Winter Term 2004/05

1. Monetary Policy and Financial Regulation Winter Term 2004/05 Institute for Law and FinanceJohann Wolfgang Goethe-UniversitätFrankfurt am Main

2. Lecture 1 INTRODUCTION AND OVERVIEW

3. What is money ? • Money is typically defined by describing its functions. • Important functions are: • the easing of transactions of goods and services (medium of exchange); • unit of account • the store and transfer of value (wealth). • The functions of money are embedded into a historical process. • The definition of money is thus evolving.

4. Historical forms of money • Commodity money in a barter economy: • “Goods” with a use value such as salt, corn, spices, colors (e.g. indigo), cattle; • “Assets” that are rare and tradeable such as gold, perls, gems, feathers of rare bird, cowrie shells; • In societies where people are considered “assets”, money could also be slaves, children, or women of marital age.

5. Historical forms of money • Store and transaction of value requires • Durable assets (precious metals) • Assets with an esthetic or ideal value such as jewellery, ritual gear, relics, standards • Problem: Inhomogeneity of different forms of money requires a “standard”. • From “standards” derives “standardized money” (Portuguese “escudo”, French “écu”, Austrian “Schilling”)

6. Why do we need money ? • “In a world of certainty ... there is no need for money” (Charles Goodhardt). • Such an economy does not require money, because every good can function as a monetary unit (numéraire). • If there is no time constraint, the same is true in the case of uncertainty, because all uncertain outcomes could be rendered negotiable as „contingent claims“ (claim of good x for y, if state of the world z occurs).

7. Why do we need money ? • As in the case of certainty, all decisions on the allocation of resources over time could still be collapsed into the original period -- whatever path the economy takes (certainty-equivalent economy). • With markets for contingent claims, no money is needed, because everyonewould know all relative prices in advance.

8. Do we really need money ? • Indeed, where people are bound together by family, tribal or social ties, there is typically no need for money (khibbuzz, monastery). • More importantly, most economic activities are performed without a conforming flow of money (e.g. the work performed by an employee, meal service in a restaurant).

9. Where do we need money ? Money is needed where there is • uncertainty and/or a lack of trust; • a time contraint to processing all information required to establish a complete set of contingent prices for all states of the world; and • there is no other mechanism to overcome a lack of trust (agreement, custom, threat).

10. What is money ? “Money is what money does. Money is defined by its functions” (John Hicks). Money is an information processing technology that aims at reducing uncertainty and establishing trust. John Hicks 1904-89

11. Functions of money • Unit of account • Medium of exchange • Store of value • Payment function

12. Unit of account • It requires a standardized form of money • It is also necessary that money is divisible in subunits of account • Money must also be durable and should not erode its value over time For these reasons, precious metal play an important role as forms of money

13. Medium of exchange • In a barter economy, any good may take the role of a medium of exchange, but it is required that exchange intentions are mutually consistent • One good often serves as a “numéraire” (which reduces n*(n-1) possible exchange relationships to (n-1) ) • Money decomposes one act of exchange into two such acts: Good x Money Good y

14. Medium of exchange • The decomposition of exchange acts renders a modern economy based on labor sharing possible • But this requires the existence of a social consensus, according to which money is accepted as a general medium of exchange • A legal provision can facilitate such acceptance, but it cannot necessarily be enforced

15. Medium of exchange: Lack of confidence • Where there is lack of confidence in a legal tender, there could be escape into “substitute currencies”(= “hard” currencies or commodity money --> such as cigarettes, butter) • Such “monies” circulate forcibly as media of exchange, but they are unsuitable as a store of value (Gresham’s “Law”): Bad money replaces good money!

16. Store of value • The prerequisite for storing values and the creation of net worth is the existence of an order on property rights • Net worth possesses two kinds of merits. It is useful: • Directly: By providing consumption services (real estate, jewellery, antiques, totems, relics) • Indirectly: By bridging the temporal gap between income flows and expenditures

17. Store of value • To the extent that assets may have monetary characteristics, money can produce returns (interest income) • Normally, money is held interest-free • The question is: Why do individuals hold money without interest? • This brings us to the notion of Ability to pay or “liquidity”

18. Payment function • This function permits the granting of credit, the transfer of credits and liabilities, and the redemption of debentures • The prerequisite is that credit money will be provided and is universally accepted within a society

19. The features of money • In order to comply with the four prerequisites mentioned, money has to be • homogenous • divisible • durable, and • “rare”. • Forms of money are • Commodity money, metal money, and credit money

20. Credit money: A historical review 1. Stage : Emergence of bank certificates (covered trade bills) 2. Stage : Lending of deposits against debentures 3. Stage : Emergence of “book money” or “credit money” (which is not necessarily covered at 100 %) New appearance of money: Paper money (to the extent that it is “securitized”)

21. Credit money:Bullionist Debate • In18th century‘s England, banknotes, which circulated as money, were issued by private banks. These bearer notes were claims on gold held by the bank. • In Scotland, banknotes often had a clause that allowed the bank to suspend convertibility. Although banks were legally required to pay the bearer in gold bullion, they could temporarily suspend that conversion. • Suspension was to respond to the „bullying“ trick whereby banks would hold back notes issued by one bank, and then collectively unload the notes upon that bank to ruin it.

22. Credit money:Bullionist Debate • The Bullionist argument: If banks are not required to convert notes into gold, they will be tempted to issue notes in excess of the gold in their vaults. This will lead to an excess supply of money and hence, a cheapening of the price of money, i.e. inflation. DavidRicardo1772-1823 Henry Thornton 1760-1815

23. Credit money:Bullionist Debate • The Anti-Bullionist argument: It refers to the „Real Bills“ doctrine of John Law and Adam Smith who argued that banknotes are issued only in exchange for merchants' bills of exchange. • As long as the repayment of these bills is credible („real bills“), the demand for banknotes by commerce is limited by the „needs of trade“; hence even without convertibility, there will never be excess note issue. Robert Torrens1780-1864

24. Critique of the Real Bills doctrine • Thornton (1802) provided the following critique of the Real Bills Doctrine. He asked • Who guarantees that the demands of commerce were limited? • Suppose actual capital yields returns are higher than the rate of interest (or discount) charged by the banks: Would not merchants demand an interminable amount of notes - however „real“? • Bills offered for exchange into notes might not readily be „limited“ as the Real Bills advocates argued. Inflation must thus ensue. Thornton's analysis formed the germ for the later „cumulative process“ of Knut Wicksell (1898).

25. The Currency-Banking Controversy The Bullionist debate re-emerged during 1840-50. • England’s financial system was based on means of payment in the form of gold coins and notes of the Bank of England (founded 1694) and of commercial banks outside London (after 1844 insignificant). • There were no demand deposits or checks, but there were trade bills and credit on the books of account.

26. Currency School (George W. Norman, Bank of England, J. Pennington und S. J. Lloyd) Money = Coins + Notes Sir Robert Peel (1844): “If I use the word money, it only means the coins of the Kingdom and promissory notes which have to be redeemed, upon request, in gold. With the word paper money I mean exclusively such promissory notes. It does not include commercial papers or bills, nor bankers’ acceptances, nor any other form of paper credits.” Sir Robert Peel (1788-1850)

27. Currency School: Motives • The representatives of this school chose a narrow definition of money (bank notes of commercial banks can only be created if covered by notes of the Bank of England that are covered by gold). • Although the amount of credit money was = 4 x (notes + coins), its pace of development was seen as being more or less proportional to the expansion or contraction of central bank money. • There was need for a maximum amount of note issue (as under the gold standard) or else inflation would result.

28. Quantity theory of money P y = M  V • With real incomeyfixed and the velocity of circulation of money V being constant, the expansion or contraction of the money stock M will determine the price level P. • Thus the Bank of England (and especially the “country banks”) could be rendered responsible for cylical variations of the price level. • It also provided an argument in favor of a central bank monopoly.

29. Banking School (John Stuart Mill, John Fullarton und Thomas Tooke) Why shouln’t “first-class” commercial bills be as good as money or function at least as money substitutes? John Stuart Mill1806-73

30. Banking School Thomas Tooke: “The greatest part of the country’s wholesale transactions is effected through credit, of which commercial bills function as the visible proof ...” Consequence: The price level is determined by expenditures (including those effected via credit finance). Monetary policy as interpreted by the quantity theory of money is ineffective. Thomas Tooke 1774-1858

31. Ending the debate: Peel’s Act (1844) • The Bank of England (Issue Department) obtains the monopoly for emitting currency. • Circulating money of about £14,000,000 has to be “covered” by gold to one third of its value. • New emissions of currency have to be covered by gold at 100 %. • The Currency School dominated monetary constitutions all over the world until the beginning of World War I.