Money and Credit (I)

KS Macroeconomics I

Bernhard Schtz Johannes Kepler Universitt Linz Institut fr Volkswirtschaftslehre

Overview
Literature Introduction
Origin of money Nature of money Forms of money

The monetary circuit without a central bank The monetary circuit with a central bank (next week) The monetary circuit with a government (next week) Interbank transfers

Literature
Lavoie, M. (1992): Foundations of Post-Keynesian Economic Analysis, Elgar, Chapter 4. Tymoigne, E., Wray, L. R. (2006): Money: an alternative story. In: Arrestis, P., Sawyer, M., A Handbook of Alternative Monetary Economics, Elgar.

Origin of money
Difference between the standard textbook story and historical evidence Standard textbook story
Money (coins) was invented to facilitate trade

Historical evidence
First forms of money are much older than the oldest coins First form of money was credit Coins appeared much later and probably as a means to pay soldiers

Nature of money
Neoclassical economics: money is a commodity
It is scarce like any other commodity Therefore it has a price like any other commodity (interest rate)

Most other economic schools (including PKE): money is a social convention

It is not scarce, but rather is constantly created and destroyed within the production process Interest rate is just another social convention

Forms of money
Usually people distinguish between
High powered money Money stock

High powered money

Consists of banknotes and bank reserves Supply of money that is directly controlled by the central bank

Money stock
Consists of banknotes and deposits Money used in daily transactions

The monetary circuit

Describes the circulation of money in a modern production economy The monetary circuit includes the creation of money as well as the destruction of money
Money is created when firms receive bank loans Money is destroyed when firms repay their loans

We will proceed in 3 steps:

The monetary circuit without a central bank The monetary circuit with a central bank The monetary circuit with a government

Monetary circuit without a central bank

Firms require credit because
they have to pay their workers when production starts but they receive their revenues only when they sell the finished products

Balance sheet of commercial banks once they give loans to the firms sector
c and i stand for the consumption and the investment goods sector

Commercial banks Assets New loans to firms Rc + Ri Liabilities New deposits of firms Rc + Ri

Monetary circuit without a central bank

The creation of a loan creates
an asset for the banking sector an additional deposit for the firm sector

Money is created ex nihilio with the stroke of a pen In a next step firms have to pay the households:
Commercial banks Assets New loans to firms Rc + Ri Liabilities New deposits of firms 0 New deposits of households Rc + Ri

Monetary circuit without a central bank

Households will spend part of their income and save a part Sh

Commercial banks Assets New loans to firms Rc + Ri Liabilities New deposits of firms Rc + Ri Sh New deposits of households Sh

Monetary circuit without a central bank

Firms use these revenues to repay their loans:
Commercial banks Assets Loans to firms Sh Deposits of firms 0 Deposits of households Sh Liabilities

Since households are saving Sh, firms cannot repay the amount Sh of their loans
The amount of money on households deposits is equal to the amount of unrepaid credit

Monetary circuit without a central bank

If households do not want to hold all their savings in deposits, firms can issue bonds or shares (Eh)
This enables the firm to get hold of some of the households savings and reduce their debt at the bank
Commercial banks Assets Loans to firms Mh Liabilities Deposits of households Mh = Sh Eh

Summary
Banks create money with the stroke of a pen
Each loan creates a deposit Deposits are used for transactions When loans are repaid, money is destroyed

For each loan there must be a deposit

If everyone would repay his or her loans, money would disappear from the economy