3. Money: Lubricant of the Economy

In the general case with n goods and without money, the number of relative prices equals n(n − 1)∕2. If one good serves as the unit of account, only (n − 1) prices are needed.

During the twentieth century, hyperinflation occurred, for example, in Russia (1921–1924), Germany (1922–1923), Hungary (1945–1946), Argentina (1989–1990), Brazil (1989–1990), Ukraine (1991–1994), Zimbabwe (2006–2009), and Venezuela (2018). Episodes of very high levels of inflation also occurred before 1900, such as, for example, during the French Revolution (1789) and the American Civil War (1861–1865).

In a two-tiered banking system, banks occupy strategic positions in the monetary system. Recently, cryptocurrencies aspire to challenge the monetary role of banks through the use of innovative technology. In particular, a cryptocurrency, such as bitcoin, relies on a publicly available compute code, which specifies an algorithm to create new currency, determines how monetary transactions can be made, and keeps a record of current and past transactions. However, until now, cryptocurrencies represent a speculative asset rather than a commonly accepted means of payment. Furthermore, similar to the early forms of commodity money, cryptocurrencies could be vulnerable to a collapse in trust and suffer from an inflexible money supply (especially in times of financial crisis). For a monetary discussion of cryptocurrencies, see Bank for International Settlements, 2018: Cryptocurrencies: looking beyond the hype, BIS Annual Economic Report 2018.

To be precise, central-bank money and the monetary base are not identical concepts per se. For example, coins are issued by the government and not by the central bank in the euro area, England, and Switzerland (the central bank typically distributes the coins). In these cases, coins are not included in central-bank money. Of course, coins only account for a tiny fraction of the monetary base.

Technically, credit-card payments do not immediately enter M1. Rather, they represent short-term loans from the credit-card company. The monetary side of the transaction occurs only when the invoice from the credit-card company is settled by the cardholder.

This proposal was made by the Swedish economist Knut Wicksell (1851–1926) in his principal contribution Interest and Prices (1898, McMillan and Co.).

This line of argument was developed by Nobuhiro Kiyotaki and John Moore in a paper entitled ‘Evil is the Root of all Money’, which was presented during the 2001 edition of the Clarendon Lectures at the University of Oxford.

Perhaps, mathematical formulae can help to clarify this point. For the present scenario, we have that monetary base= cash+ reserves. In case only demand deposits are considered (e.g. we contemplate M1), we have furthermore that M1= cash+ demand deposits. A 100% reserve system implies that reserves= demand deposits. Hence, M1= monetary base.

The exact formula of the money-and-credit multiplier can be derived from the definition of monetary aggregates. Consider the example of M1, which is defined as M1= cash+ demand deposits. Furthermore, we have that monetary base= cash+ reserves. Define the reserve ratio by m= reserves/demand deposits and the fraction of cash c= cash/demand deposits. Now we have that

Hence, the money-and-credit multiplier within the banking system decreases with the fraction of reserves m and cash c.

For a paper demystifying this belief, see Tobin, James, 1963: Commercial Banks as Creators of ‘Money’, Cowles Foundation Paper, 205.

In principle, this type of activity is not restricted to commercial banks, as anybody can create inside money as long as he or she manages to issue financial claims which are broadly accepted as a means of payment. Of course, by being close to the money and capital markets, specialising in monitoring credit, and running parts of the payment system, commercial banks are in a unique position to create inside money.

Of course, ordinary citizens have access to central-bank money by holding cash.