ENTREPRENEURIAL ECONOMICS Money and Banking

ENTREPRENEURIAL ECONOMICS Money and Banking
Prof. Dr. Stefan Kooths BiTS Berlin Summer term 2017

Contact data Prof. Dr. Stefan Kooths Head of Forecasting Center Kiel Institute for the World Economy Office Berlin In den Ministergärten Berlin 030/

The Kiel Institute for the World Economy (est. 1914)
Forecasting Center

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Outline Introduction and Overview Nature and Origin of Money Finance, Banking, and Credit Creation Value and Impact of Money Central Banks and Monetary Policy Foreign Exchange and Currency Systems Free Banking and Currency Competition

Curricular context Subjectivist theory of capital
Capital and production as a structure Savings and capital accumulation Economic growth Interest as a surplus problem (agio theory) Time preference Intertemporal coordination

Reading Menger, C. (1892): The Origins of Money; Economic Journal (2), Mises, L. v. (1953): The Theory of Money and Credit; New Haven, Conn.: Yale University Press. Huerta de Soto, J. (2009): Money, Bank Credit, and Economic Cycles; 3rd ed., Auburn, Ala.: Ludwig von Mises Institute. Hülsmann, J. G. (2008): The Ethics of Money Production; Auburn, Ala.: Ludwig von Mises Institute. Hülsmann, J. G. (2012, Ed.): Theory of Money and Fiduciary Media – Essays in Celebration of the Centennial; Auburn, Ala.: Ludwig von Mises Institute. Rothbard, M. N. (2011): The Austrian Theory of Money; in: Economic Controversies; Auburn, Ala.: Ludwig von Mises Institute: Salerno, J. T. (2010): Money – Sound and Unsound; Auburn, Ala.: Ludwig von Mises Institute.

(The enigmatic phenomenon of) Money
One of the greatest socio-cultural achievements of mankind

Nature of money: Conventional (textbook) view
Deutsche Bundesbank, Money Museum

Essence of money as an economic category
Generally accepted medium of exchange Unit of account (numéraire): follows, not specific Store of value: necessary, not specific

Direct vs. indirect exchange
Direct exchange (barter trade) A  B Double coincidence of wants Indirect exchange (via money) A  M, M  B M must be more marketable than A and B Vast reduction of transaction cost (search and matching) Dramatic deepening of division of labor (specialization) Allowing for open societies (complex and anonymous)

Money as a good sui generis
Objects of consumption (1st order goods) Means of production (higher order goods) Medium of exchange (money) Pervasive good Utility does not depend on quantity

Evolutionary vs. regulatory origin of money
Evolutionary learning Discovery by individual human interaction (social process) Fruit of indirect exchange and increasing specialization Knies (“Geld und Credit” 1873), Menger (1892) Different degrees of saleableness (liquidity) of commodities Money as a spontaneous product of the market State regulation (Chartalist School) General convention or law Plato, Aristoteles, Romans, …, Roscher, Knapp (“The State theory of money” 1905), Peacock (“Introducing Money” 2013) When? Why around the globe?

Spontaneous (= evolutionary) order
“Social structures of all kinds were the result of human action, but not the execution of any human design.” Adam Ferguson (1782)

A (very short) history of money I Media of exchange around the globe

A (very short) history of money II Stone money: The world’s largest currency

A (very short) history of money III Emergence of coins (700 BC)

A (very short) history of money IV Emergence of banknotes (1000 AD)

A (very short) history of money V Hard and heavy money (Sweden, 1700 AD)

A (very short) history of money VI First bank notes in Europe (Sweden, 1700 AD)

Money production, minting, and sovereigns
Precious metals Homogenous Durable Reversibly divisible Ideal characteristics for medium of exchange Transaction costs Weighing (e.g. gold balance) Checking the degree of purity (fineness) Standardization (minting) Sovereigns Monopolization of minting Diluting purity (inflation) Conflict of interest: Standard setting vs. fiscal financing Seigniorage (profits from counterfeiting)

Seigniorage Source Kemmerer, E. W. (1944): Gold and the Gold Standard – The Story of Gold Money, Past, Present and Future; McGraw-Hill, New York; p. 22

Money proper and money substitutes
Money in the broad sense Money proper (money in the narrow sense) Useful to make bids for other goods in market exchanges Not a claim on other goods Money substitutes Money certificates (full coverage) Fiduciary media (no coverage) claim

Classification of money (Mises) Following Hülsmann (2012:34)
Money proper Commodity money Precious metals Other Credit money Fiat money Fiat token coins Fiat notes Fiat bank deposits Money substitutes Money certificates (100%) Token coins Notes Bank deposits Fiduciary media (0%)

I PROMISE TO PAY THE BEARER ON DEMAND THE SUM OF TWENTY POUNDS
Monetary transformation: From commodity money certificates to fiat money I PROMISE TO PAY THE BEARER ON DEMAND THE SUM OF TWENTY POUNDS

Monetization/Monetary Transformation: Regression theorem (Mises)
? Purchasing power of money depends on the demand for money Demand for money depends on its purchasing power Application of subjective theory of value to money Purchasing power (PP) = value in exchange Value of money = industrial value (consumption, production) + value as medium of exchange (additional use) Sequence of valuation: PP of immediate past  today Regress back to first appearance as medium of exchange (monetization) Historically-continuous component in exchange value of money

Demand for money and uncertainty/disequilibrium
Human action takes place in a context of uncertainty Demand for sums of money to be held in reserve against unforeseen or uncertain expenditures

Financial capital markets
Financial capital (loanable funds) = Temporary transmission of purchasing power

Markets for securities
Securities (in a broad sense) Shares Bonds Credit contracts IOUs … Documented claims to (re-) payments Market sides and transactions Demand for capital = Supply of securities Supply of capital = Demand for securities Exchange of present purchasing power for future purchasing power

Expenditures (products) | Income flows | Financial flows
Financial intermediation in the macro economy: Circular flow diagram (expenditures and loanable funds) Expenditures (products) | Income flows | Financial flows

Financial intermediation in the macro economy: IS-Identity

Interest rate and market for loanable funds
LF LFS=S i* LFD=I + BD + NX

Money market in a credit-backed monetary system (1/2)
Demand side: Money using real sectors (non-banks) Private households Companies Government RoW Demand for money (L) Supply side: Money producing banking sector (banks) Commercial banks Central banks Supply of money (M) Transactions Exchange of securities Production of money via credit creation (out of thin air) Monetary financial institutions (MFIs)

Money market in a credit-backed monetary system (2/2)
Demand for money = Supply of securities Supply of money = Demand for securities Transactions between real economy and banking sector

Financial markets Demand for securities Supply of securities
Supply of capital (savings) Securities markets (shares, bonds) Demand for capital (investment) Credit market Credit intermediation Money supply Credit creation Money demand Banking sector Demand for securities Supply of securities

Interest rate and loanable funds including money market
LFD=I+BD+NX+L LFS=S+M iM i LF LFS=S i* LFD=I+BD+NX

Money production via credit creation: Balance sheet expansion

Fractional-reserve banking: Central bank money and money supply
Monetary base (MB): Cash + Reserves Cash = Currency in circulation Reserves = Deposits of commercial banks at the central bank Money supply (M): Cash + Demand Deposits Demand deposits = Deposits of non-banks at commercial banks Fractional-reserve money production Reserves < Demand deposits (reserve ratio < 100 percent) Interaction of central bank and commercial banks “Public-private-partnership” (T. Mayer)

Fractional-reserve banking: Balance sheets by financial and non-financial sectors

Economic system (monetary flows): Surplus and deficit sectors
Private investment Gross income Households Firms Private consumption Taxes Imports Capital market Private investment Savings Public budget deficit Net exports Exports Transfers RoW Government Public consumption and investment

Economic system (monetary flows): Financial intermediation
Private investment Gross income Households Firms Private consumption Taxes Imports Capital market Private investment Savings Public budget deficit Net exports Exports Transfers RoW Government Public consumption and investment

Economic system (monetary flows): Financial system
Private investment Gross income Households Firms Private consumption Financial system (market for securities) Taxes Imports Shares, Bonds Private investment Savings Credit intermediation Capital market Banks Public budget deficit Net exports Exports Transfers RoW Government Public consumption and investment

Economic system (monetary flows and stocks): Financial system
Private investment Gross income Households Firms Private consumption Financial system (market for securities) Taxes Imports Shares, Bonds Private investment Savings Credit intermediation Capital market Public budget deficit Net exports Banks Money supply (credit creation) Exports Transfers RoW Government Public consumption and investment

Economic system: Monetary stocks
Households Firms Financial system (market for securities) Banks Money supply (credit creation) RoW Government

Economic system: Banks and Non-Banks (1/2)
Households Firms Financial system (market for securities) Banks Money supply (credit creation) RoW Government

Economic system: Banks and Non-Banks (2/2)
Firms Households Government RoW

Economic system: Banks, Non-Banks, and monetary stocks
Money and credit creation Non-Banks Credit Money Money Credit

Economic system: Banking system, Non-Banks, and monetary stocks
Money and credit creation Non-Banks Central bank Commercial banks Credit Cash Money Credit Reserves Reserves Deposits Credit

Fractional-reserve banking: Money multiplier
C = Cash (coins and notes) DD = Demand deposits M = C + DD R = Reserves (central bank money at commercial banks) MB = C + R (monetary base = central bank money) c = C/M (cash ratio) r = R/DD ([minimum] reserve requirement)

Fractional-reserve banking: Multiple money production process
Example MB0 = 625, MB = +100 c = 20 % r = 6.25 %

Fractional reserve banking: Monetary base and money
Cash Demand deposits Reserves Cash Monetary base Money multiplier Money

Monetary aggregates (EMU)
M0=MB (Monetary base, High powered money) Cash (coins and notes in circulation) Central bank deposits of commercial banks (reserves) M1 (Narrow money) Demand deposits (overnight/sight deposits) M2 (Intermediate money) M1 Short-term time deposits (maturity of up to 2 years) Deposits redeemable at notice of up to 3 months M3 (Broad money) M2 Repurchase agreements, money market funds, debt securities (maturity of up to 2 years)

Classification of contemporary money under fractional reserve banking (example: M1)
Money proper Commodity money Precious metals Other Credit money Fiat money Fiat token coins Fiat notes Fiat bank deposits High powered money central bank money Cash (coins and notes) Reserves Money substitutes Money certificates (100%) Token coins Notes Bank deposits Fiduciary media (0%) Low powered money (<100%) commercial banks money Demand deposits Credit-backed M1 M0

Money types and convertibility
Commodity money  money = commodity Substitutes: permanently convertible Credit money  money = promise to pay later Convertible in the future Fiat money  money = stamp Not convertible

Fiat money: Backed and unbacked (the role of collateral)
Unbacked fiat money Issuing entity holds no assets against the money No redemption for anything of value Examples: Assignats (French Revolution), Continental dollars (US) Likely loss of all value due to no backing Backed fiat money Issue of money in exchange for good collateral Financial convertibility Value depends on quality of collateral Financial vs. physical convertibility (convertibility ≠ backing)

Value source for fiat money
Property theory of money (debt backed) Debtors obligation to economic activity to redeem their property as collateral in debt contracts Chartalism (tax-burden backed) Sovereign power to levy taxes on economic activity payable in the state-issued currency

Debate Systemic consequences of banning cash?

Ban on cash Intentions Consequences Convenience? Fight against crime?
Cost reduction (commercial banks) Negative interest rates (Gesellian stamped money) Consequences Loss of legal tender?  Highly unlikely Electronic central bank money for everyone  Competition for DD 100-percent-money Legal tender laws (example: Germany)  Legal tender = cash Johann Silvio Gesell (1862 – 1930)

Reading Huerta de Soto (2009), Chapter 4

Purchasing power of money (PPM)
Exchange ratios between money and other economic goods “Average price level” Results from interplay of demand for and supply of money Subjectivist theory of value (individually held stocks of money) Demand for money = demand for wealth in liquid form PPM: Higher prices  higher demand for money Trade volume: More transactions  higher demand for money Other factors (in particular: uncertainty) Supply of money Controlled by central bank (contemporary system) Private money production (commodity money or free banking)

Purchasing power of money (fixed money supply)
Equilibrium Increase of money supply PPM M M0 Supply of money Demand for money PPM0 PPM M M0 PPM0 M1 PPM1

“Velocity” of money (V)
Money: Stock quantity (measured at a point in time) Transactions: Flow quantity (measured for a period of time) Turnover of the quantity of money = “velocity” of money A unit of money can be used over and over again for transactions Number of transactions per period depend on length of period

Equation of exchange, Quantity theory of money, and Aggregate demand
Equation of exchange (identity by definition) M*V = pi*ti micro view: all individual transactions M*V = P*T macro view: aggregation/averaging P as “average” price level (relative prices disappear) T as “homogenous” trade volume (product structure disappears)

Price level measured by price indices (Laspeyres vs. Paasche)
Base year (t=0) Reporting year (t=1) Commodity Quantity Price (per unit) Quantity Price (per unit)

Price index problems Innovations Self-test Improved quality
New products Very hard to measure Self-test In real (= price-adjusted) terms, Rockefeller would still be the wealthiest man on earth. Would you swap with him?

Equation of exchange (identity by definition)
Equation of exchange, Quantity theory of money, and Aggregate demand (cont.) Equation of exchange (identity by definition) M*V = pi*ti micro view: all individual transactions M*V = P*T macro view: aggregation/averaging P as “average” price level (relative prices disappear) T as “homogenous” trade volume (product structure disappears) Quantity theory of money Irving Fisher (1911): The Purchasing Power of Money V = fix or trending (exogenous) T determined by factors in the real sectors P proportional to M Aggregate demand T proportional to production (Y) Nominal demand proportional to M Cambridge equation and “money market” equilibrium

Cambridge equation and aggregate demand
Arthur C. Pigou (1917): Value of Money John M. Keynes (2923): Tract on Monetary Reform Transaction demand for money holdings “Money market” Money demand: MD = k*P*Y (Cambridge equation) Money supply: MS (exogenous) “Money market” equilibrium MD = MS  M = k*P*Y Formally: k=1/V Aggregate demand: Y = M/(k*P)

Aggregate demand of goods and services (AD-AS model)
Equilibrium Increase of money supply P AD0 AD1 P Y YFE P0 P1 AS aggregate supply of goods and services AD0 aggregate demand for goods and services P0 YFE Y

Two meanings of inflation/deflation
Original  quantity of money Inflation: Increase in the quantity of money (M > 0) Deflation: Decrease in the quantity of money (M < 0) Modern  price level Inflation: Increase in the general price level (P > 0) Deflation: Decrease in the general price level ((P < 0)

Sources for changing purchasing power of money
Money side Quantity of money (money supply) Velocity of money (money demand parameters) Commodity side Volume of transactions (production)

Price deflation fears Debt burden Deflation spiral Growth break
Nominal debt becomes heavier in real terms Relevant for unexpected deflation only Deflation spiral Speculation for lower prices tomorrow (hoarding, shrinking demand) Hard to substantiate Growth break Price stickiness  hard to substantiate Money illusion, wage stickiness  labor market regulations

Two sources of price deflation
Good (healthy) price deflation: Productivity gains PPM increases due to changes on the real side Society becomes wealthier No downward nominal wage pressure Originating from commodity side Bad (disturbing) price deflation: Shrinking money supply PPM increases due to changes on the money side Society does not become wealthier Downward nominal wage pressure Originating from money side

Static/macroeconomic view: Quantity theory of money
Neutrality of money? Static/macroeconomic view: Quantity theory of money Focus: Average price level Unspecific money inflation (helicopter money) Comparative analysis, no explicit transmission process: M0 vs. M1 “Money is a veil” Dynamic/structural view: Cantillon effects Focus: Individual money prices (price relations) Money injection at specific point: M Diffusion process analysis: Individual price adjustments Early receivers of new units of money win Late receivers of new units of money lose Lasting distributive and allocative effects Richard Cantillon (1680 – 1734) Essai sur la nature du commerce en général (1855)

Non-neutrality of money: A subjectivist interpretation
Subjectivist value theory (perspective of individuals) An extra unit of money does not mean the same to all individuals Change in monetary conditions (demand for or supply of money) affects the distribution of income and wealth Level of money is irrelevant for the utility of money (any amount of money can serve the needs of society) … … but change in the level of money is not neutral

Neutrality of money: Strong and weak definition
Strong neutrality of money Proportional change of all prices (= no change of relative prices) No impact on resource allocation Weak neutrality of money Short-term impact on level of production and unemployment No long-run impact on: Growth rate of production Level of unemployment (“natural rate of unemployment”) Vertical long-run Phillips-curve

Phillips-curve and DAD-DAS-analysis (dynamic AD-AS)
DAD-DAS-model Price level (P)  price inflation (gP) Money supply (M)  money supply growth rate (gM) Aggregate demand (YD) gM > gP  YD (expansionary monetary stance) gP > gM  YD (contractionary monetary stance) Aggregate supply (YS) Expectations-augmented Phillips-curve: gP = gPexp + f(Y-Ypot) Y > Ypot  gP (overutilization of production capacities) Y < Ypot  gP (underutilization of production capacities) Expectations Short-run vs. long-run “Rational” (= model consistent) vs. adaptive (= backward looking)

“Bad money drives good money out of circulation”
Gresham’s law (1/2) “Bad money drives good money out of circulation” Sir Thomas Gresham (1519 – 1579) “good and bad coin cannot circulate together” Predecessors Nicolaus Copernicus (1473 – 1543) Nicole Oresme (1320 – 1382) …

“Bad money drives good money out of circulation”
Gresham’s law (2/2) “Bad money drives good money out of circulation” Good money: Face value = commodity value Bad (= debased) money: Face value < commodity value Official debasement or counterfeiting Private debasement via clipping Clipping (example: Siliqua, Roman silver coin, 4th century A.D.)

Gresham’s law revisited: The role of legal tender laws
“Bad money drives good money out of circulation” (if they exchange for the same price) Legal tender laws (official exchange ratio ≠ market exchange ratio) Good money: Undervalued Bad money: Overvalued Anti-Gresham’s law (Thiers’ law): Good money drives out bad Free market: No legal tender laws apply Hyperinflation: Legal tender ceases to be considered as money depends on

Today: (Independent) monetary authority
Central banks Origins Exchange banks, cashless international payments Monetary consolidation, clearing house Reserve banks Child of fractional reserve banking: Lender of last resort Government financing Public banks or private banks with state privileges: note issuance Currency monopoly, reserve management Today: (Independent) monetary authority Issuance of legal tender Foreign exchange and gold reserves Monetary policy: Price stability, macro-management Financial stability: LoLR, financial supervision

Forerunners to central banking
Amsterdam Wisselbank (1609) Bank of Amsterdam Sveriges Riksbank (1668) Bank of Sweden Bank of England (1694) Bank Charter Act 1844/Peel’s Banking Act 1844 Monopoly of note issuance 100-percent gold backing (+ 14 million in government debt) Lender of Last Resort since the 1870s

Monetary debates in England (19th century)
Economic crises: Monetary theory  monetary policy Bullionist debate (1810s) Bullionists: Convertibility Anti-Bullionists: Inconvertibility (Real Bills Doctrine) Banking debates (1830s to 1840s) Consensus: Mixed currency Coins and banknotes Convertibility into specie (gold) Long-run value of gold determined by production cost Controversy: Control of money supply Short-run fluctuations Prevention of economic crises

Currency-Banking-Controversy
Currency School Money = Coins + banknotes Quantity theory of money Money production initiated by commercial banks Limiting note issuance to prevent price inflation Currency principle Gold parity (full backing) Monopoly central bank (legal privilege) Mixed currency works as metallic currency Banking School Money = Coins + banknotes + deposits Real bills doctrine Money production follows needs of commerce Over-issuance of banknotes is impossible (law of reflux) Banking principle Gold convertibility sufficient Competitive banking (quality of bank assets matter) Elastic money supply best serves the real economy

Non-neutrality of money and monetary policy
Mainstream/Keynesian view Short-run real impact … … and effects are quantitatively predictable Money as a policy instrument for macro-management Austrian view Short-run and long-run real impact … … but effects are too complex to be controlled “Handle with care!”

Monetary policy (interventionism)
Policy goals Price stability Other: Output gap/unemployment, growth Policy target variable Money supply Inflation rate, inflation expectations Exchange rate Policy instruments Reserve requirements  Money multiplier Open market operations  Monetary base Refinancing rates  Market interest rates, credit creation incentives Collateral quality, capital requirements  Credit creation capacity Communication: Forward guidance  Expectations

Business cycle Capacity utilization  (contraction/downswing)
Capacity utilization  (expansion/upswing) Actual output output Potential output Recovery Recession Cooling Boom Positive output gap Negative output gap time

Monetary policy strategies
Money supply stabilization Fixed (growth rate of) money supply (Friedman rule) Real money supply (M = MN/P) moves counter-cyclically Automatic (built-in) stabilizer Discretionary control of money supply Inflation, output gap  counter-cyclical monetary interventions Time lag problem Inflation targeting (endogenous money supply) Taylor-rule for central bank interest rates (output-inflation trade-off) Deviation from target inflation rate (gP*) Output gap Natural real interest rate (!)

Taylor rule Source: John B. Taylor (1993), Discretion versus policy rules in practice

Taylor rule ( ) Source: John B. Taylor (1993), Discretion versus policy rules in practice

Taylor rule ( ) Source: Ben Bernanke (2015), The Taylor rule: A benchmark for monetary policy?

Modified Taylor rule (1993-2015)
Source: Ben Bernanke (2015), The Taylor rule: A benchmark for monetary policy?

“Quantitative easing” (QE)
Type 1 Liquidity provision in times of financial stress Effective (financial stability) Type 2 Stimulus at the zero lower bound in the aftermath of financial crisis Domestically ineffective Exit strategy?

“Quantitative easing” around the globe

Financial framework of a debt-backed monetary system
Claims to RS Equity Reserves Cash Deposits Securi- ties Assets (physical capital stock + future tax base) Money Central Bank Commercial Banks Real Sectors Securi- ties held by FS Financial Sector Debt- backing

“Quantitative Easing” inflates central bank’s balance sheet
Claims to RS Equity Reserves Cash Deposits Securi- ties Assets (physical capital stock + future tax base) Money Central Bank Commercial Banks Real Sectors Securi- ties held by FS Debt- backing

Assets (physical capital stock + future tax base)
Serious default scenario: Transformation of fiat-money system (loss of credit backing) Money over- hang Claims to RS Equity Reserves Cash Deposits Securi- ties Assets (physical capital stock + future tax base) Money Central Bank Commercial Banks Real Sectors Securi- ties held by FS Debt- backing

Global QE: Risk of currency wars Source: Thomson Reuters Datastream, IfW-calculations

Recording cross-border transactions: Balance of Payments
inflow Economic area outflow

Balance of Payments: Types of cross-border transactions
CURRENT ACCOUNT Trade flows Goods (merchandise) Services Cross-border incomes (compensation for use of production factors) Labor: Compensation of employees Capital: Investment income Transfers Current transfers (regularly) Capital transfers (one-off) Financial transactions Nonofficial: Direct/Portfolio/Other investment Central bank: Changes in official international reserves CAPITAL AND FINANCIAL ACCOUNT

Credit item (measured with a positive sign/entry on the left side) …
Accounting principles: Credit and debit items (double-entry bookkeeping) Credit item (measured with a positive sign/entry on the left side) … … results from a transaction for which the country must be paid. It sets up the basis for a payment by a foreigner into the country – that is, it creates a monetary claim on a foreigner. Debit item (measured with a negative sign/entry on the right side) … … results from a transaction for which the country must pay. It sets up the basis for a payment by the country to a foreigner – that is, it creates a monetary liability against a foreigner. Double-entry system (sum of all credit entries = sum of all debit entries) BUT: Statistical discrepancies („errors and omissions“)

Cross-border inflows and outflows
Transaction Credit = inflow of money Debit = outflow of money Goods and services Selling Exports Buying Imports Primary production factors (wages, interest, profits) Factor export = income received Factor import = income payed Transfers (regular or one-off) From RoW Transfers received To RoW Transfers payed Financial assets Capital import Capital export Official international reserves

Example: US Balance of Payments (2010, $ billions)

Interpreting BoP balances (BoP and National Accounts)
Goods and services balance / trade balance (NX) Net exports of both goods and services Current account balance (CA) Net credits on the flows of goods, services, income, current transfers Financial account balance, exl. official reserves (FA) Net credits involving changes in nonofficial foreign financial assets and liabilities Overall balance / official settlements balance (B) Current account balance + (nonofficial) financial account balance [+ statistical discrepancy] = Increase of official reserve assets Link to National Accounts NX  GDP CA  GNI CA + net capital transfers  Net external lending

International Investment Position (IIP): Germany

Exchange rates (spot vs. forward rate)
Exchange rate: e Price of one nation‘s money (e.g. USD) … … in terms of another nation‘s money (e.g. EUR) Euro area view: e = 0,73 [€/$] United States view: e = 1,37 [$/€] Time dimension Spot rate: price for immediate exchange Forward rate: price set now for an exchange in the future

Exchange rate systems: Terminology
Flexible exchange rate Appreciation (e) Depreciation (e) Synonym Floating exchange rate Fixed exchange rate Revaluation (e) Devaluation (e) Synonym Pegged exchange rate

More than two currencies: Currency arbitrage
Exploiting price differentials Between trading centers (NY, London, Frankfurt, Tokyo, …) Between multiple currencies 1,6 [USD/GBP] 0,9 [USD/CHF] 0,5625 [GBP/CHF] 1,6 [USD/GBP]   1,0227 GBP 0,9 [USD/CHF]   1,6363 USD 0,55 [GBP/CHF]   1 GBP = 1,8181 CHF

Cross-border flows and the foreign exchange market
Supply of foreign exchange Demand for foreign exchange Transaction Credit = inflow of money Debit = outflow of money Goods and services Selling Exports Buying Imports Primary production factors (wages, interest, profits) Factor export = income received Factor import = income payed Transfers (regular or one-off) From RoW Transfers received To RoW Transfers payed Financial assets Capital import Capital export Official international reserves

Foreign exchange market (example: USD vs. EUR, euro area view)
Exchange rate [EUR/USD] Supply (Ex+CapIm) Demand (Im+CapEx) Transaction volume [USD]

Capital flows: Cross-border shifts of purchasing power
No capital flows  balanced current account (CA = 0) Given (= exchange rate independent) net capital flows  induced current account balance (CA = FA) Intertemporal perspective (Böhm-Bawerk 1914): “The financial account commands, the current account follows.”

Fixed exchange rates: Defending the peg (1/2)
Exchange rate [EUR/USD] Demand Supply Excess supply absorbed by central bank interventions (increase of official reserves) Peg eM R = MB > 0 Transaction volume [USD]

Fixed exchange rates: Defending the peg (2/2)
Exchange rate [EUR/USD] Demand Supply eM Peg Excess demand provided by central bank interventions (decrease of official reserves) R = MB < 0 Transaction volume [USD]

National currency unit = quantity of gold
Gold standard National currency unit = quantity of gold Exchange rates trend towards gold parities Adjustment via induced gold flows No international coordination of central banks Globally integrated monetary system Gold flows Deficit in overall BoP balance: Gold export  Deflationary pressure Surplus in overall BoP balance: Gold import  Inflationary pressure Automatic stabilization

Gold standards: True and false
True: Genuine (or pure) gold standard Free flow of gold  net cross-border shifts of money “If a domestic money consists of a commodity (…) the principles of monetary policy are very simple. There aren’t any. The commodity money takes care of itself.” (M. Friedman) False: Pseudo gold standard Gold price rule  external standard for monetary policy “Stripped of its gold-standard terminology, the price rule can be seen as a technique designed to guide the monetary authorities in managing the supply of fiat currency.” (J. Salerno 1987)

Impossible trinity (or: monetary trilemma)
Monetary policy options Free flow of capital (vs. capital controls) Fixed exchange rate (vs. flexible exchange rate) Sovereign monetary policy (vs. endogenous money supply) Pick two, give up the third

Free Banking ≠ Currency Competition
Single currency (reserve medium) Provision of fiduciary media Mises: Free Banking as means to limit credit expansion Currency competition Multiple currencies in circulation Competition for price level stabilization Hayek: De-Nationalization of money to limit credit expansion

Free Banking Adverse clearing and reputation effects (inherently precarious position of money substitutes) vs. Cooperation on interbank-markets (profit sharing of credit expansion)

Banking reform: 100 percent banking
Banks as money warehouses Chicago plan, Huerta de Soto

ENTREPRENEURIAL ECONOMICS Money and Banking

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