Cigarettes as money

• En el contexto de la lectura “La organización económica de un campo de concentración”:

• Cigarettes evolved naturally as a way of money

  • They were convenient because they were homogeneous, durable, and could be used individually for small transactions or in packages for larger transactions.

  • They were available in sufficient quantities because of the supplies of the Red Cross.

  • And smokers made sure they would always have value.

• People began inspecting the cigarettes to make sure they were up to standard and thus valuable.

  • Money whose value is unclear raises transaction costs and reduces trading.

• Gresham's law: bad money drives good money out of circulation.

  • If two units of money have the same nominal value but one is in reality more valuable than the other, then the one with lower value will circulate and the one with higher value will be hoarded.

• Cigarettes were also subject to deflation whenever the Red Cross's supplies were interrupted.

  • Deflation is an increase in the value of money.

The evolution of money

• Precious metals were accepted as the preferred medium of exchange

  • Because they can be divided into parts and reunited again, are limited in supply, and they are valued for other purposes.

• The one disadvantage is that people couldn't readily determine the true weight of it.

  • Politically powerful people benefitted from this and started accepting metal bars to mint into coins.

  • They kept some of the metal to themselves, this deduction is called seignorage.

  • People accepted this because they preferred to have metal with known value rather than unminted metal.

• Milling the edges (putting ridges on the edges) preserved its value because it made it more difficult for people to shave metal from the edges.

• Wealthy people turned to goldsmiths for a safe space to store their money.

  • The receipts issued by goldsmiths were the first form of paper money.

  • These receipts could be given to other people as a form of payment instead of actual gold.

• When commercial banks arose, bakers saw that they could lend out at interest some fraction of the money deposited with them.

  • They lended banknotes instead of actual coins.

  • These banknotes were ornately printed to frustrate counterfeits.

• Now banks can't issue bank notes, only government-managed banks can.

The myth of fiat money

• The Latin word fiat means let it be or let it become.

• Some people say our money is mere fiat money.

  • It's not real money because it's no longer backed by metal.

  • It's a government scam so they can print more to fund their own spending.

• People who say this don't take into account is that what makes anything money is that it is in fact accepted and used by people as a medium of exchange.

  • Governments have learned that if they print more, people are reluctant to use it.

• That doesn't mean that gov doesn't possess special powers to help push its money as accepted.

  • It can promise to accept its own notes in payment of taxes.

  • It can declare any money not printed by them illegal.

• Mere fiat doesn't create money, but rather, general acceptability.

The nature of money today

• What we use today as our medium of exchange consists almost entirely of the IOUs of trusted institutions.

  • When notes were initially issued, they bore a promise to pay back in "lawful money"

  • When that promise was removed from the notes, no one cared because the notes themselves had become lawful money.

• Are there substitutes for cash?

  • We can use checkable deposits.

• Checkable deposits and notes are basically liabilities of trusted institutions.

So how much money is out there?

• The M1, or the narrowly defined money stock, is the sum of the currency in circulation, demand deposits, other checkable deposits, and traveler's checks.

• The M2 is the sum of M1 plus noncheckable deposits in banks in amounts of less than $100,000 and shares in retail money market mutual funds.

  • It is an attempt to measure the dollar value of assets that the public can easily turn into the medium of exchange.

• The M3 is M2 plus noncheckable deposits of more than $100,000, shares in money market mutual funds that require initial investments of $50,000 or more, and dollar-denominated deposits that Americans are holding in foreign branches of US banks or in Canada and the UK.

• If the quantity of money demanded by the public is greater than the quantity supplied, or vice versa, the disequilibrium can lead to inflation or recession.

  • The Feds keep an eye on M2 and M3 to be able to turn them into M1 if the need arises.

The creation of money

• Banks create money.

  • But not by printing it, but rather by lending it.

• Commercial banks are able to create money because the public is willing to accept bank liabilities in payment.

• But while money is created when banks make loans, it's also destroyed when customers repay bank loans.

Credibility and confidence

• In a society where bank lending is not regulated, its only limit to its ability to create money would be its credibility.

• If you start doubting the bank's ability to pay you back, you'll come to collect sooner, and so will other people.

  • While this won't change the money in circulation, the bank will be unable to pay everyone back.

  • So the Federal Reserve Bank will have to be the one to pay back.

• People must remain confident in a particular money or they'll stop accepting it.

• The more money a bank creates, ceteris paribus, the less ability it will have to meet its depositors' demands.

• Banks that want to earn interest by creating money to lend must therefore maintain a balance between their desire for additional income and their need to retain the confidence of their depositors.

Banks under regulation: legal reserve requirements

• Legal reserve requirement: banks are not allowed to have deposit liabilities in excess of some multiple of their reserves.

  • The reserve requirement is expressed as a percentage, called the required reserve ratio.

  • In other words, banks must always have reserves in its vaults or on deposit at a Federal Reserve bank.

  • This percentage is typically less than 10% of its deposits.

  • It varies depending on the type of reserves, called tranches.

• The dollars held in the vaults of a bank earn no interest.

• Increasing the required reserve ratio means lower excess reserves, which reduces the ability to make loans and potential profitability.

The fed as monitor and rule enforcer

• The Federal Reserve is the central bank of the USA, created by an act of Congress in 1913.

• It restrains the process of money creation in commercial banks.

  • It also decides what may count as legal reserves.

• How does the Fed expand or contract the money supply?

  • The authority to establish legal reserve requirements.

  • It does so by altering the discount rate or engaging in open market operations.

The discount rate

• The Fed is known as a banker's bank or a lender of last resort.

  • It can extend a loan to a commercial bank directly.

  • The discount rate is the rate that the Fed charges banks for short-term loans.

• A decrease in the discount rate could increase the nation's money supply.

• The Fed does not lend to any bank, it only does so in special circumstances.

• Because of this, commercial banks tend to borrow from other banks, in what is called the federal funds market.

Open market operations

• The most common technique that the Fed uses to manipulate the nation's money supply is the purchase and sale of US government bonds in what are called open market operations.

  • Government bonds: a debt security issued by a government to support government spending and obligations.

• When the Fed buys bonds, banks get dollars.

  • M1 increases and interest rates fall.

What about gold?

• The critical factor in preserving the value of any kind of money is limited availability plus confidence that the supply will continue to be limited.

• Some people think we should return to gold because they distrust the government.

  • While gold is valuable because it is naturally scarce, money is kept scarce by the government.

• Governments don't always resist the temptation to print more money to fund expenditures, especially during wartime.

  • This creates inflation.

• A government so irresponsible that it must be reigned in by gold would be most unlikely to adopt a gold standard and even more unlikely to respond to the pressure of such constraint.

Once over lightly

• Money is a social institution that increases wealth by lowering costs of exchange, thereby enabling people to specialize more fully in accordance with their own comparative advantages.

• An item functions as money in a society when people are willing to accept it in exchange merely because other people will accept it in exchange.

• The liabilities of trusted financial institutions make up most of the money used in modern commercial societies: principally paper currency issued by central banks and checkable deposits in commercial banks or other financial institutions.

• In the United States today, the narrowly defined stock of money (M1) is the total of currency held outside the banking system plus checkable deposits in financial institutions.

  • But other assets that can be converted into currency or checkable deposits at negligible cost are included in more comprehensive measurements of the money stock, such as the M2 and M3.

• Commercial banks add to the society's stock of money by creating deposits for borrowers.

  • The banks are limited in their ability to create additional money by the requirement that their deposits not exceed some multiple of their legally defined.

• The managers of the Federal Reserve System have the responsibility for regulating the size of the money stock.

  • The Fed does so by controlling bank lending through its power to set the legal ratio between commercial bank liabilities and reserves and to expand or contract those reserves through loans to commercial banks and through buying and selling government bonds in what are called open market operations.

• The idea that money must have material "backing" to have value is not correct.

  • Money must only be acceptable as a medium of exchange to have value.

  • Limited availability and the belief that availability will continue to be limited is a necessary condition for continued acceptability of any functioning medium of exchange.