This is a textbook for students and practitioners alike. It intends to explain the theoretical background of monetary policy. It is based on the author’s German book “Geldtheorie und Geldpolitik.
Contents
1 Fundamental Concepts.
1.1 Money
1.1.1 Monetary Functions
1.1.2 Forms of money
1.1.3 Monetary Aggregates
1.2 Credit
1.2.1 Definition of credit
1.2.2 Forms of credit.
1.2.3 The economic function of credit
1.3 Liquidity
Comprehension questions on Chapter 1
Bibliography for Chapter 1
2 Money supply..
2.1 The central bank’s money supply and lending facilities..
2.2 The commercial banking sector’s supply of book money and credit facilities..
2.2.1 Introduction.
2.2.2 Fundamental static analysis.
2.2.3 Dynamic analysis.
2.2.4 Base money and other monetary aggregates
2.2.5 More recent aspects of the money supply
Comprehension questions on chapter 2.
Bibliography for chapter 2.
3 Demand for money.
3.1 Introduction..
3.2 Classical/neoclassical money demand theory
3.2.1 The velocity approach
3.2.2 The cash-balance approach
3.3 The Keynesian liquidity preference theory
3.3.1 Introduction
3.3.2 Transaction-cash balances..
3.3.3 Speculative-cash balances..
3.3.4 The general demand function according to Keynes
3.4 Post-keynesian demand theories.
3.4.1 The inventory theory approach
3.4.2 Portfolio selection theory
3.5 M. Friedman’s money demand theory
4 Monetary Euquilibrium and Transmission
4.1 Interest Formation and Transmission in classical/neoclassical Theory.
4.2 The Keynesian Monetary Equilibrium Model and the Transmission Mechanism
4.2.1 Monetary Equilibrium and Interest Formation according to Keynes.
4.2.2 The Transmission Mechanism.
4.2.2.1 The Curve of Equilibria in the Money Market (LM Curve)
4.2.2.2 The LM Curve and Changes in Price Level..
4.2.2.3 The Curve of Equilibrium in the Goods Market (IS Curve)
4.2.2.4 The IS Curve and Changes in the Price Level
4.2.2.5 Equilibrium in the Goods and Money Markets at Constant Price Level
4.2.2.5.1 Monetary Measures to Achieve Equilibrium at a Constant Price Level
4.2.2.5.2 Goods Market Measures to Achieve Equilibrium at a Constant Price Level
4.2.3 Summery of the Hitherto Results and Their Consequence for Economic Policy
4.3 Further Developments of the Classical Theory.
4.3.1 Wicksell’s Processes..
4.3.2 The Loanable Funds Theory..
4.4 The Basic Concept of Monetarism and the Monetarist Transmission Process
4.4.1 The Basic Concept of Monetarism
4.4.2 The Monetarist Transmission Process...
4.4.3 Some Comments on Monetarism..
5 Changes in the Value of Money..
5.1 Definitions.
5.2 Measuring Changes in the Value of Money..
5.3 Types of Inflation..
5.4 The Monocausal Approach in the Theory of Inflation..
5.4.1 The Classical/neo-classical Theory of Inflation
5.4.2 The Monetarist Theory of Inflation
5.5 The Multicausal Approach in the Theory of Inflation
5.5.1 Demand-pull Inflation
5.5.2 Supply-push Inflation
5.5.2.1 Cost-push Inflation
5.5.2.2 Profit-push Inflation..
5.6 The Effects of Inflation..
5.6.1 Effects on the Function of Money.
5.6.2 Effects on International Competitiveness..
5.6.3 Effects on Employment.
5.6.4 Effects on Growth..
5.6.5 Effects on Distribution
5.7 The Effects of Deflation
List of Symbols and Abbreviations.153
1 Fundamental Concepts
1.1 Money
When we speak about themoney in an economy, we assume that this means itslegal tender. Money is thus “a creature of law” asGeorg Friedrich Knappput it in “Die Staatliche Theorie des Geldes” (The State Theory of Money).
By contrast,JohnLocketook the view that the emergence and value of money are attributable to an agreement (convention) between people.
The opinion that money is created and has its value assigned by law is termednominalist theory, whilst the view that money comes into being through an agreement between people is calledconventionalist monetary theory.
However, in times of crisis it becomes clear that the money created by the state by law is able to perform importanteconomicfunctions, such as serving as amedium of exchangeor astore of value, only to a limited extent.
Other goods assume its tasks for in an economy only counts the principle that money is what money does.
However, even if an economy‘s legal tender performs all monetary functions, other assets, which can likewise assume at least some monetary functions, also exist. Therefore, money is a good amongst other goods – but the one with the highest degree of liquidity – which like other goods is held for particular purposes. This opinion, which is termed theliquidity approach, has its origins in the views put forward byAlfred Marshall,Arthur Cecil PigouandJohn Maynard Keynes.
The following is an attempt to describe the phenomenon of “money” with the help of its functions in the economic process: this is calledfunctionalist theory.1
1.1.1 Monetary Functions
The functions of money in the economic process become clear through a comparison of a moneyless economy (barter economy) and a money economy. Themoneyless economywill be considered first. Figure 1.01 shows the exchange of consumer goods.[2]
Figure 1.01: Barter exchange of consumer goods between two economic agents
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Figure 1.02, by contrast, shows the exchange of the production factor labour (producer good) of a household (as a consumer household) for an enterprise’s consumer good.
Figure 1.02: Barter exchange of the production factor labour for a consumer good
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In Figure 1.02, the production factor labour is remunerated with the consumer good which it has helped to produce. Thus, for example, Volkswagen employees would be paid in Volkswagen cars. This form of remuneration is known as the “truck system”.[3]
Both examples show that several problems arise for the parties involved in abarter exchange.
It is extremely difficult for the parties involved in an act of barter to find always exactly the rightmarket partner(referred to as “the double coincidence of wants”). The economic agents thereby incur high search costs (information costs) and possibly even losses through a rotational barter system. Moreover, the value of the two barter goods must be estimated correctly.[4]In the case of the truck system, the employees have the additional problem of reselling the consumer goods received as they are not normally able to live off these goods.
In order to highlight the problems which arise incalculating anddeterminingthe value relationshipsbetween bartered goods in a moneyless economy, the following matrix shows all of the possible value relationships (also referred to as exchange ratios or relative prices) between only four goods.
The matrix shows that there are at most 16 value relationships between four goods. In general, the following applies: for “n” goods there are “n2” value relationships. However, not all of the value relationships are of relevance. For example, the matrix shows that a quantity of good A is worth precisely a quantity of good A. This information is of no interest. Therefore, if the value relationships on the central diagonal (A/A, B/B etc) are disregarded, the number of value relationships decreases by “n”. This leaves (n2 - n) value relationships. Moreover, if the value relationship A/B is known, it is possible to calculate the reverse value relationship. Therefore, for “n” goods, only (n2-n)/2 value relationships are required.
Thus, there are six relevant value relationships between four goods. However, this figure increases to 4,950 value relationships for 100 goods and 280,875 (!) value relationships for the 750 goods which constitute the basket of goods in the consumer price index (2000 basis).
These numerical examples show that astandard goodmust almost inevitably be introduced into an economy so as to drastically reduce the number of value relationships. If this standard good is given the value 1, the number of value relationships for 100 goods falls from 4,950 to 99.
Table 1.01: Matrix of value relationships
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It thus becomes clear why standard goods already came into being in the form ofcommodity moneyamongst individual peoples at an early stage in history. However, these kinds of goods also emerge again and again in times of crisis in today’s economies when the legal tender in the form ofpaper moneyno longer fulfils its economic functions, such as in the period from 1945 to 1948 with the so-called “cigarette currency” in Germany.1
Theintroduction ofmoney as a standard goodtherefore considerably facilitates the barter transaction. Money thus also takes on the function of ameasure of value or unit of account(means of calculation).
This function is described as beingabstractas the money itself does not necessarily have to be available in a tangible form. An enterprise in the Federal Republic of Germany can present its balance sheet in US dollars without being in possession of a single dollar.
If one moves from a moneyless economy to amoney economy, then money starts to perform thespecificfunction of ageneral medium of exchange. In a money economy, it is not necessary to find the “right” barter partnerimmediately. The good is first of all exchanged for money and then a partner is sought.
This is demonstrated in Figure 1.03.
Economic agent 1 would like to exchange good A for good C. As it does not immediately find an appropriate market partner (economic agent 3), it exchanges good A for money (Mt) in the period t.
Economic agent 1 can then acquire good C with money at a later time (t+1). Subsequently, economic agent 3 could use this sum of money to acquire good B from economic agent 2 in the period t+2. Therefore, it would no longer be necessary to have adouble coincidenceof wants, but rather only asingle coincidence.
Figure 1.03: Exchange of consumer goods in the money economy
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By contrast, the following macroeconomic circular flow diagram shows the exchange offactor services for money.
In exchange for the factor services which they make available to enterprises, households (as consumers) receive income in the form of money with which they can acquire the consumer goods of their choice.
Figure 1.04: Exchange of factor services and consumer goods for money in the
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As there are alsounilateral transactionswith no directly attributable counterperformance, for example, gifts of money between individuals, money also serves as a payment medium for unilateral performance, i.e. as ameans of transferring value.
As already mentioned, money makes it possible to select the right market partner at a later juncture. In the meantime, it leaves several options open.
Purchasing power is stored,i.e. money also serves as astore of value.
It is thus a means of forming savings and enables the possessor to acquire goods in the future, i.e. it is “a link between the present and the future” asKeynesreferred to it. Money thus also fulfils a temporal function.
Money can be held in the same way as other assets. However, it is a special asset, i.e. it is accepted by everyone as it can be directly exchanged for other assets. Money has thehighest liquidityof any asset although its connection with other assets is of a substitutional nature, above all, with regard to storing value.
As indicated by the latter function of money as a store of value, purchasing power stored in the form of money can be retained only if the value of the money does not diminish.
It is therefore necessary for thestock of legal tender in an economy to bemanaged in such a way that its monetary value remains stable.This simultaneously ensures that money’s other functions are also safeguarded.
Acentral bank’s key taskis thereforeto maintainmonetary stability.
In a market-based system, monetary stability is synonymous with “price stability”.1
1.1.2 Forms of money
Historically, money as a standard good has taken various forms in individual economies, predominantly ascommodity money,such as, for example, furs in Canada, tea in Tibet, livestock in the Roman Empire, glass beads in Africa, shells on the coast of India or nails in a village in Scotland as mentioned byAdam Smith.2
In the case of pure commodity money, the value of the money was determined by the value of the commodity itself.
These forms of commodity money mostly had several practical disadvantages. Although they fulfilled the aforementioned monetary functions, this was not enough. A standard good should also have certain special properties: indestructibility, homogeneity (as it must be divisible), scarcity and transferability. Moreover, the costs of storing and transporting the good should be low.
If the giv2en historical forms of commodity money are considered in view of these criteria, it is clear that a large number of them did not have these properties and were, therefore, superseded by other forms of money.
The required practical properties are indicative of the development of the precious metals gold and silver as commodity money. Therefore, gold and silver as metallic coin standards are the culmination of the development of commodity money.
The unique feature ofmetallic coin standardslay in the fact that the “issuer” of the coin guaranteed the “imprinted” value by way of his stamp (minting). However, problems arose, in particular, through the concurrent use of different metals, for example, the bimetallic standard of gold and silver. If the value of silver fell in relation to the value of gold (for instance, as a result of silver discoveries), then the exchange ratio deviated from the official value relationship. Gold was hoarded. The “good” gold money was crowded out by the “poorer” silver money. This phenomenon was already discovered by the EnglishmanSir Thomas Gresham(1519-79) in the mid-16th century (Gresham’s law).
In modern economies, the followingstate-issued forms of moneyhave emerged:
1. coins
2. banknotes (paper money)
These two forms of money are jointly referred to ascash.
Today’scoinsdeveloped from full-value circulated coins (bullion coins), which were made of precious metal, although the value embossed on today’s coins - referred to as the nominal value or issue value - does not match the commodity value. As they are alloys, these coins are referred to as low-value secondary coins.
In the Eurosystem, the governments of the participating countries, i.e. in Germany the Federal Government, have the right to mint coins and put them into circulation (coinage prerogative). They are entitled to the difference between the face value and the production costs of the coin (seigniorage).
Seigniorage comes into being when the central bank purchases the coins from the government at face value. The coins are issued by the European Central Bank on behalf of the Euro-area governments. However, the governments cannot have unlimited amounts of coins minted and use this money to finance their budgets as the overall volume of coins to be issued has to be approved by the European Central Bank .
There are Euro (€) and cent coins (1 Euro = 100 cent) in the denominations 1, 2, 5, 10, 20 and 50 cent, and 1 and 2 Euro.
The obverse side of each coin is common to all Euro-area countries, but the reverse side has been individually designed by each country. Despite this difference, all of the coins are legal tender throughout the Euro area.
TheEuro banknotesare issued by the European Central Bank and the national central banks. There are no national differences in their appearance.
The banknote series comprises seven denominations: €5, €10, €20, €50, €100, €200 and €500. There is no upper limit for the number of banknotes issued by the European Central Bank. It is, however, guided by its primary objective of price stability in banknote issuance.
Banknotesandcoins are legal tenderwhich have to be accepted as a means of payment in unlimited amounts. They are, therefore, also calledobligatorymoney.
Ahistorical digressiononcover principlesandforms of moneyin the 19th century, in particular the Currency Principle and the Banking Principle, would be appropriate at this juncture.[5]
The proponents of theCurrency Principle(includingDavid Ricardo) called for complete gold cover of the banknotes in circulation. The intention was to prevent inflationary developments. The Currency Principle probably came into being on the basis of the inflation experienced in Great Britain during the Napoleonic Wars when the banknotes in circulation were not completely covered by gold.
This Principle was implemented (although only in a modified form) by the Bank of England in Peel’s Bank Act of 1844. The Principle proved to be not very suitable in a growing economy with cyclical fluctuations, which is why it had to be breached three times in the 19th century (with the authorisation of Parliament).
By contrast, theBanking Principlecalled for the banknotes in circulation in an economy to be covered by good trade bills, which the central bank purchased from the commercial banks. The intention was again to prevent inflation as, following the creation of money through the central bank’s purchasing of a bill, the destruction of money automatically occurred upon maturity of the bill through the reflux of money to the central bank. Money creation could also take the form of credit at the central bank. The Banking Theory, therefore, also considered sight deposits held at the central bank to be money.
When theDeutsche Reichsbankwas first established (1 January 1876), it applied a combination of the Banking Principle and the Currency Principle, but predominantly the Banking Principle. The regulations governing the Reichsbank stipulated (in principle) that banknote issuance was to have one third gold cover and two-thirds cover by trade bills.
Both principles showed an attempt to restrict increases in the money in circulation by means of institutional rules in order to prevent inflationary developments The proponents of the Currency Theory assumed that the money stock and, with that, economic activities, were controlled by the central bank. This means that the money supply was dependent on the gold holdings and, therefore, on an exogenous factor.
By contrast, the proponents of the Banking Theory assumed that the money stock was determined by economic activities and, therefore, endogenously. The money supply is thus dependent upon the demand for money.
In pegging the banknotes in circulation to the central bank’s gold holdings, the proponents of theCurrency Theorytook only gold to bedefinitemoney whilst banknotes were considered to beprovisionalmoney (token money). This view of money is known asmetallism. This “gold standard” (in contrast to paper currency) created an obligation to exchange currency for gold on the part of the central banks.
Parliaments (before 1914) imposed a restriction by pegging the banknotes in circulation to a particular exogenous variable, such as the central bank’s gold holdings. This had to regulate the banknotes in circulation in accordance with a particular rule. This is known as arule-based monetary policy.
The Parliament of the Federal Republic of Germany did not pursue this option when it established the Deutsche Bundesbank. It imposed a self-restriction in granting the Bundesbank autonomy. Moreover, it did not impose a commitment to rules on the Bundesbank.
The Deutsche Bundesbank controlled and regulated the money supply and credit supplied to the economy independently of the government until the end of 1998. The banknotes in circulation were not pegged to an external variable, nor was a maximum amount stipulated.
The European Central Bank is likewise not subject to any restrictions regarding the issue of banknotes. The ECB Governing Council makes decisions on banknote issuance at its own discretion.
Besides banknotes and coins,book moneyordeposit moneyhas developed as a further form of money. This form of money concernsnon-certificated claims vis-à-vis the central bank or commercial banks. “Non-certificated” in this respect means that the claim is not proven by means of a particular document, but is only entered in the banks’ books. The customer (as a creditor of the bank) can draw on this credit position at any time by way of cheques and credit transfers. In contrast to obligatory money, book money is onlyoptionalmoney, i.e. there is no obligation to accept it as a payment medium. A credit transfer or a cheque can be refused.
As banks’ books now take the form of data stored on computer databases, this form of money is nowadays referred to as “computer money”. Book money comes into being, e.g. when a loan is granted and the amount is credited to a current account, also referred to as an operating account or chequing account. Asight balance,also called asight deposit or demand deposit,comes into being with this credit entry, which is tantamount to the creation of book money.
The quantitative and practical relevance of book money is constantly increasing in comparison with the other forms of money. Book money’s share of the money stock, i.e. thebookmoney ratio, amounted to approximately 76% in the Federal Republic of Germany at the end of 1998, whilst thecash ratiowas around 24%.1
More recently, so-called“plastic money”in the form of credit cards has been gaining ground. The customer makes payments using his credit card and signature. The bills are then submitted to his bank for settlement. The prerequisite is, therefore, that the customer must have book money or credit at the bank. However, this prerequisite must not necessarily exist until the bills are submitted to the bank. It is supplier credit, which is repaid without cash. The medium of exchange function can thus be performed.
Theelectronic cash procedureis another new payment development which allows payments to be debited directly from a customer’s bank account at a point of sale (POS) in a shop or store on the presentation of a Eurocheque card. A reloadable electronic purse is another means by which payments can be debited directly from an account. Supplier credit is not given in this case.
Nowadays, the majority of bills are paid in a cashless form, i.e. through credit transfers, credit cards, cheques or electronic cash.
Besides coins, banknotes and sight deposits, a number of otherforms of liquidityand investment are coming to the fore.
The collective term“near money”(A.C.Hart) ornear-money assetscan be used to describe some of these forms of liquidity. Most of them are financial assets (also called money substitutes), which do not serve directly as a medium of exchange, bur rather as a store of value.2
Thesefinancial assetsinclude
- savings and fixed-term deposits,
- credit balances with insurance corporations,
- credit balances with building and loan associations,
- all kinds of securities and
- credit balances in foreign currency (foreign exchange assets).
Other assets, i.e. even goods, could ultimately be counted as liquidity in the broadest sense.3
This again highlights the fact that other assets can also take on monetary functions, e.g. the store of value function, which is why it is necessary to includeother forms of liquidityapart from money andother financial institutionsapart from the commercial banks in the analysis as demanded by proponents of theliquidity approach.
1.1.3 Monetary Aggregates
The monitoring of the development of certain monetary aggregates - also referred to as global monetary variables - over time is especially important for monetary policy and theory.
Monetary aggregates can serve asindicatorsof monetary development or asintermediatetargetsof monetary policy. The changes in their values are also of particular interest.
Monetary aggregates are calculated by adding together certain money holdings and possibly holdings of financial assets (e.g. deposits on savings accounts) of economic agents. Monetary aggregates are used to monitor the development of liquidity in the whole economy, but also in individual sectors.
By issuing cash (banknotes and coins), but also by exerting an influence on the holdings of book money, a central bank tries to influence an economy’s overall money supply and in this way to achieve its most important objective of price stability.
In order to be able to decide on appropriate money stocks, the economic entities must be divided up into sectors. In doing so, central banks endeavour to differentiate betweenmoney-creatingsectorsand other sectors.
The central banks are particularly interested in the money supply of the sectors which do not create money as they fear that excessive monetary expansion could lead to an increase in the demand for goods and, with that, to inflation. The objective of achieving price stability would then be breached.
In Germany, up to 31 December 1998, theDeutsche Bundesbankdefined different money stocks in order to monitor and exert an influence on the liquidity of the economy. The Deutsche Bundesbank made a distinction between the banking sector and the non-bank sector. The Bundesbank and the commercial banks belonged to the banking sector, whilst the public sector (=general government) and the private sector (=households and non-bank enterprises) belonged to the non-bank sector.
This distinction is important as a claim on a bank concerns book money if a customer can draw on this credit position at any time by way of cheques and credit transfers, whilst a claim on a non-bank does not concern “money” in the narrower sense of the word as the creditor cannot draw on this credit position immediately.
In theEurosystem, a distinction is made between theMonetary Financial Institution (MFI)sectorand thenon-Monetary Financial Institution (non-MFI) sector,also referred to as thenon-financial sector.
The MFI sector is the money-creating sector. It comprises the central banks, the credit institutions within the meaning of Community law and all other resident financial institutions whose business is to take deposits and/or close substitutes for deposits from non-MFIs, and, for their own account, to grant credits and/or to make investments in securities. In Germany, this sector also includes the money market funds and the building and loan associations.
Sectoral breakdown for determining the money supply of the Eurosystem:
1. Monetary Financial Institutions (MFIs)
a. Central Banks
b. Credit institutions (including building and loan associations) and other financial institutions (money market funds)
2. Non-MFIs
a. Private sector (households and non-financial corporations)
b. Public sector (= general government)
In considering the sectoral breakdown of the Eurosystem the followingmonetary aggregateswill be briefly explained.
- Currency in circulation
Thecurrency in circulationconsists of the banknotes in circulation and the coins in circulationoutsidethe central bank. The central bank has a direct influence on this variable as it has the right to issue banknotes (banknote prerogative) and issues coins on behalf of the government or governments which hold the coinage prerogative.
The central bank ascertains the amount ofcurrency in circulationin the non-MFI sector by deducting the amount of cash holdings of the MFIs from the total amount of currency in circulation.
- Central Bank Money
Besides cash, the sight deposits of the MFI sector and the non-MFI sector held at the central bank are also considered to be central bank money. An economy’s stock ofcentral bank moneyis therefore defined as follows:
All of the currency in circulation (outside the central bank) plus the sight deposits held at the central bank.
Central bank money is also referred to asbase moneyor high-powered money, as it is regarded as the monetary base for other monetary aggregates. Themonetarists’monetary base conceptassumes that the central bank is able to autonomously control the growth of the money stock and of credit in an economy with sufficient precision by means of this monetary base.1
The monetary base can be determined from the assets side or liabilities side of the central bank’s balance sheet. Account 1.01 shows the balance sheet of the Eurosystem as at 31 December 2013.
On the basis of the central bank balance sheet, a simplified balance sheet with the addition of the coins in circulation must be drawn up to show the monetary base. This simplified balance sheet (Account 1.02) comes into being predominantly through the net recording of claims and the pooling of several items.
The left side of the simplified balance sheet shows thesources of themonetary base, e.g. net claims on non-euro area residents, financial sector refinancing, lending to general government by the central bank, the acquisition of securities by the central bank and the issuance of coins. The liabilities side of the balance sheet shows how themonetary base is absorbed, i.e. the currency in circulation (banknotes and coins in circulation) and financial sector deposits with the Eurosystem.
- Cash reserves and excess reserves
The current level of central bank money in the financial sector (MFI sector) can be determined on the basis of the financial sector’s cash reserves or the size of the excess reserves, whereby
the financial sector’scash reservesare understood to mean holdings of central bank money (money holdings and sight deposits at the central bank) and
theexcess reservesresult from the financial sector’s holdings of central bank money less the minimum reserves amount.
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However, the size of the financial sector’s excess reserves shows only the current level ofprimary liquidity availablein the financial sector. As a rule, it is possible for the MFIs to obtain additional central bank money, e.g. through borrowing from the central bank, and thus to increase the excess reserves if they require this central bank money as a basis for granting a loan.
- Money stocks
The Eurosystem have developed different money stocks (M1, M2, and M3). These are solelymoney stocks oftheEuro area’s non-MFI sector. The ECB’sMonthly Bulletindoes not refer to money stocks, but rather to monetary aggregates. These aggregates are considered to be financial sector liabilities and are defined as follows: themonetary aggregatescomprise the monetary liabilities of the MFIs and central government to non-MFIs resident in the Euro area (excluding central government).
Table 1.02: Definition of the Monetary Aggregates M1, M2 and M3
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In determining the money supply, the very narrow monetary aggregate M1 is taken as a starting point and then more and more money substitutes (near-money claims) are included in the analysis.
The different money stocks were created, on the one hand, to be able to detect pure shifts in financial assets by means of a narrow definition and, on the other, to be able to eliminate these shift effects through a broad definition.
This is explained in the following example based on the Eurosystem’s monetary aggregates.
If a household changes its fixed-term deposits (deposits with an agreed maturity of up to two years) into sight deposits, then M1 increases and M2 remains constant. A shift of this kind is interesting for a central bank as it may lead to a greater demand for goods. However, the non-MFI may hold sight deposits to be able to purchase securities at a later point in time so as to obtain a greater return than from the fixed-term deposit.
A shift from fixed-term deposits to deposits with an agreed maturity of up to three months (savings deposits) is, by contrast, a simple portfolio shift in the form of a conversion from fixed-term deposits to savings deposits. These shifts are thus, as a rule, to be viewed in connection with interest rate changes (yield considerations). The Eurosystem created the monetary aggregate M2, which also includes savings deposits, in order to eliminate these shift effects (portfolio effects).
The very broad monetary aggregate M3 is not altered by portfolio shifts (with a maturity of up to two years). However, M3 increases if a MFI extends credit to a non-MFI. It likewise increases if a non-MFI sells a debt certificate back to a MFI and receives a fixed-term deposit in return. M3 does not change, for example, merely if money market fund certificates are exchanged for fixed-term deposits.
M3 is intended to help to describe effective purchasing power demand in the broadest sense.
Table 1.03 shows the development of Euro-area monetary aggregates and their components over time, and the rates of change. The rates of change are shown by way of illustration for five months in chart form in Figure 1.05. However, only the rates of change for M3, overnight deposits and deposits with a maturity of up to two years (fixed-term deposits) and up to three months (savings deposits) are shown.
The chart illustrates the aforementioned fact that, despite considerable changes in the individual sub-components owing to portfolio shifts, the Eurosystem’s very broad monetary aggregate M3 remains often virtually nearly unaltered, i.e. the aggregate M3 is not as volatile as its components.
For example, in February 2014, there was a 0.6 % decrease on the month in deposits with a maturity of up to two years (fixed-term deposits), but currency in circulation increased by 0.5 % and overnight deposits (sight deposits) even by 1.2 %. The monetary aggregate M3 increased only very slightly by 0.3 % (Table 1.03 and Figure 1.05).
The increase of 1.2 % of the Overnight deposits indicates the actual problem that many commercial banks don’t trust in the credit standing of the other banks and therefore deposit their money with the European Central Bank.
The Deutsche Bundesbank considered its money stock M3 (similar to M2 of the Eurosystem definition) to be an especially suitable indicator for a central bank. However, it also served as anintermediate targetfor the Deutsche Bundesbank from 1987 to 1998.
The monetary aggregate M3 as defined above for the Eurosystem is no longer an intermediate target for the ECB, but rather only a monetary indicator.
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1.2 Credit
1.2.1 Definitions of credit
In order to complete transactions between economic agents, it is not always necessary for payment to be made immediately when the goods pass from the supplying economic agent to the recipient economic agent. The goods can also be suppliedon credit, i.e. payment is made at a later time.
The following three credit operations are examples of this.
- Exchange on account
Good A is supplied in the period t (At) and paid for later in the period t+1 with good B (Bt+1). This is termedcredit in kind.
Figure 1.07: Credit in kind
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- Purchase on account
Good A is supplied in the period t (At) and paid for later in the period t+1 with money (Mt+1).
This is an example ofsupplier creditor aninstalment sale. In the case of an instalment sale, however, payment is provided (as a rule) in instalments and not in one sum.
Figure 1.08: Supplier credit
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In the case of supplier credit, the supplier lets the customer temporarily retain his purchasing power and abstains from exercising his own purchasing power until the end of the period allowed for payment t+1.
- Monetary credit
In the case of monetary credit, money in the present (Mt) is exchanged for money to be provided at a later time (Mt+1).
Figure 1.09: Monetary credit
illustration not visible in this excerpt
This is an example of standard monetary credit, which predominantly takes the form of a bank loan. The creditor lets the debtor have a certain amount of money in the period t (Mt), which the debtor promises to repay at a later time t+1 (Mt+1).
Anyone attempting to find adefinition of creditbased on the three credit operations described above may, however, encounter the difficulty that not all three examples are covered by the definition.
If we take, for example, the definition of credit put forward byWerner Ehrlicher, who understoodcreditas a
“temporary transfer of the power of disposal for a certain sum of money with the promise of repayment”1
Then it is clear that this is a special definition of monetary credit. The two other examples can be incorporated only with an addition, e.g. supplier credit: the customer would like to pay immediately, but the supplier is prepared to place the sum at his disposal temporarily.
It would, therefore, be more appropriate to choose a comprehensive definition ofcreditand to describe it as a “temporary transfer of purchasing power.”
This easily covers credit operations B and C. In the case of credit in kind, “purchasing power” would also have to be taken as meaning a good based on a very broad definition of liquidity (as for the near money concept).
Another possibility would be to introduce the terms “current good“ and “future good” and thus to understandcreditas meaning the exchange of a current good for a future good.1
All of these definitions make it clear that credit always concerns only a “temporary” and not a “permanent” transfer, which distinguishes it from a gift. Credit involves a repayment or the provision of consideration at a later time.
However, the definitions of credit provided up to now have not mentioned interest. Interest is regarded as the fee for the loan of money or goods (premium theory). The charging of interest is also justified, however, with the fact that the creditor abstains from exercising his purchasing power and is thus remunerated through interest payments on the part of the debtor (abstinence theory).
However, interest isnot a constitutive elementof credit as supplier credit shows.2
As regards theconnection between money and credit, not every example ofcredit creation(as an extension of a loan), also known as credit accommodation, automatically and immediately leads to thecreation of money(money production).
In the case of a bank loan, money is not created until the loan is used and the amount is credited to a current account.
In the case of credit creation within the bounds of supplier credit, this credit creation can lead to money creation only if the supplier attempts to “certificate” his customer’s book debt, i.e. has his customer sign a bill of exchange. However, money is created only when abankpurchases this bill of exchange with money.
1.2.2 Forms of credit
Credit takes various forms, which can be classified according to different criteria.
If one takes the criterion“liability basis”, a distinction can be made between
- a real estate loan and
- a personal loan.
In the case of an (unsecured)personal loan, the borrower as a person constitutes the liability basis. The creditor’s confidence is based on the debtor’s personal willingness and ability to effect performance.
This shows particularly clearly that the lender’s confidence in the borrower is the basis for granting credit. This is expressed in the word “credit” which comes from the Latin word “credere” meaning to believe or trust.
In the case of areal estate loan, the creditor secures his claim through liens on assets belonging to the debtor (secured in rem).
Another possible classification criterion is the “origin of the loan” or the “creditor”. For example, a distinction can be made between
- private loans (supplier credit, advance payments),
- bank loans (credit granted by commercial banks or the central bank) and
- public authority loans (central government, state government, local government, Reconstruction Loan Corporation (Kreditanstalt für Wiederaufbau, KfW).
The “use of the loan” or the “debtor” can also serve as a criterion, i.e.
- loans to private non-bank enterprises as producer credit (short-term operating credit, investment loans) or to households as consumer credit (instalment sales),
- loans to banks (sight deposits, savings deposits, fixed-term deposits of non-banks) and
- loans to public authorities (Federal bonds, Federal savings notes).
Finally, the criterion “maturity (term)” is also important for our analysis.
It is possible to differentiate between short-term, medium-term and long-term loans. As a rule, in Germany, “short-term” is understood to apply to loans with a maturity of up to one year, “medium-term” means between one year and four years, and “long-term” means over four years. However, there is no clear economic criterion for this maturity breakdown.
In this respect, an importantfunction performed by the commercial banksshould be pointed out: they transform short-term deposits into long-term loans and long-term deposits into short-term loans, i.e. they have atransformation functionwith regard to the maturity (term) of loans and deposits.
A further classification criterion is the “place where credit is granted orraised (territory)”, i.e. in Germany or abroad.
1.2.3 The economic function of credit
The above explanations have made it clear that, first and foremost, credit has a temporary bridging function for all economic agents.
Forenterprises, for example, this may beproducer creditin the special form of short-term operating credit if sufficient equity capital is not available. Credit in this case is required to bridge the period between remuneration of the factors of production (time t) and the receipt of proceeds from the services or work provided (time t+1), i.e. the production periods and the storage periods (storage of raw materials, intermediate storage, storage of finished goods).
Credit also has a temporary bridging function intradeof course, namely the period between purchasing and selling a good. Figure 1.10 schematically shows the bridging function in enterprises.
Figure 1.10
illustration not visible in this excerpt
Credit also has a temporary bridging function forhouseholdsin the form ofconsumer credit. For example, a good is purchased in the period (t) and paid for at a later time (possibly in instalments). Credit in this case facilitates consumption at an earlier time than would otherwise be possible. The period between acquisition and possible payment from the consumer’s own income is bridged.
In particular, credit has the task of safeguarding or even increasingoverall demand in an economy.
The existing level of overall demand is safeguarded if borrowers are matched against other economic agents who abstain from exercising their purchasing power to the same extent, i.e. saving. This is referred to ascompensatory credit, i.e. credit which compensates for the shortfalls in demand.
If the credit raised is greater than the other economic agents’ abstention from exercising their purchasing power, this is termedsupplementary creditas shown in Figure 1.11.
Figure 1.11
illustration not visible in this excerpt
This credit is used to create additional purchasing power, which may be tantamount to an expansionary stimulus for an economy provided that it does not lead to inflation.
According toJoseph Alois Schumpeter, this credit is a necessary but not an sufficient condition for economic growth.1
1.3 Liquidity
As already became clear with the introduction of the term “near money” and the description of the European Central Bank’s monetary aggregates, the term “liquidity” is at the heart of both monetary theory and monetary policy.[6]
The term “liquidity” has already been used in two ways, namely as
- a property of assets and
- a property of economic agents.
- Liquidity as a property of an asset
“Liquidity“ in this respect is understood to mean the property of an asset to be used as a means of payment or to be converted into central bank money (with varying degrees of ease). Individual assets, therefore, have differentdegrees of liquidity. The “moneyness” criterion is crucial in this respect. The degree of liquidity is determined by the time and the conversion costs involved in converting an asset into the highest form of liquidity, i.e. into central bank money. In this concept of liquidity, the emphasis is on thedegree of moneyness, which can also be described as “absolute liquidity” (Heinrich Nicklisch).[7]
- Liquidity as a property of an individual economic agent
“Liquidity” as a property of an economic agent is understood to meanan economic agent’sabilityto fulfil his payment obligations on time.[8]This kind of liquidity is also termedtimely liquidity.
Thetimely liquidityof an individual economic agent is determined by the following variables.
Stock of liquid assets (banknotes, coins, sight deposits at banks);
1. Holdings of claims, for which credit institutions or the central bank have provided definite purchase or lending commitments;
2. Holdings of claims without such commitments, which can be exchanged for money with only minor conversion costs (e.g. marketable securities);
4. Definite loan commitments.
Items 3 and 4 can also be described as “near money”.
These liquidity holdings or means of procurement must match to the matured liabilities at exactly the right time, which is why this timely liquidity is also referred to assolvency, i.e. the economic agent’s ability to pay.
Besides liquid assets and financial assets, non-monetary assets such as goods may also be attributed to liquidity in the broadest sense as most of an enterprise’s assets such as capital goods and stocks will be reconverted into money within a certain period of time. Companies factor their asset depreciation and consumption of materials into the price and get this back in the form of money through the turnover generated. This is termedself-liquidation.
Assets can of course also be sold without disturbing the production process as long as they are no plant equipment.
Liquidity analyses are used to try to determine the timely liquidity of individualenterprisesthrough comparing the stock of liquid resources and liabilities. Liquidity is understood to mean acover ratiohere, which is why it is also calledrelative liquidity.[9]
Besides this static analysis, expected future inflows of liquid funds are matched against expected maturing liabilities in financial planning. This constitutes a switch to a dynamic analysis.
- Sectoral and overall liquidity
The factors applicable to an individual economic agent can be transferred analogously to agroup of economic agents,i.e. tosectors, only if intra-sectoral claims and liabilities are offset.
Therefore, liquidity in the non-MFI sector increases if the sector monetises near-money claims at a bank, which signifies an increase inexternalliquidity. However, there isnochange in the sector’sinternal liquiditywhen non-MFI A sells a bill of exchange to non-MFI B for cash. This leads only to a shift in the primary liquidity within the non-MFI sector.
The liquidity in some sectors was defined in the section on “Monetary aggregates”, for example
- the currency in circulation in the non-MFI sector and
- the excess reserves and cash reserves in the financial sector (MFIs).
However, this covers only a part of the total liquidity in each sector.
Up to 1982, the Bundesbank determined the sectoral liquidity in the commercial banking sector, i.e.bank liquidity, using the indicator “commercial banks’ free liquid reserves”.
This indicator included
- current central bank money in the form of excess reserves and holdings of domestic money market paper (which the Bundesbank redeemed at any time) and
- potential central bank money in the form of unused rediscount quotas, which corresponded to the commercial banks’ remaining acceptance and bill-based borrowing reserve.
The Deutsche Bundesbank abandoned this indicator a long time ago as it did not cover all of the commercial bank’s means of obtaining liquidity, such as Lombard loans and securities repurchase agreements.
The indicator could, therefore, no longer be seen “as the appropriate yardstick, in macroeconomic terms, of the scope available to the banking system for recourse to the central bank”1.
The ECB every month publishes a description of the Eurosystem’s contribution to the banking system’s liquidity in connection with the trend in minimum reserves so as to show changes in bank liquidity.2
It is important for the combined groupnon-MFIsand MFlsnot only to shift liquidity within the group, but also to obtain liquidity from the central bank.
This occurs, as a rule, through thefinancial sectorobtaining central bank money from the central bank in various ways (e.g. via the refinancing policy), thus increasing bank liquidity. With the help of this variable the central bank tries to control indirectly theliquidity in the non-MFI sectorin order to fulfil macroeconomic objectives.
In contrast to monetarist theory, theliquidity theory of moneydoes not take the monetary base as the key variable, but ratheroverallliquidity. This liquidity concept was supported in particular in the Radcliffe Report, a study of the British financial sector which was published in 1959. According to this report, the central bank policies should focus oncontrolling overall liquidity, although there is no guarantee that they can always do this autonomously. The Radcliffe Report thus takes up the Banking Theory again.1
The Deutsche Bundesbank tried and the European Central Bank is still trying to record the development of overall liquidity with the help of its monetary aggregates M1, M2 and M3.
However, these monetary aggregates include only a part of the liquidity holdings at a particular time, namely only thenon-MFI sector. All the same, at least M2 and M3 include not only money holdings but also other liquid resources.
[...]
[1] See R. Peto (2002), Geldtheorie und Geldpolitik, 2nd edition, Munich, p 14 ff., in the following referred to as “Geldtheorie“. For a definition of money and money stocks see also R Peto (2000), Einführung in das volkswirtschaftliche Rechnungswesen, 5th edition, Munich, p 203 ff, in the following referred to as “VRW”.
[2]Real flows (flows of goods) are depicted as solid lines, and monetary flows (flows of money) and appreciation are depicted as dotted lines.
[3]The truck system is not permitted in Germany pursuant to section 115 of the Industrial Code (Gewerbeordnung). However, payments in kind are still given in agriculture, in the tobacco industry, by breweries and in other economic sectors: besides remuneration, the employees receive non-cash benefits in the form of the goods produced.
[4]The major difficulties experienced in correctly estimating value relationships are described in the fairy tale “Hans in Luck” by the Brothers Grimm.
1 American cigarettes served as a measure of value until the currency reform of 20 June 1948. The black market price for one American cigarette was 30 Reichsmarks just before the currency reform.
1 Cf. also chapter 5 “Changes in the value of money”, p 129ff. . Regarding the macroeconomic objective of price stability, see also R. Peto (2000), Grundlagen der Makroökonomik, 12th edition, Munich, p 23 ff. and Peto, R. Makroökonomik und wirtschaftspolitische Anwendung, 13th revised and extended edition, Munich 2008, pp 19ff.
2 Cf. A. Smith (1776), An Inquiry into the Nature and Causes of the Wealth of Nations, Vol I, London, p 28.
[5]Cf. detailed description in K. E. Born (1977), Geld und Banken im 19. und 20. Jahrhundert, Stuttgart 1977, p 20 ff.
1 By international standards, this ratio was in the middle of the scale (at the end of the year in each case): France (1995: 15%), Japan (1998: 25.3%); Switzerland (1998: 23.7%) and the USA (1998: 35.7%). The high figure for the USA is presumably a result of the widespread international use of the US dollar as cash. (See Statistisches Bundesamt (Federal Statistical Office), Statistisches Jahrbuch 2000 für das Ausland, p 296).
2Cf. also chapter 1.3 “Liquidity”, p 31 ff.
3 This very broad concept of money was supported above all by O. Veit in the German-speaking world. See comments by E. M. Claassen (1970), Probleme der Geldtheorie, Berlin, p 46 ff.
1Cf. chapter 4.4 “The Basic Concept of Monetarism”, p 119 ff.
1 W. Ehrlicher (1975), “Geldtheorie”, Kompendium der Wirtschaftslehre, Vol 1, 5th edition, Göttingen, p356.
1 Cf. H. Guitton (1965), Economie politique, Vol II, Paris, p 16.
2 Supplier credit is not “free of charge”, however, as the supplier factors cash discounts into the price.
1 Cf. J. A. Schumpeter, Konjunkturzyklen, Vol I, p 117 ff.
[6]For the concept of liquidity, see the detailed description provided by E. M. Claassen (1970), Probleme der Geldtheorie, Berlin, p 41 ff.
[7]With a few restrictions, the balance sheet layout pursuant to the Companies Act takes liquidity aspects into account in such a way that the assets side is broken down according to increasing liquidity and the liabilities side is broken down according to mounting urgency.
[8]Section 11 of the Banking Act (Gesetz über das Kreditwesen) stipulates that “Institutions must invest their funds in such a way as to ensure that adequate liquidity for payment purposes is guaranteed at all times.”
[9]See G. Wöhe (1990), Allgemeine Betriebswirtschaftslehre, 17th edition, Munich, p 752 ff.
1 Cf. Deutsche Bundesbank, Monatsbericht, April 1982, p 21.
2 Cf. Europäische Zentralbank, Monatsbericht, Juni 2001, p 27.
1For a detailed description and assessment of the liquidity estimate see in particular R. Schittko (1980), Der Liquiditätsansatz in der Geldtheorie, Bochum.
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