Money, Banking, and International Finance ( PDFDrive )
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Money, Banking, and International Finance
Economists use liquidity to define money. Liquidity is people can easily convert an asset into cash with little transaction costs. For example, if you take all your assets and list them in terms of liquidity, then liquidity forms a scale as shown in Figure 1. Cash is the most liquid asset because a person already has money and does not need to convert it to money. Subsequently, a savings account is almost as good as cash because customers can arrive at a bank or ATM and convert their deposits into cash quickly with little transaction costs. Nevertheless, cars and houses are the least liquid assets because owners require time and hightransaction costs to convert these assets into cash.
Figure 1. Ranking assets by liquidity
Economists define the money or the money supply as anything that people pay for goods and services or repay debts. In developing countries, people use cash as money. In countries with sophisticated financial markets like the United States and Europe, the definition of money becomes complicated because money includes liquid assets, such as cash, checking accounts, and savings accounts. People can convert these assets into cash with little transaction costs. Consequently, economists include highly liquid assets in the definitions of money. However, economists never include assets such as houses in the definition of money. Unfortunately, homeowners need time and have high-transaction costs to convert a house into cash. Many homeowners will not sell their homes quickly by selling it for a lower value than the home’s market value.
Central Banks
Every country uses money. Therefore, every country has a government institution that measures and influences the money supply. This institution is the central bank. For example, the central bank for the United States is the Federal Reserve System, or commonly referred to as the “Fed.” The Federal Reserve regulates banks, grants emergency loans to banks, and influences the money supply. Since the money supply and the financial markets are intertwined, the Fed can influence financial markets indirectly, when it affects the money supply. Therefore, the Fed can indirectly affect the interest rates, exchange rates, inflation, and the output growth rate of the U.S. economy. When the Fed manages the money supply to influence the economy, economists call this monetary policy. Consequently, this whole book explains how a central bank can influence the economy and its financial markets. Furthermore, readers can extend this analysis to any central bank in the world.
Central bank influences three key variables in the economy, which are: 11
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Variable 1: Inflation is a sustained rise in the average prices for goods and services of an economy. When a central bank increases the money supply, it can create inflation. For example, if you place $100 in a shoebox and bury it in your yard for one year. That $100 loses value over time because, on average, all the prices for goods and services in an economy continually rise every year. If the inflation rate rises 2% per year, then after one year, that $100 would buy on average, 2% fewer goods and services. Although inflation erodes the value of money, a low inflation rate is not necessarily bad because it might indicate economic growth.
Variable 2: A business cycle means the economy is experiencing strong economic growth, and economists measure the size of the economy by the Gross Domestic Product (GDP). GDP reflects the total value of goods and services produced within an economy for one year. When businesses boost production, they produce more goods and services within the economy. If GDP grows quickly, then the economy experiences a business cycle. Thus, consumers’ incomes are rising; businesses experience strong sales and rising profits, and workers can easily find new jobs, which decrease the unemployment rate. However, if the money supply grows too quickly, then inflation can strike an economy with rapidly rising prices.
Variable 3: Interest rates reflect the cost of borrowing money. People borrow money to buy cars, houses, appliances, and computers while businesses borrow to build factories and to invest in machines and equipment, expanding production. Moreover, governments borrow money when they spend more than they collect in taxes. Since economies with complex financial markets create many forms of loans, these loans have different interest rates. Usually economists refer to “the interest rate,” because interest rates move together. As a central bank expands the money supply, the interest rates fall, and vice versa, which we prove later in this book. Thus, an increasing money supply causes interest rates to fall in the short run.
One important function of monetary policy is to create economic growth. Unfortunately, the GDP can grow slowly or decrease as businesses produce fewer goods and services within the economy, while consumers’ incomes fall or stagnate. When an economy produces fewer goods and services, then unemployed workers have more difficulties in finding jobs. Subsequently the unemployment rate increases, and the economy enters a recession. Unfortunately, if the money supply grows too slowly, or even contracts, it could cause the economy to enter a recession.
Economists calculate both the nominal GDP and real GDP. Nominal GDP includes the impact of inflation. For example, if economy experiences inflation, or firms produce more goods and services during a year, then the nominal GDP rises. On the other hand, economists can remove the effects of inflation by calculating real GDP. When the real GDP increases, it means firms in society have produced more goods and services while inflation does not affect real GDP. That way, if real GDP is rising, then the public and economists know the economy is expanding, while a decreasing real GDP indicates a society's economy is contracting. Finally, economists define many variables in real or nominal terms, such as interest rates and wage rates, which we explain later in this book.
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Barter and Functions of Money
If an economy did not use money, what would it look like? Without money, the buyers would exchange goods with the sellers by exchanging one good for another good, which we call barter. Unfortunately, barter has many problems.
Problem 1: Barter suffers from a double coincidence of wants. For example, if you produce shoes and want to drink a Coca-Cola, then you search for a person who produces ColaCola and needs shoes. Thus, you need to search for a person who wants the opposite of you, which could take a long time.
Problem 2: Many goods, like fruits and vegetables, deteriorate and rot over time. Growers of perishable goods could not store their purchasing power. They would need to exchange their products for goods that would not perish quickly if they want to save.
Problem 3: Products and services do not have a common measurement for prices. For instance, if a store stocked 1,000 products and money circulated with this economy, subsequently, this store would have 1,000 price tags. Then customers can compare products easily. With barter and no money, this same store would have 499,500 price exchange ratios as calculated in Equation 1. Variable E indicates the number of price ratios while n is the number of products produced in a barter system.
E = |
n n 1 |
|
1,000 999 |
499,500 |
(1) |
|
|
||||
2 |
2 |
|
|
||
A price ratio shows the amount of one good that buyers and sellers exchange for another good, and we show examples of price ratios in Figure 2. For example, a person could exchange one apple for 3 bananas or two Coca-Colas.
1 apple = 3 bananas
2 Coca-Colas = 1 apple
.
.
1 cup of coffee = 1 Coca-Cola
Figure 2. Examples of price ratios
Problem 4: Business people would have trouble writing contracts for future payments of goods and services under a barter system. Consequently, a barter society would produce a limited number of goods and services.
Money eliminates many problems with barter and has four functions. First function of money is a medium of exchange because people use money to pay for goods and services and repay debts. Medium of exchange function promotes efficiency and specialization. For example, the author teaches economics. Under a barter system, the author would search a market extensively to find a person who would exchange goods and services that the author needs. In
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the author’s case, he could experience considerable search costs for people wanting economics instruction. With money, the author does what he does best and teaches for money. Then he takes this money to the market and buys goods and services that he wants. This function of money allows the specialization of labor to occur and eliminates the problem of double coincidence of wants under a barter system.
Second function of money is a unit of account. Money conveniently allows people to place specific values on goods and services. For example, a two-liter of Coca-Cola costs $0.89 while Pepsi costs $0.99. Thus, customers can compare products’ prices easily. This function is extremely important for businesses because business people place values on buildings, machines, computers, and other assets. Then they record this information into financial statements. Subsequently, investors read the financial statements and gauge which companies are profitable. Finally, this function of money eliminates the massive number of price exchange ratios that would occur under a barter system.
Third function of money is the store of value. Money must retain its value. For example, if a two-liter of Coca-Cola costs $0.99 today, then it should cost $0.99 tomorrow. Unfortunately, inflation erodes the “store of value” of money. As the price level increases, the value of money decreases because each unit of money buys fewer goods and services. Inflation causes consumers to lose their purchasing power over time. If the inflation rate becomes too high, then money as a “medium of exchange” breaks down too. In countries with high inflation rates, people resort to barter and immediately exchange their local money for stable money, such as euros or U.S. dollars. However, people must use money as a medium of exchange because government laws legally require people to accept money as a means of payment to repay a debt or to pay taxes. The legal requirement is “legal tender.” On the other hand, bank checks are not legal tender, and people and businesses can reject checks as payment.
Fourth and final function of money is the standard of deferred payment. This function combines the “medium of exchange” and “unit of account” of money because contracts state debts in terms of a “unit of account” and borrowers repay using the “medium of exchange.” Hence, this function of money is extremely important for business transactions that occur in the future. Businesses and people can borrow or lend money based on future transactions that create the financial markets.
Money needs six desirable properties for people and businesses to use money, which are:
1.Acceptable: Businesses and public accept money as payment for goods and services. People must trust money in order to accept it for payment.
2.Standardized quality: Same units of money must have the identical size, quality, color, so people know what they are getting. If a government issued money in different sizes and colors, how would people determine whether bills are legitimate or counterfeit?
3.Durable: Money must be physically sturdy, or it might lose its value quickly as it degrades and falls apart. In some countries, people do not accept torn, ripped, or faded money.
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4.Valuable relative to its weight: People can easily carry large amounts of money around conveniently and use it in transactions.
5.Divisible: Public can break money down into smaller units to purchase inexpensive goods and services.
All modern countries use coins and paper bills as money, which possess the five desirable properties. Total value of paper bills and coins equals currency. Furthermore, people become psychologically dependent on a currency because they use a particular currency for a long time. For example, U.S. citizens have used dollars as their currency for two centuries. If the U.S. government wanted to introduce a new currency with a different name, then the public could reject the new currency.
Forms of Money
People since the dawn of civilization created payment systems. Thus, money facilitates business transactions, and the payment system becomes the mechanism to settle transactions. First and oldest payment system is commodity money. Commodity money is government selects one commodity from society to become money, such as gold or silver. If society did not use gold or silver as money, then people still use the commodity for other purposes. People use gold in jewelry, teeth fillings, electrical wires, or the pins of a microprocessor. Commodity money could be anything. For example, prisoners use cigarettes as money in U.S. prisons, while people accepted vodka and bullets as payment in remote parts of Russia during the 1990s.
Commodity money could be full-bodied money. Its value as a good in non-money purposes equals its value as a medium of exchange. For instance, if the market value of one ounce of gold is $1,000, and the government made one-ounce gold coins, then the face value of the coin would equal $1,000. Thus, this coin represents full-bodied commodity money because the coin's inherent value equals the coin's market value.
Governments discovered a trick about commodity money. What would happen if a government made one-ounce gold coins with a face value equaled to $2,000 while the coin contained $1,000 of gold? Subsequently, a government had created $1,000 out of thin air! Government can create value by “printing money,” which we call seigniorage, and government could receive significant revenue by creating money.
Government can debase its currency by relying on seigniorage. For example, the Roman government “printed money” by recalling its gold and silver coins. This it re-minted more coins that contained less gold and silver by adding cheap metals. In the beginning of the ancient Roman Empire, coins were almost pure gold and silver, while, towards the end of the empire, Roman coins contained specks of gold and silver. For example, government can debase coins. If government issued one-ounce, gold coins for $1,000, and the coins were 98% pure gold, then government can print money by collecting the old coins and mint two new coins with a value of $1,000 that only contain 49% gold. Then government fills the remaining 51% of the coin with cheap metals. Unfortunately, government could create extremely high inflation rates if it depends on seigniorage too much.
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Second form of commodity money is representative full-bodied money. This money has little inherent value, such as paper bills, but people can convert the money into a valuable commodity, such as gold and silver. For example, if you possessed U.S. dollar bills before 1933, you could exchange the bills for gold at the U.S. government’s exchange rate of $20 per gold ounce. Most of humanity used commodity money before the 20th century until government and central banks had replaced it with fiat money.
Governments and central banks created the second payment system, fiat money, and it is a 20th century creation. Most central banks in the world today use fiat money. In the United States, the Federal Reserve System has the authority to issue U.S. dollars, and the public cannot use this money for anything else. Furthermore, the people cannot exchange U.S. dollars for another commodity from government. For example, if people do not want to use U.S. dollar bills as money, it has no other function other than being fancy paper. Unfortunately, no authority can limit the amount of money the Federal Reserve System can issue. If the Fed wants to inject an additional $1 trillion into the economy, it could do so easily. However, a rapid expansion in the money supply could be drastic to an economy. For instance, countries with high inflation rates or hyperinflation have rapidly growing money supplies. Hyperinflation is a country’s inflation rate becomes extremely high, and prices become meaningless. Subsequently, people stop using money, and they resort to barter. We show a 100-trillion Zimbabwe note in Figure 3. A noble prize laureate in economics, Milton Friedman, stated, “Inflation is always and everywhere a monetary phenomenon.”
Figure 3. One-hundred-trillion Zimbabwe note
Third payment system, a check, is credit money tied to a person’s checking account. Banks, credit unions, and other financial institutions offer checking accounts to people and businesses. Then people use checks as a medium of exchange, allowing them to purchase goods and services. Once sellers accept a check, they present the check to a bank for payment. Consequently, checks have three benefits. First, people and businesses do not carry cash. Second, the check provides proof of a business transaction. Finally, checks become convenient in large transactions, such as buying a house or car. Buyer does not need to carry a suitcase of cash for this transaction. However, checks create two problems. First, the financial institution charges fees for using checks, or the check writers abuse their accounts and write fraudulent
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checks for amounts that exceed their account balances. Some businesses and people do not accept checks because they cannot verify if a person has sufficient funds in his account.
Checks evolved into the last payment system – electronic funds. The most common form being debit cards. A debit card improves the payments system’s efficiency and extends the function of checks. Many retail and grocery stores allow consumers to pay for goods and services using a debit card. When customers purchase their goods and services, they use a plastic card that contains either a chip or magnetic strip. Next, the store has machines that read the chip or magnetic strip and allow the store to transfers funds electronically from the customer’s checking account to the store’s bank account. Consequently, the debit card reduces the uncertainty the customers have sufficient funds in their account for business transactions. Although many businesses do not accept checks, they do accept debit cards.
Debit cards expanded electronic funds leading to the automated teller machine (ATM) and the internet. Automated teller machine (ATM) allows people to withdraw cash from machines that are located at banks, grocery stores, shopping malls, and gas stations. ATMs are connected together through computer networks, and one of the largest networks is Visa Debit. The Visa network allows customers to access their checking and savings accounts at financial institutions 24 hours a day, 7 days a week, from almost every city in the United States, and many foreign countries around the world. Finally, people can buy products and services, transfer bank funds, or pay utility bills by sitting behind a computer screen. They only need a computer connection to the internet to transfer money or pay bills.
Bitcoins
The internet created a new money that exists only in cyberspace. We call this money Bitcoin, where bit refers to the computer term – a piece of information, either a one or zero. This money has other names including virtual money or cryptocurrency.
No central bank or government issues Bitcoins, and 11.75 million Bitcoins were circulating in the world in October 2013. Bitcoins’ supply continuously grows until 2140, stopping at 21 million Bitcoins. Furthermore, cryptography plays a key role in Bitcoins. Every Bitcoin has a unique, encrypted number that only a Bitcoin operator can decrypt. A person opens an account or wallet and can buy Bitcoins from online vendors. A person can store his Bitcoins on his computer or cellphone or use an online wallet.
A person does not have to reveal his identity. Then he or she settles transactions by sending the other party his Bitcoin information. As a buyer completes a transaction, software encrypts that person’s private key into the transaction along with the Bitcoin number. A private key is like a person’s bank account number. Ensuring people do not spend the same Bitcoin for multiple transactions, a miner completes the transaction. A miner decrypts the transaction and records it in a ledger. Then it re-issues the Bitcoin to the seller. A miner can earn transaction fees and receives newly created Bitcoins by clearing transactions.
Miner is not the proper terminology. A miner functions as a clearinghouse. A clearinghouse can be a large bank that helps member banks transfer money between them. Then member banks have accounts at the clearinghouse. For example, you buy $500 in clothes from an internet store and send a check to the seller. Next, the seller deposits the check into his or her
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bank account. Seller’s bank sends information about the check to the clearinghouse and the clearinghouse checks with your bank. Your bank checks your balance ensuring you have enough funds in the account to pay the check. Once your bank approves the transaction, the clearinghouse reduces the account for your bank by $500 and adds $500 to the account for the seller’s bank. Then your bank reduces your account by $500 while the seller’s bank adds $500 to his or her account, thus clearing the transaction.
Bitcoins have four drawbacks that would prevent wide scale adoption.
1.People who deposit their savings into banks have deposit insurance. If their bank fails, the deposit insurance guarantees the depositors will not lose their money. The Federal Deposit Insurance Corporation insures bank deposits up to $250,000 for U.S. banks. However, no government agency insures Bitcoin or protects people from losses.
2.Hackers can break into online wallets and steal the Bitcoins. Since all transactions are electronic, they can erase history, and people may not recover their stolen Bitcoins.
3.Price of Bitcoin fluctuates greatly between $80 and $1,000, which we show in Figure 4. For people to use and accept money, people must know the money’s value. Some investors purchased Bitcoins, hoping to buy at a low price and sell for a high price.
4.Few sellers accept Bitcoins as payment.
Source: http://bitcoincharts.com/charts/
Figure 4. The Bitcoin’s value
Bitcoins provide three benefits. First, buyers and sellers do not have to reveal their identities to each other. They can remain secret. Second, people can use Bitcoin to launder or smuggle currency outside a country. A buyer would purchase Bitcoins in one country and withdraw the Bicoins in another country, circumventing currency controls. Finally, buyers and sellers use
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Bitcoins to settle transactions in the underground economy that is hidden within the internet. We call this the deep internet where most internet users would never see. The deep internet allows buyers and sellers to communicate with each other without revealing their location or identities.
Bitcoin is evolving into the currency of the black markets on the internet. Buyers and sellers use Bitcoin like the numbered Swiss bank accounts. For example, they open a numbered account at a Swiss bank that contains no personal information. Then they can use the account to settle transactions secretly. For example, a person pays for an illegal service. This person contacts the Swiss bank and asks the bank to transfer the bribe amount from his bank account into the seller’s bank account. This person gives the banker a code (or private key for Bitcoin) to approve the transfer. Consequently, the transaction remains secret because no one has revealed his or her identities.
U.S. federal government is cracking down on the internet black market and is closing down Bitcoin operators. Agents believe that if they can shut down the money, they can eliminate the black markets operating in the deep Internet or prevent the funding of terrorists. For example, the U.S. Department of Homeland Security shut down Mt Gox, the largest Bitcoin operator in the United States in May 2013 although Mt Gox did not participate in illegal activities. U.S. law requires all money exchangers to register with the Financial Crimes Enforcement Network. Unfortunately, the federal government will fail because people can use Bitcoins anywhere in the world.
Bitcoin continues to flourish despite its drawbacks and U.S. government crackdown. Bitcoin ATMs are cropping up in Hong Kong, New York City, and Vancouver, and more stores and vendors are accepting Bitcoins for payment.
Money Supply Definitions
Economists use two approaches in defining the money supply: transaction and liquidity. If economists use the transaction approach, they emphasize the money’s function as a medium of exchange. Only a few assets possess this property. As the central bank boosts the money supply, people raise their spending that boosts national output, increases income, reduces unemployment, and creates inflation.
If economists use the liquidity approach, they take all assets, rank them by liquidity, and include only liquid assets in the money supply because people can easily sell these assets at a future time at a known price with minimum costs. This approach emphasizes money’s function as a “store of value,” because if highly liquid assets retain their value, people can easily use the assets to purchase goods and services directly or indirectly. Why does this approach work? When the central bank boosts the money supply, people will adjust their portfolios of assets, affecting consumer spending, national output, income, and employment.
The Federal Reserve System defines money supply as M1, M2, M3, and L. Many central banks in the world measure their money supply similarly to United States. However, they differ which financial instruments they include in their measures. Every country uses different financial instruments because countries differ in their legal systems, regulations of financial markets, and customs.
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Economists define the M1 as the narrowest definition of money supply because they use the transaction approach to determine which financial instruments to include. M1 adds the following three items together:
Currency held by the public and in bank vaults. It excludes currency held by the government.
All forms of checking accounts.
Traveler’s Checks that are held by people and not by the banks.
Economists define the M2 as a broader definition than M1 because they use the liquidity approach to define the money supply. Economists add the following together for M2:
Include everything in M1.
Include all small denomination savings deposits and time accounts at all financial institutions. Small denomination in the U.S. means the bank account has a balance less than a $100,000. Examples include Certificates of Deposit or savings accounts at banks.
Economists define M3 broader than M2 and include the following items summed together:
Include everything from M2.
Include large denomination savings and time accounts, and liquid securities with longer investment times than the financial instruments included in M2. For example, a corporation holds a $1 million Certificate of Deposit.
Economists define L for liquidity as the broadest measure of the money supply and include all liquid assets. The Federal Reserve does control this measure. L sums the following items together.
Include everything from M3.
Include all short-term securities, such as Treasury Bills issued by the U.S. Federal government. (Refer to Chapter 2 for examples of short-term securities).
The Fed stopped publishing the M3 definition of the money supply on March 23, 2006. It stated M3 does not provide any useful purpose, and the Fed does not use M3 in formulating monetary policy. Some international investors believe the Fed stopped publishing M3 because some people fear a U.S. dollar collapse on the international markets because the United States suffers from large trade deficits and a massive national government debt. (We discuss these
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