Money: 7

I will write a little about money and commerce with foreign countries.  How does exchange occur when there are different currencies involved?  From my introductory economics text, the process is confusing.  If exactly the same dollar amount bought by the United States from one country is sold to that country things are simple.  Then, the exchange can be handled by changing the balances in the accounts of the buyers in the United States  and changing the balances in the accounts of the sellers in the other country.  Nothing but the goods or services get exchanged between the two countries.  Obviously the inflow and outflows never match exactly over a time period.  However, foreign accounting is set up so that the accounts always balance.

Balance of payment accounts are set up into current accounts and capital and financial accounts (using the International Monetary Fund practice – which the United States accounts follow).  Current accounts measure what is bought and sold and capital and financial accounts measure the exchange of capital.  Adding the current account balance to the capital and financial account balances should give zero.  In other words, when money is spent on foreign goods, the foreign money which is paid to the seller must come from somewhere.  Likewise, when money comes from sales to foreigners, the dollars which are received must come from somewhere.  In practice, usually the accounts do not balance.  The negative of the sum of the current account and the capital and financial accounts is called the statistical discrepancy.

In the United States, the current account is the net of the dollar amounts of all of the goods and services exported and imported, plus net transfers of dollars for which nothing is received in return – such as foreign aid, plus net investment income.  Exported goods and service increase the current account – we import dollars, and imported goods and services decrease the current account – we export dollars.  Transfers into the country increase the current account – we import dollars, and transfers out of the country decrease the current account – we export dollars.  Income from foreign investments increases the current account – the foreign company buys dollars to give to the investor and sells their foreign currency, and income from the United States to foreigners for investment in the United States decreases the current account – the domestic company buys foreign currency and sells dollars to pay the foreign investor.

The capital and financial accounts measure flows of ownership of capital.  According to what I have read, most of the world works with a capital account, but the International Monetary Fund splits the capital account into a capital account and a financial account.  The capital account is then mainly forgiveness of foreign debt.  The financial account – which contains most of the exchanges – is measuring net investments of various kinds and the buying and selling of currencies by national governments.  Some of the types of investments measured are the buying of a manufacturing plant in a foreign country, a foreigner buying stocks on the New York Stock Exchange, or a loan by a foreign bank to a domestic borrower.   Returns such as interest and dividends on investments are put in the current account.  If a foreign manufacturing plant is bought by a domestic buyer, the capital account decreases – dollars are sold and the foreign currency is bought.   If a foreigner buys stocks on the New York Stock Exchange, the capital account increases – dollars are bought and the foreign currency is sold.  If a loan is made by a foreign bank to a domestic borrower, the capital account increases – dollars are bought and the foreign currency is sold.

The government is one of the buyers and sellers of foreign currency. The usually reported balance of payments deficit (surplus) is the difference between the current and the capital and financial accounts without the net foreign assets and foreign liabilities of the federal government.

The buying and selling of currency also fall in the financial account.  Let’s say that businesses in the United States have bought a lot of goods from China.  The businesses need to have Chinese money to pay the Chinese company for the goods. Foreign currency is bought and sold in the foreign exchange market at the exchange rate between two countries. There is quite a history of how foreign exchange works. However, over the last forty years, exchange rates have pretty much been free to float, and a foreign exchange market has developed which is currently the biggest of the financial markets. While, in some cases, actual currency is transferred – for example, a tourist to Canada exchanges US dollars for Canadian dollars, I think that most foreign currency transactions occur “on the books” – that is an account in one currency is credited and an account in another currency is debited.

With exchange rates free to float, sometimes a government will want to raise or lower the rate at which the country’s currency trades. The government’s central bank would then buy the country’s currency on the foreign exchange market to raise the exchange rate or sell the country’s currency to lower the exchange rate. Sometimes a country will peg the country’s currency to another country’s currency. For example, I have read that China pegs the Chinese currency to the US dollar. Then, I think, the Chinese government will buy and sell the Chinese currency at the pegged exchange rate without regard to the foreign exchange market. While the foreign exchange market facilitates foreign transactions, the market has developed into a market where most of the trading is for speculation.

At the national level, the International Monetary Fund was created out of the Bretten Woods conference after World War II to help manage the fixed exchange rates that came out of Bretten Woods. By 1969, the fixed exchange rates were breaking down and the International Monetary Fund created something called special drawing rights, which were not denominated in any currency and through which governments could exchange currency. All of the members of the International Monetary Fund received some. Special drawing rights are still part of financial accounts, but the International Monetary Fund exists now mainly to facilitate loans to countries in financial trouble.

The United States has been running a trade deficit for at least forty years now. The claims on dollars by foreigners that have not been balanced by foreigners buying our goods and services (the current account balance) are mostly balanced by foreign investment in the United States of those dollars (the capital account balance). For example, the Chinese government has been “returning” United States dollars to the United States by investing in government securities.

Here is a link to the international accounts of the United States for 2011 and part of 2012, http://www.bea.gov/iTable/iTableHtml.cfm?reqid=6&step=3&isuri=1&600=1. For the second quarter of 2012, the current account showed $735,670 million in exported good and services, -$821,039 million in imported goods and services, and a net of -$32,743 million unilateral current transfers, giving a current account balance of -$118,162 million. The capital account has a balance of -$291 million. For the financial account, the change in US-owned assets abroad, excluding financial derivatives, was $248,186 million (a positive number indicates a decrease), foreign owned assets in the United States, excluding financial derivatives, was -$143,607 million (a negative number indicates an decrease) and net financial derivatives, were $464 million, giving a capital and financial account balance of $104,752 million. The statistical discrepancy is then $13,360 million. So, in the second quarter of 2012, the United States was decreasing investments abroad, foreigners were decreasing investments in the United States, though the investors in the United States were decreasing investments faster. From the current account, the United States was buying more goods and services from abroad than were being bought by foreigners from the United States.

While foreign exchange rates used to be fixed by governments and all currency was ultimately redeemable for gold, now money is “fiat” money, not backed by anything, and markets determine the cross values of national currencies. Currency markets work like the usual market. If the demand for a currency goes up, so does the price if the supply is held constant. If the supply of a currency goes up, the price of the currency falls if the demand stays constant. The main buyers and sellers of currency these days are large banks. I suspect that the markets now balance imbalances in supply and demand for currencies, whereas before governments did.

Money: 6

First, I will write about the three things that money does, which are: (1) acts as a medium for exchange, (2) stores value, (3) provides a metric for exchanges.  The first function of money combined with the third function of money provides people with a way to buy and sell and to have a sense of the value of the exchange in the process.  The second function of money gives a way of saving the value of a sale, to be used in future exchanges.

With regard to money as a medium of exchange, I would think that the ease with which a person can use money to buy things which the person values and can afford and the ease with which a person can receive compensation for labor or goods, greases the wheels of an economy.  With regard to money as a store of value, money is not a good store of value over time unless sufficient interest is paid on the money over time.  Because our economy has had persistent inflation over many years, the value in terms of buying power of a given quantity of money stored in earlier years has been less in the present than when first stored.  With regard to money as a metric for exchanges (a unit of account),  money measures value.  Because of inflation, the measure is not constant over time, but, at any given time, money measures the value of an exchange.

Next, I will write a little on to the neutrality of money.  According to my introductory economics book, early theorists in economics thought that money was neutral.  That is, if the money supply expanded, the expansion would not affect the quantity of goods produced, but would increase the prices of all goods by the same proportion, until all of the excess money was absorbed.  I believe that we now know that changing the money supply affects the economy.  I think that we have found that increasing the supply of money of money increases economic activity, which produces growth.  Certainly, the population is growing, so the money supply would need to grow just to stay even.  Also, the goods and services available for sale are always changing, so neutrality of money does not make sense with respect to a constant set of goods available.

Last, I will write a little on the velocity of money.  The velocity of money is a measure of economic activity (for example, the Gross Domestic Product) divided by a measure of the money supply (for example, M1).  The velocity of money is the number of time the money turns over within the economy within a time period.  In a day, say I buy some juice, the grocery store pays my friend, partly with the money that I spent at the store.  My friend buys some socks.  The money I spent on the juice has been spent three times during the day.  So the economic activity depends on both the money supply and the velocity of money.  If the velocity of money is higher, not as much of a money supply is needed for the same amount of economic activity.  See the Wikipedia entry, Velocity of Money, for a more complete explanation.

Money: 5

Monetary policy is used to try to expand or contract the economy in the face of unemployment or inflation, mainly with monetary tools which manipulate  interest rates and the money supply.  Monetary policy is implemented by the Board of Governors of the Federal Reserve Banks and the decisions makers are independent of the President or Congress.  The Board of Governors of the Federal Reserve are appointed by the President and confirmed by the Senate, so the executive and legislative branches of our government do have some influence over the Federal Reserve, but the members of the board are appointed for 14 years.  There are 7 members of the board and the members serve staggered terms,  a new one being appointed every two years.  Board members can only serve one term.  According to the Wikipedia page, Federal Reserve System, there are currently two vacancies on the board because Obama is having difficulty getting his nominees through the Senate.

Some tools of monetary policy are open market operations, the reserve ratio, the discount rate, and quantitative easing.  Open market operations involve the Federal Reserve banks buying or selling either repurchase agreements (for the very short term) or government securities in order to keep interest rates level.  If interest rates are going up, a Federal Reserve bank buys government securities from a commercial bank, then the commercial bank has more money to lend and the money supply goes up and interest rates go back down.  If interest rates are going down, a Federal Reserve bank sells government securities to a commercial bank, then the commercial bank has less money and the money supply goes down and interest rates go back up.

The effect of the reserve ratio is described in previous blogs.  Currently, manipulating reserve ratios is not a large part of monetary policy in the United States, since most of the accounts that still have a reserve ratio requirement are checking accounts and are only a small portion the larger measures of the money supply.

The discount rate is the interest rate charged to commercial banks that borrow, usually for the short term, from the Federal Reserve system because of problems with liquidity.  When commercial banks borrow from the Federal Reserve system using the discount rate, the borrowing is called borrowing from the discount window.  Changing the discount rate has an effect on the different interest rates within an economy and, as such, an effect on the money supply.  Increasing the discount rate makes the borrowing of money more expensive, so has a contracting effect on the money supply.  Decreasing the discount rate makes borrowing cheaper, so has an expansionary effect on the money supply.  From what I have read, the discount rate is not currently a big part of monetary policy.

Quantitative easing involves the government buying financial assets from commercial banks and other financial entities in order to put more money into the economy.  According to the Widipedia article Quantitative Easing, open market operations are used to maintain interest rates, but, when interest rates are already low and the economy is stagnating (called a liquidity trap), quantitative easing is used to expand the money supply and put downward pressure on interest rates out into time.  The purpose of quantitative easing is to expand the money supply when interest rates already low and there is no wiggle room for more traditional methods of monetary policy.  With open market operations, the Federal Reserve banks buy and sell short term government securities from and to commercial banks in order to affect the interest rate.  With quantitative easing, different kinds of financial assets are bought that are longer term than with open market operations, which affects longer term interest rates.  The sellers include more than commercial banks and the assets include more than government securities.

Monetary policy, as opposed to fiscal policy, seeks to expand or contract an economy through the ease of access to money, which depends partly on the interest rate.  If the supply of money goes up, interest rates should go down.  If the supply of money is reduced, interest rates should go up.  Fiscal policy seeks to expand or contract an economy through buying goods and services, and thus increasing the amount of money in the economy available to be spent (rather than borrowed).

Money: 4

There are a number of different ways of measuring the money supply.  Five ways that I know of are M0, M1, M2, M3, and the monetary base.  Money supply measures estimate the amount of available monetary resources in the economy.  The measures do not include money available through credit, since such money must be payed back.  Some of the monetary measures include the various types of savings deposits.  All of the monetary measures include the currency of our country.  From the Wikipedia page,  Money Supply , M0 is mainly the physical money in circulation, M1 is mainly M0 plus checking accounts of various kinds, M2 is mainly M1 plus most savings accounts, money market accounts, and CD’s of value less than $100,000, M3 is mainly M2 plus CD’s of value greater than $100,000, time deposits in foreign banks denominated in US dollars, and repurchase agreements.  Also from the Wikipedia page, the monetary base is the physical currency plus minimum and excess reserves of the Federal Reserve Banks.

Below, I have plotted Securities Held Outright from historical data of the Federal Reserve (see http://www.federalreserve.gov/releases/h41/current/) divided by historical data for M1, M2, and M3 (see http://www.federalreserve.gov/releases/h6/current/) for the years 2003 to 2009.  The data is not seasonally adjusted.  According to a note in the Wikipedia page, Federal_Reserve_System , Securities Held Outright under the listing of Federal Reserve assets previously represented the part of the federal public debt that the Federal Reserve owned, that is the money that the Federal Reserve has created.  According to the note, in 2007 and 2008, some facilities were added and, after that time, Securities Held Outright was not the federal public debt owned by the Federal Reserve banks.  I only found data back to late in 2002 for Securities Held Outright.  Securities held outright are reported weekly.  I used the average for the first week of the month to plot against monthly money supply data.  For the money supply measures, the M3 series ends in February of 2006.  The Bush administration felt that measuring M3 was not worth the cost.

Securities Held Outright are about 11% of M2.  The reserve ratio for a bank depends on the size of the bank and the type of deposits in the bank.  This year, 2012, for transaction accounts, if a bank holds under $11.5 million, there is no reserve requirement.  If a bank holds between $11.5 million  and $71.0 million in transaction accounts, the reserve ratio is 0.03.  If a bank holds more than $71.0 million in transaction accounts, the reserve ratio is 0.10.  While the levels where the two reserve ratios go into effect change each year, the 0%, 3%, 10% split has been law since 1982.   There other types of accounts have no reserve requirement.  See http://www.federalreserve.gov/monetarypolicy/reservereq.htm for information on the historical levels of the breaks (tranches), for a description of transaction accounts, and for information about the other types of accounts which have no reserve requirement.

According to the description of transaction accounts in the Federal Reserve page linked in the last sentence, transaction accounts are essentially M1.  The components of M2 and M3 in excess of M1 do not have reserve requirements. We see the ratio of Securities Held Outright by the Federal Reserve banks – that is , the money the government has created out of thin air – in a ratio of about 0.10 with M2 and M3.  So, even though there is no reserve requirement on M2 or M3, overall financial institutions seem to have been loaning out money at a defacto reserve rate of  about 10%, that is, the money supply is about ten times the amount of money that the Federal Reserve banks have created out of thin air.

Below, I have plotted the actual and required reserves from 1959 to the present.  The source of the data can be found at http://www.federalreserve.gov/releases/h3/current/h3.htm .  The reserves that I have plotted are not adjusted for seasons or breaks.  I have made two plots, since there has been a huge change in both the size and behavior of the reserves since 2008.

In 2008, the Federal Reserve banks began paying interest on excess reserves held at the banks.  I am assuming the interest is the reason reserves have increased so much.  I wonder what the effect has been on the money supply, since I would think that banks would have less money available to lend.  There is an interesting paper of reserves written in 1993 at the Federal Reserve, a link to which can be found at http://www.federalreserve.gov/monetarypolicy/reservereq.htm, under ‘article (119 KB PDF)’.

Money: 3

My economics text gave a history of money and the development of creating money through banks.  According to the text, originally, trade was done by barter.  Then, people found more convenience in exchanging something considered of value, but easy to store and carry – like coins of precious metals, to carry value in trade.  Eventually, to keep the exchange medium safe, people began storing the medium with a person – say someone who worked in gold smithing for gold coins – and exchanging the medium through paper IOU’s.  The persons holding the medium of value found that the persons could give out more IOU’s than the persons had in the value of the medium the persons had in the persons’ vaults.  The persons were expanding the money supply, quite unwittingly.  Later, banks came into existence to hold the medium of value and came to print money backed by the medium of value held in a bank’s vault.  While the government printed money during the Civil War, by the late nineteenth century in the United States, banks were printing the county’s paper money.  However, sometimes there would be “runs” on banks, that is more people turning in paper money for the medium of value behind the money than the bank had in store.  Runs on banks lead to bank failures.  In 1914, the federal reserve system came into existence, with the Federal Reserve banks being the banks of the federal government.  After 1914, only the federal government printed money.  At first, the government maintained gold reserves to back the paper money, but by 1971, paper money could not be exchanged for gold by anyone.  Since 1971, we have had fiat money – that is money with nothing behind the money.

The Federal Reserve banks are the federal government’s bankers.  All money going into or out of the government goes through a Federal Reserve bank.  The Federal Reserve banks also serve as bankers to the commercial banks in this country.  Much of the reserves required by the reserve rate is on deposit at a Federal Reserve bank, the rest being in vaults within commercial banks.  The Federal Reserve distributes all new currency in circulation.  When a commercial bank’s reserves fall too low, the bank can borrow from the Federal Reserve (from the discount window at the discount rate).  The Federal Reserve System is responsible for the implementation of monetary policy, too.

When there is less money taken in by the federal government than is spent, the difference between the money taken in and the money spent must be financed in some way.  The government has two ways of financing the difference, by borrowing or by “printing” money.  When the government borrows money, the money is either borrowed from the American public or from foreigners (here I am ignoring intra-government transfers).  When the government borrows money, the Treasury Department sells securities to the public.  If the market is such that the public does not want to buy the  securities, the Federal Reserve buys the Treasury securities and pays the bill by borrowing from itself, which is called “printing” money.  The money borrowed is created electronically out of nothing.  Note that the federal government gets most of the earnings of the Federal Reserve banks.

The money supply is increased when borrowing from foreigners, since money comes into the economy from outside, but borrowing from the the American public should not affect the money supply, since the money is just returned to the economy.  When money is “printed”, the money supply increases, since money enters the economy from outside, that is, money is created out of nothing and put into the economy.  The Federal Reserve has other ways of influencing the money supply, like open market operations and quantitative easing, as well as changing the reserve rate.  However, permanent growth necessitates injecting money into the monetary system from outside of the system, either from our government or from foreigners.

But, the debt, which is mostly money owed to the general public and money owed as part of intra-governmental bookkeeping, is much more than the money supply.

Money: 2

To continue from Money:1, how does the money supply expand?   Before getting to what I gleaned out of my introductory economics text (I took my introductory economics course in 1980 at Harvard University’s Extension.), I will write a little about goods and money.

I can think of no reason against a conclusion that all money spent for all goods and services ultimately ends up as someone’s income.  For example, think about buying a car.  You are not buying a car, you are buying the labor and services of the persons who mined the ore to make the metal in the car, who created the machine to mold the plastic parts, who stood on the salesroom floor and sold you the car, and so forth.  No iron ore receives any payment, no petroleum, from which plastic is made, gets any income.

Okay, how does the money supply expand?  Let’s create a simple economy.  There are banks that hold all of the money.  When people buy something, they use their debit cards.  Say that when something is bought, money is instantly transfered from one bank to another.  No matter how many transactions there are, the overall stock of money does not change.  What comes out of one account goes into another.  This is a system in which money is conserved.

Now let us say the business of the bank is to lend out the money that has been deposited in the bank.  We will have the government mandate that the banks keep a certain percentage of the banks’ deposits in the banks.  The government mandate helps protect banks from runs on the bank by persons worried the bank will fail and the persons will lose their money.  (Before the Federal Reserve System came into existence in 1914, banks issued our paper money and there definitely were runs on banks and bank failures, where people lost their savings.)

Say there are three banks in the system.  Say the first two banks each have $10,000 deposited (this is an ant economy) and that the reserve rate is 20%, so each bank has $8,000 in loans and $2,000 in reserves.  Say that the third bank that only receives loans, so all of the third bank’s assets are reserves.  We will assume there is no interest payed.  Clearly, the first and second banks both have lent $8,000 to the third bank.  The total of the assets of the three banks together is $36,000.  Say that the second bank moves $1,000 to the first bank (say, because a depositor in the second bank owes money to a depositor in the first bank).  Then, the assets of the first bank are $11,000 and the assets of the second bank are $9,000.  The first bank will increase the amount loaned to get the bank to the correct reserve rate.  The second bank will have called in $1000 worth of loans from the third bank to pay the first bank, but will put some money back in the third bank, since the second bank then has more reserves than the bank needs.

Twenty percent of $11,000 is $2,200 dollars, which is $200 more than the first bank has in reserves.  The first bank will lend out 80% of $1,000, or $1,000 – $200 = $800 to the third bank and put $200 in the bank’s reserves.  Twenty percent of $9,000 is $1,800, which is $200 less than the second bank has in reserves.  The second bank will take $200 out of reserves and loan the money to the third bank.  In the end, the first bank has $2,200 in reserves and $8,800 loaned to the third bank or $11,000 in assets.  The second bank has $1,800 in reserves and $7,200 loaned to the third bank for $9,000 in assets.  The third bank still has $16,000 of loaned assets.  The over all amount in the system, $36,000 –  counting both the loaned money in the third bank and the credit for the loans in the first and second banks, does not change.

Now, let’s say that the government gives the first bank $1,000.  Say that the reserve rate is still equal to 20 percent.  The first bank now has $12,000 in assets.  Twenty percent of $12,000 is $2,400, which is what the bank needs for reserves.  The bank already has $2,200 in reserves, so the bank puts $200 of the $1000 the bank received into reserves and loans the rest of the money ($800) to the third bank.  The third bank then has $16,800 in assets.  The assets of the second bank remain the same, at $9,000.  The sum of the assets of the three banks is now $37,800, $1,800 greater than before the government gave the first bank $1,000.  The extra $800 comes from the loan to the third bank being on both the first bank and the third banks’ books.

Say we have a bank that receives from outside the banking system $1,000.  Say the banking system is made up of many banks and that there is no interest charged for loans and all of the money above the reserve rate is loaned out.  Say the reserve rate is 20 percent.  Then the bank will loan out $800.  The bank that receives the loan will loan out 0.8 time $800, or $640.  The lending continues until there in no more to lend ($512, $410, $328, $262, $210, $168, $134, $107, $86, $69,  $55, $44, $35, $28, $23, $18, $14, $12, $9, $7, $6, $5, $4, $3, $2, $2, $2, $1, $1, $1, $1, $1, which, including the $640, $800, and original $1,000, sums to $5,000.)  Five thousand dollars is 1 divided by .2 times $1,000.  So, the original deposit from outside the system created $1000/0.2 = $5000 worth of assets in the system.  If all money from outside the system is lent out to the reserve rate, the assets in the system will increase by the original money divided by the reserve rate, where the reserve rate is measured in proportion (20% being a rate of 0.2).

I do not know if there are other ways to expand the money supply.  My introductory text just gave the method above.  So the money supply expands by banks lending out money that stays on the banks’ books as assets.  If the method above is the only way of expanding the money supply, given a given amount coming from outside the system, the money supply can only expand so far, based on the reserve rate.

Money: 1

Many years ago, when I was young, I remember telling a mother, whose children I had played with, that I would explain money when I grew up.  In the mean time, I have taken several courses in economics.  A year or two ago, a columnist for a local paper asked if anyone could explain money to him.  The request brought to mind the early ambition of mine.  Even with the courses I had taken, I did not understand money – how money gets into the economy and how the money supply expands.

Some time around the time of the money request, the thought popped into my head questioning me about what I knew about the deficit.  I thought maybe the deficit was the money supply.  Shortly after that, the Republicans began to make a big issue of the deficit.

My original college education was in hard science, so I am used to thinking in terms of conservation laws.  For example, in a closed system, no matter what happens, the energy of the system remains the same.  So I questioned, do conservation laws apply to money?  Here are what were some of my thoughts.

If money is conserved, then the money supply would be totally supplied by the government and the deficit would be the size of the money supply.  The government would have had to have given all of the money supply away for free.  Has the government given all of our money supply to us for free?  If money is conserved, how could the debt be payed back without removing all of the money from the money supply plus some (the interest)?  How is money created in the economy if the money does not come from the government?  Only the government can supply money.  Why does the government borrow any money if the government can just give money away for free?  Why does the government tax?  The money supply has to expand as the population size increases, to accommodate a larger economy.  How is the expansion done?  Is money given away for free?

I have read that the Australians paid off the Australian national debt, so, obviously, there is more to the question than that the national debt is the money supply.  In my next blog, I will write about what I discovered reading my college introductory economics book.