Prepared By Ella Luo
FINC 5090
FINANCE in the Global Economy
1
Part 2:
Money
2
1 Role of Money
Ø Role of Money
• Broadly speaking, money is used to buy or sell something.
• Pure barter system is inconvenient.
Ø Three conditions are needed for money to be a successful least-cost medium of exchange:
• It must be storable
• It must have stable purchasing power
• It must be easy to handle
Ø Money also acts as a unit of account or numéraire when prices are quoted in units of money.
Ø Money can also be lent or borrowed, which allows one to transfer the purchasing power over time
in a low-risk fashion.
2 HowMoney is Created
Standard
commodities
Official
Precious
Metals
Privately Issued
Paper Money
Official
Paper Money
Animals are bulky
and hard to handle
and transport Advantage:
• Less bulky and easier to transport.
• Do not die or rust
• Cost of producing precious metals still remain high.
Problem:
• Transportation
• Gold and Silver that defines by weight
v coin flipping (scratching precious metal off coins)
• Local lord set up an official mint: Give the mint your precious metals,
collect your coins, and pay a small fee (seignorage)
v debasing (melting precious metal coins, and mix them with
other cheap metals)
• Coin flipping or debasing, threaten the stability of money’s
purchasing power,
2 HowMoney is Created
Standard
commodities
Official
Precious
Metals
Privately Issued
Paper Money
Official
Paper Money
Ø Mechanism:
• Traders deposited money with international bankers, who use bills of exchange and promissory notes
• The receipts and bills were convertible into the underlying coins at sight and were as good as gold as
long as the issuer was creditworthy.
• A merchant who pays with a promissory note that remains in circulation for years before being cashed
in, obtains an interest-free loan.
• Bankers know that, on average, only a small fraction of circulating notes was actually cashed in. Most of
them remained in circulation for quite some time.
• This meant that, on the basis of one coin, a bank could issue notes for a much larger total value.
• Most of the money bank created is lent to the economy, not given away.
• By refusing to roll over the loans, the bank can shrink the money supply back to the original size.
Ø Risk:
• The risk was that holders of the notes would lose confidence in the issuer, in which case there would
be a run on the bank
• To avert such crises in confidence, most governments then assigned the production of notes to a
government institution
2 HowMoney is Created
Standard
commodities
Precious
Metals
Privately Issued
Paper Money
Official
Paper Money
Ø Develop of central bank:
• Initially, the official bank notes were still convertible at sight into true money, i.e., into coins issued
by a mint or a treasury.
• Still, for all practical purposes, the central bank’s notes have become as good as the treasury’s
coins and have become the true underlying money in the eyes of the population.
v Unlike cattle and gold, modern money has basically no intrinsic value of its own, nor is the
value of modern money based on a right to convert bank notes into gold
v Rather, the value of money is based on the trust of the people who believe that money will
have a reasonably stable purchasing power.
3 Official Paper Money and Central Bank
Ø Issuing money (role of central bank)
• A central bank no longer deals directly with the public. Its customers are commercial banks, foreign
central banks, and the government.
• When a central bank buys a domestic or foreign asset from a commercial bank, it no longer pays entirely
in the form of bank notes. Commercial banks demand notes only to the extent that their own customers
demand actual currency.
• One result is that the central bank‘s liabilities consist not only of bank notes but also of commercial
banks' deposits into their account with the central bank.
• This liability side (bank notes circulating plus central bank deposits) is called the country’s monetary
base, denoted by !
3 Official Paper Money and Central Bank
Ø Issuing money (role of commercial bank)
• Any private bank knows from experience that its borrowers rarely take up the full amount of loan as
notes or coins. Rather, customers tend to leave most of their borrowed funds in the savings/checking
account.
• It means that private banks can (and do) extend loans for a much larger volume than the amount of base
money that they keep in their vaults or with the central bank.
• This mechanism again creates the possibility of runs on commercial banks if deposit-holders want to
convert all of their deposits into notes and coins.
• To avert bank runs and enhance credibility, private banks in many countries must meet reserve
requirements: they must keep a minimum fraction of the customers’ deposits in coins or bank notes or,
more conveniently, in a non-interest-bearing account with the central bank.
• The central bank also agrees to act as lender of last resort, i.e., to provide liquidity to private banks in
case of a run.
3 Official Paper Money and Central Bank
Ø Money Multiplier
" = ×! = ×( + + )
• m: money multiplier
• M!: money base
• D: Credit to the domestic private sector
• G: Credit to the government
• RFX: Reserves of foreign exchange (including gold)
3 Official Paper Money and Central Bank
Ø Monetary Policy
• Intervention in the foreign exchange markets.
v Any change in RFX leads to an identical change in !, which then affects the amount of money that
private banks can create on the basis of !.
• Open-market policy.
v Central banks can influence the monetary base by restricting or expanding the amount of credit they
give to the government (G) or the private sector (D).
• Reserve requirements.
v Central banks can curb money creation by commercial banks by changing the reserve requirements
v changing the upper boundary on the monetary multiplier m
v A 50 percent reserve requirement means that the money multiplier can be at most 2
• Credit Controls
v The most direct way to control M1 is to impose limits on the amounts that private banks can lend.
4 International Payment Mechanism
Ø Domestic Interbank transfers: gross settlement vs periodic netting
• By netting out, the volume of transfers is significantly reduced from 195 to 25 in this example.
• This allows banks to work with far smaller balances in their central bank account: you cannot make
payments exceeding what is in your account, so each bank would have needed larger central bank
balances if the gross payments had been due rather than the net ones.
• But big players with big amounts due may want their money faster.
4 International Payment Mechanism
Ø International Payments
• Let S be the sending (domestic) bank, and let R∗ be the receiving (foreign) bank.
• S and R∗ are no longer members of the same clearing organization.
• Traditional Solution: work with correspondent banks.
v If bank S has bank S∗ as a correspondent bank in bank R∗ ’s country, then they have a current-
account relationship, with a liability account called loro (theirs) or vostro (yours) and an asset
account called nostro (ours).
v Bank S will send instructions to bank to make the payment to bank R* via their country's central
bank's clearing system.
v The current account is rarely settled, say once a quarter or when balances become really large.
v The main point of postponed settlement of the loro/nostro accounts is a kind of netting over time.
v The way the party with the surplus receives a genuine payment for the net
• Correspondent bank is slow and expensive, especially with payee-driven payments: a check has to be
sent abroad, from S to S∗ , and then to R∗ , and each has to handle and record it.
4 International Payment Mechanism
Ø International Payments: SWIFT
• The most important player is the Society of Worldwide Interbank Telecommunication (SWIFT) which was
set up as a cooperative
v SWIFT transmits messages between banks, well over ten million per day, for a small fee.
v Any free cash flow remaining after SWIFT has paid its expenses is then paid out to the shareholding
banks.
v Payment via SWIFT means same-day value.
v Other services offered by SWIFT include the option to have a local check printed out in the
beneficiary’s country, by SWIFT. That check is then immediately delivered to the debtor’s bank, thus
avoiding mail float.
4 International Money and Bond Markets
Ø International Money and Bond Markets
• Banks accept deposits in order to re-lend them: international deposits must also be accompanied by
international loans.
• The development of international money and loan markets was followed by the opening of markets for
securities, the first of which was the international bond market.
• There are many reasons why some investors preferred to make their USD deposits outside the United
States, as well as why there was and is so much USD borrowing outside the US.
v Less regulated
v It was comparatively easy to evade taxes on income from international deposits, which further
increased the attractiveness of this market.

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