lose reserves. It does have enough local currency;
countries can create local currency endlessly but they cannot create dollars. That is a problem.
Sudden stop: reversal of capital flows that creates a crisis in many developing and emerging
economies. Then someone has to help the central bank of Kenya to increase reserves (ECB with
Greece).
The four big issues in global finance:
1. What will be the money of the world?
Gold standard: Why was there a
gold standard and not a silver
standard?
Sterling standard (UK currency
the dominant currency)
Dollar standard chosen at
Bretton Woods (political choice).
Can we expect that the money
of the world will change in our
lifetime.
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, Global Finance and Growth Lectures
2. Will exchange rates be fixed or floating?
Bretton Woods system stipulated that exchange rates would be fixed to the dollar. Countries have to
choose individually whether they want fixed or floating. Question mark: conversion of local currency to
dollars -> is this going to be a fixed ratio or one determined by market forces?
3. Will non-trade capital flows be allowed?
We thing about exchange rates in trade context; imports and exports generate supply and demand for
a currency. However, trade payments are only a small part of total money flows. Much bigger money
flows are capital inflows and outflows. Like the flows between private and central banks and between
central banks. There is an international payment but there is no trade but investment.
- Investment is a capital account transaction: the international movement of money. They facilitate
but also can cause problems (exhaust reserves, capital flowing out of the country, inflation, no
own decision on fixed or floating rates).
Bretton Woods (1944): system with fixed (but adjustable) exchange rates and no private capital flows.
Private parties could not make promises to pay in dollars to other parties as the central banks would
not facilitate this. Political decision.
In the pre-war these capital flows had been devastating. The international financial system is inherently
instable which is linked to the hierarchy. Because in a crisis everyone wants to go up in the hierarchy.
The question whether you are going to have capital flows is important. If you allow it, a lot of money can
be made in investment and lending but you also allow a lot of stability.
4. What to do with imbalances?
What to do when reserves are run down. There is money flowing out of the Netherlands into Kenya and
if it goes on, the money has to come from somewhere. Unless Kenya invests in the Netherlands or
imports products that would restore the balance. But there is no reason why they would do this.
Bretton Woods: we should not have imbalances that could go on and on and would ruin a country as
they do not have reserves anymore.
The Balance of Payments – International Balance Sheets
It summarized the balance sheets of firms, households, governments, banks and central banks.
- Current account = income account + trade account
o What have I earned from trade or work or lending or investing?
o What have I paid for trade or work or lending or investing?
o The difference is the current account balance.
- Capital account
o How have I attracted the money to pay for the current account balance?
o How have I invested the money the money for the current account balance?
o If you import more than you export, how are you going to pay for it?
▪ Either you have reserves
▪ Or you must investment (FDI, equity investments). Big FDI deals bring in dollars
is a survival constraint for why developing countries attracht FDI.
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