|Money as Credit
Money does not
exist in a pure barter system.
Trades are negotiated
by the participants as a fair exchange of goods and services. If
agrees to receive equivalent value later in exchange for his goods, he
accepted an IOU.
An IOU is a credit
for the seller and a debt for the buyer. If the IOU becomes
meaning others will accept it in exchange for goods and services, the
money. In essence, money is
credit that is widely accepted as a medium of
The Basic Properties of Money
An IOU will be
accepted in exchange for
goods and services only if it is seen as a store of value.
does not have to store value indefinitely to qualify as money. It
money if it retains value long enough to be generally accepted as a
exchange. Money is always a store of value, but a store of value
always money. For example, a bond is a store of value, but bonds
seldom accepted as a medium of exchange, and therefore are not money.
Most of the
money we use is denominated in
the unit of account established by the government. That enables
measure the value of a good or service against another, based on what
sells for in the market. How many quarts of milk are equivalent
to a barber shop haircut can only be determined in the market place.
IOUs as Money
A bank loan
creates a negotiable IOU (credit money) for the borrower and a
liability for the bank. The borrower incurs a matching debt (the
obligation to repay the
loan) and the bank gains an interest-earning asset (the loan contract).
The term money
is sometimes used in reference to high quality debt
nearing maturity. However such near-money
is seldom acceptable as a medium
of exchange. Besides being inconvenient to the seller, the
of near-money is not really known until sold in the marketplace.
restrictive definition of money will be adopted here.
Fed Funds and Bank Money
When the Fed
purchases a financial asset
from the public, it credits the seller's bank with a deposit at the
funds. Banks can exchange Fed funds for
Reserve notes, and vice versa, on
either form, these Fed IOUs are the most negotiable in the
is because the private sector must surrender Fed funds in paying
taxes. Conversely the government pays in Fed funds when it
usually pay taxes
with bank money, i.e. a check against a bank deposit. However the
must cover the check with its own Fed funds. It cannot issue an
cover the check. The Fed accepts bank money at par with its own
IOUs. Thus bank deposits are nearly as negotiable in the private
as Fed funds. Private party IOUs may be legally binding, but they
uncertain monetary value and seldom negotiable. They are simply
debt rather than money.
market mutual funds offer
accounts similar to checking accounts at banks. They are actually
in the ownership of short-term debt. When one pays with a draft
money market fund, he is in fact selling shares in exchange for bank
the fund must deliver. That means the fund must have sufficient
money on hand, or acquire it through borrowing or sale of its own
money market mutual
funds are not insured or guaranteed to trade at par with Fed money,
acceptance is now so widespread that they have become de
facto money. Thus non-bank financial institutions
(NBFIs) can create money by selling an
interest in short-term paper, and providing checking facilities against
Banks as Intermediaries
intermediaries, banks borrow to
lend at a profit. However banks are a special kind of
because of their role as depositories. When a bank lends, it
new deposit to fund the loan and thus expands the money supply.
issue loans only up to a prescribed multiple of its capital, and it
must hold reserves
of base money sufficient to cover
net daily withdrawals of its depositors.
to a bank's vault cash and
its Fed funds. Under present rules, a bank must hold 10% in
its demand deposits, averaged over successive two-week periods.
allows a bank to run below its required reserves on any given
Interbank lending serves to redistribute reserves lost to other banks
ordinary checking activities.
A bank can
acquire Fed funds by borrowing in
the money market, but it cannot increase its capital (assets minus
through borrowing. Banks with sufficient capital sometimes create
deposits without adequate reserves, and count on borrowing to meet the
requirement. That may leave the banking system short of reserves,
thus apply upward pressure on the interest rate in the Fed funds
In order to defend its target interest rate, the Fed will supply the
on its own initiative. Thus a net increase in credit issued by
banking system normally brings forth new base money.
Non-Banks as Intermediaries
were once the main source
of credit. Today NBFIs such as mutual funds, pension funds,
companies, and insurance companies issue far more credit in total than
banks. Indeed, deposits created by banks now comprise less than
the total credit market debt.
ordinary intermediaries that lend
by transferring their own bank money to the borrowers. For
example, NBFI B
borrows $1 million from investor A at X%, and lends $1 million
entrepreneur C at Y%. In effect, $1 million in A’s
account is transferred to C’s bank account. No new money
created, but the total credit market debt increases by $2
expects to earn (Y-X)% on $1 million. C expects to profit
loan, pay regular interest, and pay off its debt to B when it
due. B will then have funds to pay off its debt to A.
matters in this scenario is
cash flow. Intermediaries typically borrow short to lend long,
advantage of the normally upward sloping term structure of the yield curve (yield versus maturity).
Such an intermediary must be able to roll over short-term debt on a
basis at favorable interest rates. If its credit standing is
may not be able it to borrow at all.
flow also depends on
factors over which the intermediary has no control. Suppose the
raised short-term rates sharply. Not only might B be in
due to the higher cost of rolling over its short-term debt, but C
also find its income reduced. If C were unable to service
debt, B might also fail, in which case A could lose a
of its investment.
Fed has virtually no control
over the total amount of credit market debt. However the real
the financial system is not in how much credit is created. It is
cascading of debt relations in which a single default can result in a
are important players in a modern entrepreneurial economy, but they are
regulated as to their capital ratios or the type of assets they may
There is a constant danger of an over-leveraged NBFI having to default
large debt. While the Fed or other financial institutions would
come to the rescue, it is by no means certain that widespread havoc
avoided under the rules that now exist.