Money : Economic
functions and creation
process
Money: its nature, function and
creation process.
Class tests

Just a quick preliminary note on the
organisation of the class tests:


As outlined previously, they are at the same time
as the French groups’ tests
The content will be comparable

1st test: Saturday 20th of March

2nd test: Week beginning 13th of April
Money : function and creation process



We now move on to examining equilibrium in
the money market.
Next week: we will look at the money market
equilibrium, CB intervention, etc.
Before that, it is important to spend a session
examining money itself


“Modern” money has several counter-intuitive
properties: it is intrinsically worthless and it can
be created from nothing.
The money market cannot really be understood
if these are not explained properly beforehand
Money : function and creation process
The nature of money
The classical and Keynesian functions
of money
The creation of money by the banking
system
The nature of money

What is money ?



In other words, money is what we decide it
to be as a society



It is whatever a given society at a given time
agrees to use as a means of exchange
Do not confuse money and wealth (see the
Spanish “price revolution” vs. Adam Smith!)
It is a social institution
Its existence is therefore always based on the
level of trust within a society
There are several types of currency
The nature of money


Commodity money
A situation where a commodity serves as
currency
 Very close to barter, but with the currency

commodity dominating the exchanges
Gold, silver, salt, cigarettes, sea shells, marbles.
Not necessarily intrinsically valuable, but often
so: doesn’t require much trust.


The commodity is usually rare (limited supply)
Has desirable properties: divisible, fungible
The nature of money


Token money:
A situation where the currency is officially
backed on a commodity.


The commodity itself is not exchanged, instead
tokens representing units of the commodity are
exchanged (ex: bank notes in the Gold Standard)
This requires a higher level of trust, as the
intrinsic value of the token is much less than
the face value.

The tokens can always be converted into the
commodity on demand (the token is an IOU)
The nature of money


Fiat money:
Where money exists simply by law (an act of
government): it must be accepted in repayment
of all debts
 Money as a sign, a symbol.
 It typically has no intrinsic value (except for


pennies!)
Its face value is backed entirely by the state’s
credibility
This requires a high level of trust in the
institution that creates it.
The nature of money

Most countries nowadays use fiat currency,
because money supply can be controlled.


In a commodity/token currency system, the
money supply is exogenous



This is important for financing the economy
The price revolution in 16th century Europe (New
world gold arriving in Spain)
Restricted money supply during WWI, which caused
most countries to temporarily abandon it.
In a fiat system, the supply can be adjusted as
necessary.
Money : function and creation process
The nature of money
The classical and Keynesian functions
of money
The creation of money by the banking
system
The classical and Keynesian functions

The classical functions of money




Also called the Aristotelian functions.
Aristotles was intrigued by the problem of
commensurability: how can intrinsically different
goods have an exchange value?
His conclusion : exchange can only occur is the
goods are equal in a given comparable measure
1st function: Means of exchange

Simplifies exchange compared to barter: no need for
a double coincidence of wants
The classical and Keynesian functions

2nd function : unit of account


Money is divisible, so can be used to measure the and
compare the values of different goods (price system)
3rd function: Reserve of value


Payments made in money do not lose their value over
time, unlike barter or payments in kind
Money allows the conservation of values through time
(discounting inflation)
The classical and Keynesian functions


Keynes’ “General theory of employment,
interest and money” introduced more functions,
leading to a debate about the role of money in
the economy
The central argument is the existence of a
preference for liquidity in agents



With uncertainty, agents will prefer to hold liquidities
as away of adapting faster to the risky environment
Money is the most liquid and least risky way of
holding assets: it is always accepted in transactions
Money will be demanded for its intrinsic properties
The classical and Keynesian functions


Keynes identifies 3 “motives” for demanding
money
The transaction motive:



money is required for exchange (similar to the
“classical functions”)
This demand is a positive function of income
The precaution motive:


Holding some liquidity is the best option in the
presence of uncertainty.
This is also a positive function of income
The classical and Keynesian functions

The speculation motive:




This motive embodies the trade-off between holding
liquidities and assets.
Liquidity is preferred, but does not pay interest.
Assets pay interest, but are not as liquid
Therefore the interest rate is the opportunity cost of
holding liquidity : as it increases people will hold less
liquidity
This leads to an overall demand for money of
the following form:
 
M
M 
 L Y,i
 
P
d
The classical and Keynesian functions

This has lead to an important debate on the
effect of money in the economy between:

Those who believe that money is neutral (i.e. does
not affect real economic variables)
 Classical approach, quantity theory approach

Those who believe that money is not neutral (it can
affect real variables)
 This is due to the role of the interest rate on money
demand

The debate is not closed yet, but has moved to
a short-term/long-term debate

Money is neutral in the LR, not in the SR
The classical and Keynesian functions


The Keynesian argument for non-neutral
money will be shown in greater detail in the
next few weeks (IS-LM)
What about the “classical” approach?



It is grounded in the Quantity Theory of Money
(QTM)
Classical dichotomy : nominal variables and real
variables are independent
Money is only used for transactions, therefore
only the “classical” functions apply.
The classical and Keynesian functions

It is based on the Cambridge equation
M  V
Money

Prices
T
Transactions
QTM states that velocity V (the number of times a
given € is used in a given time period) and the
volume of transactions T are exogenous with
respect to money M.



Velocity
 P
Therefore increases in M lead to proportional increases in P
Inflation is a purely monetary phenomenon
But Keynesians argue this holds only in the LR: in
the SR, increasing M can change real variables
because of the liquidity preference
Money : function and creation process
The nature of money
The classical and Keynesian functions
of money
The creation of money by the banking
system
The creation of money


Most of the money is created by banks through
the process of credit (lending)
What is the purpose of a bank?




To hold the short term deposits of money by
agents
And make them available as long term loans to
other economic agents (which earn interest)
This funds economic activity (investment
projects, consumer durable purchases)
In the process, this also creates money for
transactions in the economy
The creation of money

The actors in this process are :

The agents:
 Provide deposits to banks and take out loans

The banking system:
 Which take the deposits from agents and make the
loans to agents

The central bank:
 Regulates the banking system (prudential regulations)
 Provides “base money” to the banking system
 Acts as the lender of last resort to banks
The creation of money

Central Bank
Supplies base
money B
(interbank
liquidity)
Interbank
market
Bank A
Bank B
Deposits and loans
Agents
Bank C
Supplies money M
to the economy

The amount of
money M
supplied by the
banks is larger
than the base
money B
supplied by the
central bank
M>B
There is a net
creation of
money !
The creation of money

First, let’s examine the balance sheet of a bank
Bank A
Assets
Liabilities
Reserves
Deposits
Loans


Liabilities: in the form of the deposits of money
made to the bank by agents
Assets:


Reserves: held against depositor claims
Loans: made to 3rd parties, they earn interest
The creation of money

Creation of money through credit
Bank A
Assets
Liabilities
200 €
1000 €
800 €


A bank receives a 1000 € deposit in cash
We assume a 20% reserve ratio against deposits



Bank A has to hold 200 € in reserve
It can loan 800 €
This 800 € loan is new money, created by the bank!
The creation of money

Creation of money through credit
Bank B
Bank A
Assets
Liabilities
200 €
1000 €
Assets
Liabilities
800 €
800 €



Assume the 800 € loan is deposited in Bank B
Total deposits in the economy are now 1800 €
Given the reserve ratio of 20%


Bank B has to hold 160 € in reserve
It can loan 640 €
The creation of money

Creation of money through credit
Bank B
Bank A
Assets
Liabilities
Assets
Liabilities
200 €
1000 €
160 €
800 €
800 €



640 €
Assume the 800 € loan is deposited in Bank B
Total deposits in the economy are now 1800 €
Given the reserve ratio of 20%:



Bank B has to hold 160 € in reserve
It can loan 640 €
128 € (0.2×640) held as reserves, 512€ re-loaned.
The creation of money

Assuming that all of the lending/deposits occur
in the same bank, we have :
Bank A
Assets
Liabilities
1000 €
5000 €
4000 €

One can see that the higher the reserve ratio,
the smaller the loans that can be made, and the
faster the process stops.
The creation of money

The simple money multiplier



The reserve/deposit ratio is rd
The money base is B
Money supply is
Ms 

1
B
rd
A higher reserve requirement reduces the
multiplier
The creation of money

The cash money multiplier





Suppose that on top of their deposits in the
bank agents hold cash, with a cash to deposit
ratio cd
The bank still has a reserve/deposit ratio rd
Money supply is: M s  D  C  1  cd D
Money base is:
B  R  C  rd  cd D
The multiplier is:

Ms
1  cd D
1  cd


rd  cd D rd  cd
B
The creation of money

The money multipliers

Simple multiplier:
Ms
1

B
rd

Cash multiplier:
Ms
1  cd

B
rd  cd

If rd = 0.2 and cd = 0.1
 The simple multiplier is equal to 5
 The cash multiplier is equal to 3.66
The creation of money

The interbank market and the central bank
Bank B
Bank A
Assets
Liabilities
Assets
Liabilities
200 €
1000 €
160 €
800 €
800 €

640 €
Imagine a customer from bank B buys a 2nd hand
computer 200 € from a customer in bank A


He writes a 200 € cheque, so his deposit goes down
by that amount
The deposits in bank A go up by 200 €
The creation of money

The interbank market and the central bank
Bank B
Bank A
Assets
Liabilities
Assets
Liabilities
200 €
1200 €
160 €
600 €
800 €

Imagine a customer from bank B buys a 2nd hand
computer 200 € from a customer in bank A



640 €
He writes a 200 € cheque, so his deposit goes down
by that amount
The deposits in bank A go up by 200 €
Now Bank A’s balance sheet is unbalanced !!
The creation of money

The interbank market and the central bank
Bank B
Bank A
Assets
Liabilities
Assets
Liabilities
200 €
1200 €
160 €
600 €
800 €

Bank A is potentially bankrupt.



640 €
It claims 200 € asset compensation from Bank B
(through the clearing house)
Bank B has enough assets, but not enough liquidity
(in the form of reserves)
It needs to liquidate some assets
The creation of money

The interbank market and the central bank
Bank B
Bank A
Assets
Liabilities
Assets
Liabilities
200 €
1200 €
160 €
600 €
800 €

Bank A is potentially bankrupt.



640 €
It claims 200 € asset compensation from Bank B
(through the clearing house)
Bank B has enough assets, but not enough liquidity
(in the form of reserves)
It needs to liquidate some assets
The creation of money

The interbank market and the central bank
Bank B
Bank A
Assets
Liabilities
Assets
Liabilities
200 €
1200 €
160 €
600 €
800 €

640 €
Bank B goes to either to the Central Bank or on the
Inter-bank market and swaps 160 € worth of loans
against base money.
The creation of money

The interbank market and the central bank
Bank B
Bank A
Assets
Liabilities
Assets
Liabilities
200 €
1200 €
320 €
600 €
800 €

480 €
Bank B goes to either to the Central Bank or on the
Inter-bank market and swaps 160 € worth of loans
against base money.

It can then pay the 200 € it owes bank A and still meet its
20% reserve ratio.
The creation of money

The interbank market and the central bank
Bank B
Bank A
Assets
Liabilities
Assets
Liabilities
400 €
1200 €
120 €
600 €
800 €

480 €
Bank B goes to either to the Central Bank or on the
Inter-bank market and swaps 160 € worth of loans
against base money.


It can then pay the 200 € it owes bank A and still meet its
20% reserve ratio.
Both banks are now balanced. Bank A can buy from the CB
the 160 € worth of assets that Bank B sold.
The creation of money

The interbank market and the central bank
Bank B
Bank A
Assets
Liabilities
Assets
Liabilities
240 €
1200 €
120 €
600 €
960 €

480 €
Bank B goes to either to the Central Bank or on the
Inter-bank market and swaps 160 € worth of loans
against base money.


It can then pay the 200 € it owes bank A and still meet its
20% reserve ratio.
Both banks are now balanced. Bank A can buy from the CB
the 160 € worth of assets that Bank B sold.
The creation of money


In theory, with the central bank always ready to
lend if a bank needs it, the system is secure
However: credit & money creation are not the
only form of financing the economy



A lot of financing now occurs directly (agents
investing), and banks mediate this through trusts and
subsidiaries that are “off the balance sheet”.
This activity is not “banking”, however, so is not
regulated the same way.
The problem is that the lack of prudential
regulations on this “off balance sheet” activity
has caused the financial problems we are in.