Money is a special product in that it performs several must-have functions. Yet money comes in different shapes and sizes – physical, digital and in various denominations. Essentially money is a promise, a debt. We no longer inhabit a world of commodity-backed money, ye olde gold standard. Money is what is generally accepted as money and the principal suppliers are private sector banks that have licences to “print” deposits, typically as counterparts to loans. A big helping hand that gives money its moneyness is, of course, official blessing. Namely, State-backed legitimacy and the generous provision of government/central bank support for the private banking system.
So, for fiat money,
- how much is the promise worth?
- what, exactly, is the price of money?
- how will money’s value change if the promise is suspect?
For this exercise, let’s focus on money in its “top quality” format, that is a liability of a government, or more typically, a central bank. This “top quality” money – the best that money can buy – is called the monetary base or high-powered money and FRED is at hand with data. Now let’s illustrate, with the help of simple demand-supply diagrams, the four prices of money, namely
- the interest rate price
- the foreign exchange price
- the goods price (inverse of the CPI), and,
- the par price (a $ is always a $, right? Wrong!)
Interest rate price. A price is an opportunity cost and the most frequently quoted price for money is an interest rate, reflecting the fact that money (as a demand deposit or cash) typically earns no yield. By having wealth in money format, you are forgoing the opportunity of earning interest on, say, a bill or bond. Using a standard demand and supply diagram we can illustrate this “price” and how it might change, if, for example, the Fed tightened policy by raising interest rates (necessarily being supported by a reduction in the monetary base).
Forex price. An alternative to holding a dollar is to hold another currency, say, sterling. Say the Fed supports a decision to slash interest rates by pumping up money supply, perhaps via Quantitative Easing. Other things equal, the price of a dollar – in sterling terms – will go down. You get less sterling for a dollar. Note you need to be careful as to how you express the exchange rate. Typically, “cable” – the nickname for the dollar-sterling exchange rate – is expressed as $ per £. That’s not going to work in our diagram since we are interested in the price of a dollar, NOT the price of a pound! More of this in sessions 12 and 13.
Goods price. Instead of holding value as $ money you could buy goods and services – we’ll use the catch-all term “Widget” for products in general. Our diagram this time shows a demand-side shift, a weakening of demand for money perhaps because people are worrying that product prices will go up. Buy now, before stuff gets more expensive! The effect is to weaken the price of money (in Widget terms). Expectations of inflation have actually become a self-fulfilling prophesy. We’ll be returning to that issue before too long.
Par. Remember that our focus here is “top quality” money. Cash, such as Federal Reserve notes, falls into this category as do electronic deposits at the central bank (usually only available to a select group of banks). FRED can show you that high-powered money increased sharply during the Great Financial Crisis, representing a surge of demand for safe, as opposed to risky, money. We illustrate this surge in the relevant diagram below. In 2008 some types of money – such as funds placed in Money Market Mutual Funds (MMMF) – suddenly “broke the buck“. For a while, an MMMF dollar was worth only 97c of a “proper” dollar (eg cash). Par was broken, a sure sign that the financial system was close to meltdown. Little wonder that the public authorities acted swiftly and aggressively to avoid the apocalypse. Restoring par, the litmus test of a functional banking system, required the authorities both to boost “top quality” money supply as well as contain the loss of confidence in substitute money (sometimes called quasi-money or shadow money). The GFC reminded us of a very important historical lesson: not all moneys are born equal.
12 Oct 2019