Monetary Economics I: Financial Markets

and Institutions
John Smithin
York University

Money and Capitalism

Commonsense seems to tell us that capitalism is all

about money making money, spending money,
saving money, and so forth.

E-money (electronic money) makes no difference,

this is a change of form, not of substance

The purpose of E-commerce is also to make

money, exactly as before.

Innovation of any kind would not take place at all

unless it pays in the everyday sense of the term.

Money and Capitalism

MONEY IS THEREFORE:

The most important institution in capitalist society (Ingham

2004)

BUT:

Most social science and business disciplines pay far less

attention to the phenomenon than it deserves. They only notice
when a crisis comes along.

Neoclassical economics has even tried to argue that money is

NOT all that important. Money is neutral, money is a veil, and
so on. Always surprised when a crisis does happen.

The Barter Economy

The basic idea of neoclassical economics is

that, beneath the veil of money, economics
should deal with the real (barter) exchange of
goods and services, and the determination of
relative prices (rather than money prices)

The problem with this is that many (most?)

real world economic issues DO seem to
involve money - booms/depressions,
inflation/deflation, interest rates, exchange
rates/balance of payments, etc.

Courses in Monetary Economics (or

Money and Banking)

Why do they exist?

Two possible reasons:

- On the one hand, maybe it is recognized that money,
banking and finance cannot be ignored after all?
(This would be a good thing)
- On the other, maybe there is an idea that it should be
dealt with in a separate compartment. That
monetary economics is somehow not dealing with the
same world as microeconomics - which is regarded as
the essence of real (i.e., barter) economics? (This
would not be so commendable, because barter is moreor-less a fiction)

Puzzles: Robertsons Parable about the

Velocity of Circulation
On Derby Day, two men Bob and Joe, invested in a barrel of beer,
and set off to Epsom with the intention of selling it at retail on the
racecourse at 6d a pint, the proceeds to be shared equally
between them. On the way Bob, who had one three-penny-bit left
in
the world, began to feel a great thirst, and drank a pint of the beer,
paying Joe 3d. as his share of the market price. A little later Joe
yielded to the same desire, and drank a pint of the beer, returning
the 3d. to Bob. The day was hot, and before long Bob was thirsty
again, and so, a little later, was Joe. When they arrived at Epsom,
the 3d. was back in Bobs pocket, and each had discharged in full
his debts to the other: but the beer was all gone.

Puzzles: Robertsons Parable about the

Velocity of Circulation
One single three-penny-bit had performed a volume of
transactions which would have required many shillings if the
beer had been sold to the public in accordance with the original
intention.
.

(The symbol d means a penny - from the

roman denarius. The Derby is a horse race in
England, held at Epsom racecourse. A shilling
is another coin in circulation at the time, worth
12 pennies)

What is Wrong with Robertsons Account?

Doubtful if Robertson means to comment on the morality of drinking or

gambling, etc. This is not the issue.

From the purely business point of view the episode is disastrous (the
entrepreneurs have literally drunk the profits).

But Robertson does not even NOTICE this. His point is to illustrate the
concept of Velocity of Circulation of Money. In fact, the story shows
the emptiness of this concept.

From the POV of neoclassical economics there is actually nothing

wrong with the situation. The beer has been produced and drunk, and
has given utility or satisfaction (it does not matter to whom). There is an
optimal allocation of resources and utility is maximized.

What is Wrong with Robertsons Account?

Obviously, neoclassical economics is not an accurate

theory of capitalism.
Actually, there would be nothing amiss in this story from the
POV of view of Marxism either. Nobody is being exploited
here. Obviously, Marxism is not an accurate theory of
capitalism.

The

take-away: -

Money profits are MUCH more important in reality than they

are allowed to be in theory.

Puzzles: Marxs Monetary Circuit

(1)

The entrepreneurs start with a sum of money (dollars) M.

Then they buy some commodities C (including raw materials + labour).

They engage in production - using C - to make more (that is, more valuable)
commodities C.

Note that (C - C) is the real value added.

Then they sell the enhanced commodities C for more money M.

Note that (M M) is the realized money profit.

This is capitalism according to Marx not dissimilar to Weber and others.

What is Wrong with Marxs Account?

First, we would need to define real value (an old question in economics).

More importantly - if the money supply is fixed - how can it be

possible for M to be greater than M? Crucial question. Neither
Marx nor neoclassical economists ever answered the question, but
accountants ask it of businesses every day. (Note the similarity to
the problem in the earlier Robertson story).

It would be possible to one firm to make profits and another make

losses, but it would not be possible for firms on average, or in
aggregate to be profitable. The system cannot function on this
basis (with zero profit).

Take-away:
The answer must be credit creation (money creation) by the banking
system.

Numerical Example Assuming Some

Modern Institutions: First Stage
An ENTREPRENEUR borrows money from a BANK to make a
product called WIDGETS:
Bank Balance Sheet
Assets
Loan: 1,000,000
------------1,000,000

Liabilities
Entrepreneurs Deposits: 1,000,000
-------------1,000,000

Second Stage
The ENTREPRENEUR buys some RAW MATERIALS and hires
some WORKERS, paying out the whole $1,000,000:
Bank Balance Sheet
Assets
Loan: 1,000,000
------------1,000,000

Liabilities
Worker/Supplier Deposits: 1,000,000
-------------1,000,000

Let no further financial transactions be made until the product is

finished.

Third Stage
The WIDGETS are produced and offered for sale. The WORKERS and
SUPPLIERS decide to spend their whole income on WIDGETS (An
extreme assumption - in reality they will surely save something).
Bank Balance Sheet
Assets
Loan: 1,000,000
------------1,000,000

Liabilities
Entrepreneurs Deposits: 1,000,000
-------------1,000,000

EVEN in this best case scenario it is IMPOSSIBLE for the firm to

make any profit let alone pay INTEREST to the bank. The firm will
FAIL.

Fourth Stage
Suppose the bank is able to recover the principal of the
loan from the defaulting firm. But this is no use, it also
FAILS in the sense that it makes no profit.
Bank Balance Sheet
Assets
Loan:
0
-----------0

Liabilities
Entrepreneur Deposits: 0
--------0

Solution: Some Sector or Other of the Economy

Must Continuously be Willing to Become INDEBTED
- so that OTHERS can make Profits.

Three Possibilities:

Other firms (e.g. makers of SUPER

WIDGETS and EXTRA SUPER WIDGETS).

Consumers (domestic or foreign).

The Government (they can run a budget

deficit).

Two Theories of Money

Commodity

Theory of Money

Credit or Claim Theory of Money

Commodity Theory of Money

For many centuries, well into the modern era, the value of money
was thought to derive from its intrinsic value as a commodity.

Money was thought to begin from barter exchange (itself not much more than
a myth) one commodity spontaneously becomes the medium of exchange
(e.g., gold or silver).

Even when money was obviously not a substantial physical commodity, (a

note or book entry) it was supposed to represent, or symbolize, or stand for,
some underlying physical commodity

The idea that the value of money can be guaranteed by a gold standard or
similar - was always dubious. It is impossible to sustain to today when there
is no commodity money the physical form of money is mostly just electronic
impulses in a computer network.

Credit or Claim Theory of Money

Hicks (1989, 42):
Money is paid for a discharge of debt when that
debt has been expressed in terms of money.
(Ingham 2004, 198):
All money is debt in so far as issuers promise to
accept their own money for any debt payment by
any bearer of the money.

Credit and Debt

Credit and debt are the just the mirror image of one another. Which is
actually the money?

In the modern banking context it is bank liabilities which are money.

Credit is on the other side of the bank balance sheet (loans, etc.)
Bank Balance Sheet

Assets
Loans: 1,000,000
------------1,000,000

Credit

Liabilities
Deposits: 1,000,000
-------------1,000,000

Money

Money as a Social Relation

It bothers people that money can be created with a

stroke of the pen. (These days a touch of the
keyboard).

However, a characteristic of all social relations is

they do not function by their physical characteristics,
but nonetheless have real (causal) effects on the
world.

What matters is collective intentionality, assignment

of status/function, constitutive rules, etc.

Unit of Account and Means of Payment

Money is therefore both a unit of account and a means

of payment.

How does means of payment differ from medium of

exchange?
The answer is that the typical transaction is NOT a
straight exchange of goods for money on the spot.
Typically there is a contract, (explicit or written), delivery,
and payment. Timing of payment is highly variable can
pay in advance or in arrears.

Money as a Store of Value

Supposed to be another of the functions of money

Obviously money must retain value, to some extent, from one period to the
next, if it is to be used at all, but there are usually better investments available
(stock market, real estate, diamonds rings, famous paintings, etc.)

Also money continues to be used as unit of account and means of

payment even when inflation is at very high rates. These are the crucial
functions.

It can be said that is would be a useful thing in capitalism if there was a money
capable of being increased in quantity by credit creation but, nonetheless,
retaining its real value (neither rising nor falling). However, this does NOT
necessarily mean zero inflation. It could also be achieved by an interest rate
paid on money that keeps pace with inflation. (cf. the concept of the real rate
of interest).

Heirachical Nature of Money

Debt Pyramid
Households
Firms

Financial Institutions
Central
Bank

Monetary Base and Money Supply

The

liabilities of the state central bank are

the base money of the system.
Sometimes also called high-powered
money.

Why? - Chartalism (the ability of the state

to levy taxes)
H = CU + R

Monetary Base and Money Supply

The liabilities of some financial institution (banks) in the

second tier also count as money (the money supply - much
larger than the monetary base)

Why? - (a) convertibility promises, (b) the state will also accept
tax payments drawn on these banks.
M = CU + D

M = money supply
H = monetary base
CU = currency in the hands of the non-bank public
D = deposits in commercial banks
R = bank reserves

For Canada as of December 31, 2009

H = CU + R = 55,070 + 4,179 = 59,244
M2 = CU + D2 = 55,070 + 944,845
= 999,915
(M2 definition of the money supply, millions of
dollars)

Monetary Policy

The policy rate is the interest rate set by the central bank (on base
money).

It is called federal funds rate in USA, overnight rate in Canada, etc.

It is the real policy rate that matters.

Let iB = nominal policy rate, pe = expected inflation rate, rB = real policy rate.
rB = iB - pe
If iB = 1%, pe = 1.8%
then:
rB = 1% 1.8% = - 0.8%

(negative real interest rate)

International Monetary Relations

The international economy can be viewed as competing currency networks, each with its
own central bank.

The nominal exchange rate between different currencies can be floating (flexible) or fixed
E = domestic currency price of one unit of foreign currency
e.g., suppose $1.00US is 90 cents Canadian, E = 0.9

What matters for international competitiveness is the real exchange rate

Q = EP/P*
Suppose Canadian Widgets cost $8.00 CAN per unit, P = 8.0
US Widgets cost $6.0 per unit, P* = 6.0
Q = (0.9 x 8.0)/6.0 = 1.2

Canadian goods are therefore more expensive than US goods (less competitive). US
widgets will outsell Canadian widgets. Bad for the Canadian balance of payments (BOP).