Money And Banking Essay Topic
Archaeologists have found evidence of the use of money in many primitive societies, but the role it played is unclear. Some believe that money was originally used more for purposes of ceremony than trade, as for example, in the payment of tribute by subservient groups to those who exercised power over them. It would seem, however, that as societies developed they increasingly turned to money as an instrument to facilitate trade. As is well known, the particular form money took varied greatly. Metals were commonly used as money, but so were other materials and objects, including shells and many kinds of commodities such as cattle which had a value in use as well as a value in exchange. While a broad view of the history of money suggests an evolution from things with an intrinsic value to the merely representative, from the objective to the subjective as it were, we know that even early civilisations had often sophisticated systems of money and credit including the use of purely representative paper money.
During the Middle Ages in Europe these sophisticated monetary systems seem to have disappeared to be replaced by primitive barter systems. It was not until sometime in the 9th century AD that the economy of western Europe began to be "re-monetarized". The reasons for this lapse in the history of money are not well understood, but the influence of Christian doctrine may have played a role. The Church was deeply suspicious of money and the Bible makes clear the spiritual risks posed by having anything to do with money, especially lending it in return for payment, the sin of usury.
Why National Currencies?
Money is useful. Its standard functions, according to the textbooks, are to serve as a unit of account, a means of exchange, a standard for deferred payments, and as a store of value. We perform all our reckoning of relative values and what we owe one another in terms of money. Trade without money is cumbersome and inefficient. And, like many other things, it can be used to hold on to value over time. How well any particular monetary system fulfils these functions varies. Moneys performance as a unit of account is impaired if the general price level is unstable, as is its reliability as a store of value and as a means of making deferred payments. Its performance as a medium of exchange can be impaired by counterfeiting or by the failure of the authorities to maintain the currency in reasonable physical condition. There is no question, however, of doing without it. Barter systems are hopelessly cumbersome and inefficient compared to a system which has a single unit of value. But why does every country have its own? Would it not be better if the world had a common money?
Historically, during much of the 19th century, something approximating a common international money existed in the form of the pre-World War I gold standard. Although there were national moneys under this system, their relative values were defined in terms of specified quantities of gold. So long as these defined values were maintained, there was a fixed relationship between the value of the British pound sterling, the US dollar, the German mark and so on. But this link to gold is long gone and attempts to replicate its effects through international agreements in the post-World War II era have all failed. National currencies today are alike neither in name, nor in relative values.
The Bretton Woods Agreements of 1945 laid the foundation for what was hoped would become a secure and stable system of orderly international economic co-operation which would eliminate the kinds of tensions and conflicts which led to the disasters of the Great Depression and World War II. The International Monetary Fund and the World Bank were created to help manage the new system. By the 1960s, however, it was evident that this system could not succeed. While its institutional shell survived, the world economic order disintegrated. Regional trading blocs like the European Economic Community emerged and the great powers proceeded to pursue their own interests. What stability remained in the system probably owed much to the still dominant role, at least in the industrialised western world, of the United States. Despite the rapid rise of Japan and other new industrial powers, the United States and its domestic currency provided a centre of gravity and a de facto standard of exchange. During the 1970s, however, even this stabilising influence began to erode. The causes are complex and still little understood, but a combination of events, the Viet Nam debacle, the OPEC oil crises, the extraordinary ascent of Japan as an industrial power all contributed to a relative decline in American influence. Another significant development of the period was the emergence of the Eurobank and Eurodollar system.
One of the causes of the great world-wide inflation of the 1970s was the sudden rise in energy prices triggered by the OPEC oil embargoes and the prompt decision by major central banks to effect a large increase in national money supplies to stave off an immediate economic crisis. Many oil-importing countries also found themselves forced to borrow heavily to finance their oil imports. Most of these loans were obtained from the large banking companies which were prepared to enter into large-scale international credit transactions. These banks were based in many different countries Japan, Switzerland, the US, Britain, France and Germany among others. Many of them became loosely linked, however, in what came to be known as the Eurobank system through which they conducted international transfers of deposits, investments and loans denominated in many different national currencies, including US dollars. While all these banks were (more or less) subject to the regulations of the countries in which they had their head offices only in respect to their domestic operations there, they were unregulated for the most part in their international business. As a consequence, a significant part of the worlds money appears to be subject to no control except that which these large banks see fit to impose upon themselves. To the extent that they were responsible for the enormous increases in the world-wide expansion of credit during the inflationary 1970s and early 1980s, such control apparently does not extend to sacrificing short-term profits for long-term stability in the system.
The benefits which would arise from having a truly international monetary system with a single unit of account are obvious. Exchange rate fluctuations which make it difficult for businesses to plan and that create problems for international travelers would be eliminated. It would be possible to compare prices of goods and services directly without cumbersome and inaccurate calculations. International lending and borrowing would be greatly facilitated. The attempts by members of the European Economic Community to develop a common money attest to the advantages of such an arrangement. The European experience also reveals, however, why national governments may well be reluctant to give up their domestic monetary systems.
For reasons to be discussed later in the course, modern governments are expected by their citizens to control inflation and this means that they have to have some ability to control the amount of money available in the country. Giving up this responsibility to some external agency strikes at the root of sovereignty. Submerging a national monetary system in a more broadly-based one involves sacrificing some degree of national independence. So long as nationalism survives as a force, it is unlikely that supra-national monetary systems will become popular.
A second reason for having national monies is that today, as throughout history, governments have recognised that having control over money is an easy way to help finance government spending. Having the power to create money is no small matter. If a coin with the Emperors likeness on it circulates at a value in excess of what it costs to stamp it out, the difference goes into the Emperors treasury. This "seigneurage" is even greater if, as in modern systems, there are no significant costs involved in creating money at all. A few keystrokes on a computer terminal will suffice to create any amount of new money.
(With the development of strong trading alliances such as the European Union and the North American Free Trade Association monetary unions have been much discussed in recent years. Is it likely that North American economies such as Canada and Mexico might joint with the US in such a union, or simply adopt the US dollar in place of their own national currencies? For one Canadian economist's take on this, visit this link.)
It is worth noting that in federal states, such as the US, Canada and Australia, the constitution specifically assigns responsibility for money to the central, national government, denying any such powers to the states or provinces. Nevertheless, there is some evidence that it may be possible for particular communities to create their own "money".
The Fungibility of Money
A recently-published study of the history of money in many different countries has shown that governments have always had great difficulty in controlling both the quantity and the quality of money. The author suggests that there are five main reasons for this. One is the "unceasing conflict" between the interests of debtors, who always want the money supply increased and persistently keep looking for substitutes for officially-sanctioned money, and creditors who want to limit its supply and prevent the development of substitutes (i.e., safeguard the quality of the existing forms of money). Another is the simple fact that money is so "fungible" (interchangeable or substitutable). Other reasons for the instability of money over time identified in this study are changes in the rate of world population growth, the impact of wars and revolutions, and the modern belief that increases in the money supply are necessary for economic growth and development. Because of these factors, the supply of money fluctuates over time, alternating between periods when there is too much of it and times when there is too little. In the former situation, the predominant concern is with the quality of money, in the latter, its quantity.
Substitutes for official forms of money are surprisingly easy to come up with. In emergencies, when official money supplies have been curtailed, local authorities have had little difficulty introducing substitute forms. One of the best known examples is the famous "playing card" currency issued in New France in the late 17th century when the annual shipment of money from France was delayed. There have also been many local currencies issued by cities in Europe, especially Germany, during times of war and civil disorder. Many such "notgeld" monies were actually well minted (and printed) and there is an active demand for them on the part of collectors.
More recently there is the interesting world-wide movement promoted by a Canadian, Michael Linton, to establish local currencies. These are in effect clubs, the members of which exchange goods and services, paying for them with cheques denominated in made-up, non-official monetary units. The objective purportedly is to promote cohesion among like-minded locals who seek more independence from the conventional wage economy, from remote suppliers and from established financial institutions. Relying on trust, individuals are allowed to write overdrafts at their own discretion with no interest charged, but since all accounts at the "bank" are open to all members, overspending is discouraged, as is hoarding of credit. Prices and fees are determined by members, but in the 45 schemes operating in the UK, there appears to be a narrower range of incomes among members of these groups than in the economy as a whole. The names given to the currencies include creds in Leamington Spa, bobbins in Manchester, olivers in Bath, and beaks in Kingston-Upon-Thames. The system is most advanced, however, in Australia, where some 300 schemes are in operation, some of them encouraged by local authorities which accept tax payments in the local currency. Elsewhere, however, there is some suspicion that the popularity of local currency schemes derives from the opportunities they provide for tax evasion.
Many definitions of money are possible. A widely used casual definition is that money is anything that is generally acceptable in exchange. In earlier times, for a thing to be acceptable as payment for a debt it was necessary for it to have some intrinsic value, some usefulness apart from its role as money, like a cow or a string of beads. In modern societies, however, the things that are generally acceptable in exchange, that is, normally accepted as payment for a debt, tend to be abstract representations of value that are more convenient to handle. The familiar paper bank notes and metallic coins which are used to handle most small transactions are all fiat money, that is, their value as money greatly exceeds the value of the paper or metal of which they are made. Larger transactions are handled by using an even more abstract medium of exchange. To buy a car or pay rent a check is more convenient and, with certain qualifications, equally acceptable by the car dealer or landlord. Of course there is also what is sometimes called "plastic money," the increasingly useful credit card or bank card which is readily acceptable even by machines as a means of payment. Credit cards, however, are not considered to be "money" by economists, for the reason that credit card payments are only a kind of half-way step in effecting payments. Sooner or later, the credit card transaction has to be settled in the form of either a currency transaction or, more likely, a check written on a bank account.
Modern money is consequently closely related to banks and other financial "intermediaries," so called because they receive funds deposited by customers and make funds available to borrowers or issuers of bonds and other financial instruments. It is important to understand that most of these financial institutions, including the commercial banks, are privately-owned and that, while they are often subject to close regulation by government authorities, they operate primarily as profit-making enterprises. While there are some government-owned financial institutions which do business with the public, sometimes savings banks operated by postal authorities, or specialised institutions designed to meet specific business needs, the main publicly-owned and controlled financial institutions are the central banks (although even some of them are technically organised as privately-owned entities). The important functions of these central banks include issuing the domestic paper money, controlling the operations of the commercial banks, and trying to control the domestic money supply and the foreign exchange value of the domestic currency unit. These central bank functions will be looked at later, but first it is necessary to understand the nature of modern money and the role played by the commercial banks in creating it.
The Making of Money
Money consists of cash, defined as coins and the paper money issued by the national monetary authority, probably a central bank, and commercial bank accounts on which checks may be drawn. To understand what determines the amount of money available in an economy, that is, the "money supply," attention must be given to how the quantity of cash and the quantity of commercial bank deposits are related.
The supply of cash in the economy is easily explained. Every country has a monetary authority or central bank responsible for issuing coins and paper currency. The quantities issued are largely a matter of convenience. Although it is conceivable that a government may choose to print paper money as an alternative to obtaining funds to carry on its activities through taxation or borrowing, this is unlikely because, as will be seen shortly, there are simpler ways for governments to get additional money if they want to. In practice the quantity of paper money and metal coins will be determined by nothing other than the communitys need for such conveniences. The increasing use of vending machines, for example, means that more coins are needed. Much more interesting is the determination of the quantity of commercial bank deposit liabilities, the chief form of money in all the developed countries.
Anyone with a bank account will be aware that a great many different kinds of accounts are available to depositors. Banks at one time had mainly two types of deposit accounts, those customers could write checks on, and those they could not. Today, many different kinds of personal deposit services are usually available and there are also a variety of deposit accounts for the use of commercial customers. These personal accounts typically include some on which checks may be written, with a fee payable on each check; others on which a certain number of checks can be written without any fee; accounts on which checks cannot be written, but which permit free withdrawals or transfers to other accounts; some accounts which may allow a certain number of free withdrawals and checks per month; and there are also "term deposits" which carry no withdrawal or checking privileges at all. The interest paid on the different accounts varies, as does the service provided in the way of return of cancelled checks, overdraft privileges and costs, and the provision of a bankbook.
Should all such deposit accounts be thought of as money? Obviously those that permit unlimited checking are closest to being money in the sense of cash, insofar as they represent something "generally acceptable in exchange." The term deposit account seems most remote from that. For their own accounting purposes banks usually classify deposit accounts according to whether the funds in them are repayable to the depositor "on demand," or after giving notice (seldom required) or, as with term deposits, at some fixed date. What it is important to note here, however, is that customers deposits of whatever kind are considered to be liabilities of the bank, for these are amounts the bank owes to its customers.
What do banks do with the money they collect from depositors? Some of it will be kept in the form of cash, much will be loaned out to borrowers, and the rest will be used to buy income-yielding securities, mainly in the form of corporate and government bonds.
Because banks are profit-making enterprises, they do not like to hold large amounts of cash, simply because cash does not yield any income the way securities or money lent out at interest does. But the ability of banks or other institutions to attract deposits rests on the publics confidence that the money they deposited is safe and that they will be able to get it back when they want it. Any prudent banker will consequently hold enough cash to meet the needs of customers for cash withdrawals. But there is another compelling reason to hold onto some cashexcept in the unlikely event that a single commercial bank enjoys a monopoly of the banking business in a country. If there is more than one bank, it is inevitable that account holders in one institution are going to write checks against their accounts and give those checks to customers of a different institution. When the latter deposit these checks their bank finds itself holding claims against the first bank. At the end of the day it is likely that this process will result in most or all the banks holding offsetting claims against one another. Rather than settling these claims by carrying cash back and forth from one bank to another, it is much more efficient to arrange for one bank, or the countrys official central bank, to act as a clearing centre at which there is a daily accounting of inter-bank claims, cancelling them out against one another. Any outstanding differences can then be settled by a cash transfer or, again more efficiently, the banks may all hold accounts at the clearing centre which are credited or debited with any surplus or deficiency they run up during the clearing process. To maintain their solvency and to guard against the possible embarrassment of not being able to honour a deficit at the clearing centre, banks will err on the side of prudence and maintain enough cash to meet possible obligations of this kind. (To be sure that they do, governments often require commercial banks to hold a certain proportion of their total liabilities to depositors as cash reserves.)
This need to hold cash helps to explain why bankers often claim that banks play only a passive role with respect to the supply of money. Yet economists persist in asserting that banks actually create money. This difference is largely a matter of perspective. Consider how a bank, as a profit-making enterprise, might go about increasing its income from banking. Obviously it could do so by making more loans or buying more income-yielding securities. Where would it get the additional money to lend out or buy more bonds with? Would it need to take in more cash? Suppose a customer gets a loan from the bank to buy a new car with. Would the bank hand over cash? More likely it would simply credit the customers account with the amount agreed on. Or if the bank wanted to buy a bond from an investment dealer, would it pay cash or just credit the investment dealers account with the amount it was paying for the bond? It is this potential for acquiring income-yielding assets using not cash but its own indebtedness that distinguishes banks from other kinds of private businesses. A banks debt (in the form of a deposit liability to a customer) is money. The debts of other kinds of businesses and of individuals are not moneynot something "generally acceptable in exchange."
There must be something that prevents banks from performing this lucrative sleight-of-hand without limit! Otherwise they would acquire all the income-yielding assets in existence and their profits would be virtually unlimited. In fact, banks are generally profitable but, as the relative performance of bank shares on most stock exchanges shows, not remarkably more so than companies engaged in other lines of business. What constrains bank credit creation is the need to maintain a safe (possibly legally required) position with respect to cash, which may be defined as an adequate credit balance with the central banking authority. Whenever a commercial bank increases its deposit liabilities it runs a greater risk of being unable to settle its account at the clearing house, unless the other banks in the system are increasing their deposit liabilities at the same rate. If a bank did find itself out of step in this regard, it would lose cash to the other banks. If this loss of cash was serious enough, such a bank would be able to borrow cash from the central bank, which stands by as a lender of last resort to support the commercial banks. But loans from the central bank would carry a high rate of interest, higher than the going market rate. Being forced to borrow from the central bank is costly for commercial banks and they will consequently try to make sure they do not find themselves in such a situation as described.
Consequently, from the point of view of an individual banker, it would be prudent to avoid lending out or investing money in excess of what comes in over the counter. Consider a simple transaction of this kind. Suppose a customer comes in and deposits $1000 cash. This will have the effect shown below on a simplified balance sheet for an individual bank:
If we assume that the bank had no excess reserves to begin with, it now finds that because of the increase in its deposit liabilities it has to hold more cash in reserves. This it can easily do, by using part of the $1000 deposited for that purpose. If the banks in this community choose (or are required) to maintain cash reserves amounting to, say, 8% of their total deposit liabilities, the bank would need $80 for reserve purposes. This would leave $920 of cash free for other uses. Behaving most conservatively, the bank could increase its loans, or buy income-yielding assets such as bonds, by only this amount. This would show up in the simplified balance sheet as follows (only changes are shown):
If the amount of cash available to the banking system is increased, the banks in the system may collectively increase the money supply by much more than the initial increase in cash. Suppose the $1000 deposited by the banks customer in the example above was "new" cash which had not been in existence before. The bank behaves as already described and extends a new loan in the amount of $920 to a customer who needs the money to pay his auto insurance premium The borrower promptly writes a check against the addition to his account which resulted from getting the loan, giving the check to his insurance agent to cover the premium. The insurance agent does her banking at a different bank (Bank B) and deposits the check to her account there. Bank B now has a claim against Bank A and, ignoring any possible offsetting transaction, presents it to be cashed. Bank A hands over $920 in cash to settle up and Bank B finds its cash holdings increased by that amount. Its deposits have, of course, gone up by the amount of the insurance agents deposit ($920) so it has to increase its cash reserves by 8% of that amount ($73.60), leaving Bank B with excess reserves of $846.40. It can now make loans (or buy securities) in that amount.
In this way, the original deposit of a new $1000 cash is spread throughout the banking system, with each bank expanding credit only by the amount of any excess reserves it obtains. To understand the cumulative effect of this process of credit creation it is necessary to look at the functioning of the system as a whole and not just a single bank. This can be done by simply summing the effects of the individual transactions just described. To keep everything simple assume that all the banks in the system are fully loaned up, (they have no excess reserves); that they will want to increase credit as much as possible so as to maximise their earnings; and that as they do so, the public does not want to hold more cash. Now add up the total amount of new loans made by banks as the effect of the initial injection of new cash into one of them works its way through the system.
As the bottom row in the table above shows, the banking system has increased the total amount of credit available by $11,500, in this case by expanding loans by this amount. If the original deposit of $1,000 with which the process began is included, the increase in the amount of money in the system is exactly 12.5 times the amount of additional cash made available to the system by the initial deposit placed in one of the banks. How much money could be created through this kind of process depends on how large a bite is taken out of each banks new cash by the reserve requirement. If the ratio of reserves to deposits were larger than the 8% assumed in the example, the total expansion of credit in the system would be smaller. The relationships involved can be summarised in what is called the simple money multiplier which is defined as the change in deposits divided by the change in reserves. In the example, a $1,000 increase in reserves brought about a $12,500 increase in deposits. For every $1 of new reserves injected into this system there was an increase in total deposits of 12.5 times that. The size of the money multiplier is directly related to the reserve to deposit ratio. It is, in fact, simply the reciprocal of that ratio. The simple money multiplier = 1 over the reserve to deposit ratio. In this case, the money multiplier = 1/(8%) or 1/.08 which is 12.5.
The process just described works in reverse at least as well. For every $1 of reserves removed from the system, the total of deposits will fall by 12.5 times that. The words "at least" were used because when there is an increase in cash available to the banks to use as reserves they will probably initiate an expansion in the total supply of money by increasing their loans or by buying more securities if they think they can profit by so doing. But if bankers are pessimistic about business conditions or the ability of borrowers to repay loans, they may choose instead to hold excess reserves. On the other hand, if the amount of cash available for reserve purposes is reduced and if the banks were not holding excess reserves before this reduction occurred, they will then be forced to call in loans or otherwise reduce their deposit liabilities, thereby bringing about a multiplied reduction in the money supply.
Thus, the amount of money available to be used as reserves will have a potentially very strong influence on the total money supply. Because of this, the amount of currency in the hands of the public and the cash held as reserves by the banks is often referred to as high-powered money, or the monetary base. It should be noted that banks find it convenient to hold some of their reserves in cash in their own vaults to meet their everyday cash requirements, but they also hold some of their reserves in the form of deposits at the central bank. These deposits serve as the means of effecting check-clearing among banks in the system and other purposes as well. High-powered money consists, then, of currency in the hands of the public and bank reserves in the form of currency held by the banks plus their deposits with the central bank. Given the publics demand for cash and the willingness of banks to extend credit (or, what amounts to the same thing, the banks demand for reserves) the total money supply is some multiple of the amount of high-powered money in existence.
There have been three great inventions since the beginning of time: fire, the wheel, and central banking.
Will RogersTo Top
Central Bank Control of Commercial Bank Liabilities
The central banks have several ways of exercising control over the amount of credit the commercial banks are capable of creating. Because central banks have among their normal responsibilities assisting the government to handle its financial affairs, they typically have large amounts of government money to manage. Much of this is in the form of government deposit accounts in commercial banks. If the central bank wishes to alter the relation between commercial bank deposit liabilities and the cash reserves, it can simply switch government funds into or out of these commercial bank accounts. Removing funds reduces the total amount of commercial bank deposit liabilities, putting funds in increases them.
Central banks can also operate on the relationship between commercial bank cash reserves and deposit liabilities by increasing or decreasing the size of the cash reserves. This can be done using open market operations, by which the central bank buys or sells bonds or other securities in the open market for such debt instruments. If the central bank enters the market as a net buyer of bonds and other securities, it will pay the sellers with checks drawn on itself. When these checks are deposited in commercial bank accounts, the commercial banks acquire claims against the central bank, thereby increasing their cash reserves. If the central bank enters the market as a net seller of securities, it has the opposite effect on commercial bank cash reserves. Dealers who buy securities from the central bank write checks to pay for them on commercial bank accounts. The central bank then obtains claims against the commercial banks and their cash reserves are debited accordingly. It does not matter whether the central bank buys securities from or sells securities to private persons or banks and other financial institutions, the end result is the same.
These and other techniques available to the central banks make it possible for them to exert a potentially strong influence on the total money supply in a country. Whether they use these powers is largely a matter of policy, which will be taken up later.
Money & Banking Essay
Our current economic out look and the tools that can be utilized to change its direction Economic growth continues it's sluggish down turn as the results for the second quarter of 2001 clearly dictate. The Gross Domestic Product (GDP) only rose 0.2 percent (BEA News Release) and the unemployment rate also showed an increase to 4.9 percent (BLS Summary), this shows we are not poised to avoid a recession yet. Further monetary and fiscal policy changes are needed to regain consumer confidence and induce a healthy rate of spending.
The issues that seem to be currently plaguing the economy are both economic and political. On the economic side we are still facing the effects of the huge growth period of the later half of 1999 and early 2000. Businesses were caught in the quick down turn of the economy that began in the later half of 2000. A reduced demand for their goods and services left them with excess inventories and an unrealistic perception of their demand. As businesses continue to adjust their output there may be further layoffs, which will continue to increase the unemployment rate. We also saw the dramatic decline of technology stocks during this same period. This decline cut investment spending and drove consumer confidence in a downward spiral.
On the political front we are facing similar issues. The public is unsettled with the new administration. They are looking for quick answers from the White House to help halt the descending economy. These answers do not seem to be coming fast enough to gain the needed confidence. As you can see there is increased political pressure, as well as, pressure on the Federal Reserve System ("Fed") to act quickly to change the course of the current economic situation.
The "Fed" has three tools in which it can use to manipulate the money supply. These tools are the reserve requirement, the open market operations and the discount rate.
If the "Fed" chooses to lower the reserve requirement for commercial banks it will effectively increase the money supply. This will allow the banking system to put more money into circulation. This can be effective, however it cannot force the banking system to relax its current tightened credit policies. This also cannot force the public to borrow the excess money being supplied.
Next we can look at the utilization of the open market operations. Since we are facing sluggish spending the "Fed" could buy securities from the banks causing an increase in lonable funds. This tool like the proceeding one would have similar...
Loading: Checking Spelling0%