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Another View of 
Money and Credit

An interesting and useful analysis of a monetary system appears in the paper titled,
A General Analytical Framework for the Analysis of Currencies and Other Commodities, authored by Warren Mosler and Mathew Forstater.  The paper can be viewed at http://www.warrenmosler.com.  Following is a brief synopsis.

Two Components of Money Flows

The model to be analyzed is presented in two parts, referred to as the vertical component and the horizontal component to aid in visualization.  The vertical component is illustrated in the following diagram:

State (consolidated Treasury and Central Bank)
Private Sector (cash, reserves, State securities)
Consumption (tax payment) 

The horizontal component (not diagramed) refers to the expansion and contraction of credit in the private sector.

The Vertical Component

At the top is the State, which is the sole issuer of units of currency in all of its forms.  At the bottom is the consumption of that currency resulting from taxes paid to the State.  The middle is occupied by the private sector, which exchanges goods and services for the currency units, and accumulates what is left over after taxes (State deficit spending) in the form of cash in circulation, reserves (clearing balances at the State's Central Bank), or Treasury securities ("deposits" offered by the CB).  Central Bank policy determines the relative distribution of the accumulated currency units in the private sector.  State deficit spending determines the magnitude of those accumulated financial assets.

Agents are said to participate in vertical activity when they acquire State currency, pay taxes to the State, or intermediate the process.  Since taxpayers must pay taxes in State currency, they are motivated to offer goods and services in the private sector in that currency.  There naturally follows a general recognition and acceptance of that unit of account in private sector transactions.

The Horizontal Component

Credit, the horizontal component, is what the private sector uses to ‘finance’ business activity and expand the economy.  In contrast with the vertical component which is State-controlled, the horizontal component is endogenous.  It is a leveraging in the vertical component.  It grows or contracts as the demand for credit grows or contracts, but it always nets to zero.  That is, private sector credit is balanced by an equal private sector debt.  Credit in the form of bank deposits achieves credibility by virtue of its convertibility to State currency. 

Horizontal activity arises when a buyer desires to make a purchase by borrowing that which the seller demands.  If the buyer borrowed directly from the seller, the item sold would be exchanged for an IOU of the buyer, denominated in the State’s currency unit.  Depending upon one’s definition, that IOU can be considered a form of money.

The Role of the Banking System

The same transaction could be intermediated by a bank.  If the seller did not want to accept the note of the buyer, but would accept a bank deposit, the buyer could go to a bank and request a loan.  If approved, the bank would hold the buyer’s note and grant the seller a deposit in the bank.  In this role, a bank assumes the credit risk of the buyer and would need to charge a rate of interest sufficient to cover that risk.

Banks are allowed to function as intermediaries between the State and the private sector.  This happens whenever a bank check is used for payment of taxes.  The banking system accepts funds from the State as needed to cover checks submitted for clearing, on terms that are dictated by the State. 

Net Private Sector Savings

From inception, the State must spend or otherwise provide that which is necessary to pay taxes.  The private sector will normally desire to obtain more currency units from the State than the minimum required in exchange for its goods and services.  The extra units accumulated are net private sector savings of financial assets denominated in the unit of account.

If the State does not provide the opportunity to net save desired by the private sector, horizontal activity cannot make up the difference.  The clearing of any shortage must involve the vertical component, i.e. the action of the State.  Only the Central Bank can resolve a reserve imbalance.

A significant reduction in State deficit spending could result in a deflation that stabilized only when prices fell enough for the private sector to lower its collective desire to net save.  This implies price sensitivity to supply and demand changes that may originate in the vertical component.  Only when the State runs a fiscal policy that allows the  private sector to hold the desired level of net financial assets will fiscal balance be achieved.

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