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Day two - making money

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‘Money it turned out was exactly like sex. You thought of nothing else if you didn't have it and thought of other things if you did.’


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YESTERDAY we raced through free-market economics and saw how capitalism was expected to grow into a strong and vigorous bloom in the heady atmosphere of free competition.

Less of the flowery language please. Let’s get to the point. I’m sure Smith was very important, but what I want to know about is monetarism.

Why do we have to look at that?

Well, I am the paying customer - and anyway that’s what economists talk about nowadays.

Only a few of them fortunately. True there are people who think that money is the key to everything. But others believe it is just a convenient lubricant. It doesn’t mean that much in itself, it responds to other basic forces.

But if you insist, we will talk a bit about money. A good place to start might be that jungle village, the one that we said goodbye to yesterday. The villagers there have a cashless society: not because they have abolished money, but because they don’t need it. They don’t have to buy or sell anything.

Now let’s complicate their lives a bit. One villager is a skilled potter and another, who is a farmer, wants to offer a sack of corn in exchange for a smart new set of bowls. This is no problem if he lives close by: he can just carry the corn in, and the bowls out. But if the farmer lives on the other side of a river the farmer might prefer to give something lighter, like an emerald. The potter could then swap the emerald for corn with someone else.

The emerald in this case is serving as ‘money’ - a standard means of exchange. Anything can perform this role providing it is acceptable to both buyers and sellers. This usually means it will be something in limited supply and of reliable quality. Shells have been widely used at times and tobacco became a currency during the early days of the American colonies. For many centuries, however, the most acceptable form of money has been gold.

On the whole I think I prefer gold myself.

Perhaps. But even gold has its limitations. You have to make sure that you have coins all the right size. Another solution, which governments later adopted, was to take the gold from their citizens and issue them with corresponding notes and coins which were ‘as good as gold’. These were lighter and more convenient and could just as easily be used for payment, providing everybody believed the central bank was keeping the real thing stored in its vaults.

I’d still prefer gold

Purely a matter of taste. But you might find the checkout girl at Safeways a bit unwilling to accept it as payment for a packet of Daz. The important thing about money is that everyone should accept it without question. That’s the way it oils the wheels of commerce.

It was gradually realised, however, that government-issued notes had become so acceptable that there was no need for them to correspond any more to piles of gold gathering dust in the vaults. It was possible, it proved, to print more notes than there was gold and people still accepted the money.

It’s important however only to print a limited amount. With a restricted supply, notes become just like shells or tobacco or gold. If everybody accepts them, coloured bits of paper will do just as well as a form of exchange.

Is this the famous ‘money supply’ then - all these bits of paper?

They are certainly a part of the money supply. But there is a lot more money around than the notes and coins that have come out of the mint. There is a lot of additional money made’ by the banks.

Consider what would happen if you were to deposit a thousand dollars in the Bank of Montreal. They might pay you interest and give you a cheque-book which you could use to get at your money.

But banks also lend money out as well. That’s how they make their profits: by borrowing at a low rate of interest and lending out at a higher one. So most of your deposit could be lent out again to the next person who wanders into the bank call him Mr X.

Something remarkable happens here - money is created. You have your cheque-book to draw upon your bank deposit and Mr X has the dollar bills.

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But that’s my money!

It was certainly your cash that went into the hank. But now you both get spending power at the same time. This is only possible because a calculated risk has been taken. The bank is gambling that Mr X will return the money before you write any cheques on it. This need not he a reckless gamble. It would be a small and foolish bank - and certainly not the Bank of Montreal - if it had only one lender and one borrower. When there are very many of both a bank can work out statistically how much of the money deposited with it is likely to be withdrawn by the lenders at any one time.

The money supply, therefore, includes many different kinds of bank deposits - in addition to the original notes. Both the notes and the deposits give spending power. You might have lingering doubts that Mr X has spending power at the same time as you. But consider what happens if you and Mr X turn up in the same supermarket. You can both spend at the same time - you with your cheque-book and he with the cash. Both of you can walk out with packets of Daz on the basis of your bank deposit.

Trade has a way of creating the money it needs to lubricate the system. When the Irish banks went on strike some years ago, for example, business went on much as before on the basis of personal credit and circulating cheques as well as cash. People will exchange goods with each other, bartering if necessary. even when they have no money in their pockets. Having money, either in the form of cash or credit, just makes it easier.

Good grief. If money can appear and disappear like this it’s total anarchy

It only seems like this if you focus on the money rather than the exchange of goods. At any rate, you can now appreciate the difficulties governments have when it comes to measuring the money supply. Not only do they have to count up all the notes and coins but they have to add in the various forms of bank deposits. They might have to consider, for example, that a current account was more ‘money-like’ than a deposit account where you need to give three months notice of withdrawal. All those ways of measuring money supply that you might have heard about: M1, M2, M3 are longer and longer lists of what counts as money. M3, for example, includes as money deposits that can’t be withdrawn for two years, while M2 does not.

As Professor J K Galbraith has put it: ‘The debate over what should be counted as money is between people who do not know, and people who do not know that they do not know’. So if you find all this confusing you are in very good company.

That’s a relief

Good, then while you’re relaxed I’ll throw in another complication which concerns how many times a given amount of money is used. Think of what it takes to sell a monthly magazine like the New Internationalist. The print workers print it, hand it over to their boss who sells it to the publisher, who sells it to the bookstores who sells it to the reader. There are four transactions here. Now let’s suppose that during the month of April the publisher does not pay the printer (this, I should emphasis, is an entirely Fictional case). The publisher claims that the bookstores were slow in paying him so he didn’t get his hands on cash till the end of April. So he gives the printer an IOU.

This is no comfort to the printer who has to pay his workforce in cash. So he goes to the bank to get a loan. Of the four transactions in the month therefore, two have used the customer’s cash, one has used an IOU and one has used credit from a bank. The two credit transactions cause an increase in the money supply in the way we saw earlier.

But suppose everybody paid up on time and the readers’ money got through to the printer’s workforce within April. The money would have moved so fast that there would have been no need for credit. So as the velocity of circulation goes up the money supply needed goes down.

If the printer could have afforded it he could instead have kept reserves of cash to be drawn on in the event of slow payment. In this case speeding up payment would remove the need for such reserves so again less money would be needed.

My brain is whirring round in circles with all this money

Don’t worry if it doesn’t sink in first time round. All you necd to take from this is that money is - as you might expect a lubricant to be - a very slippery commodity’. So anyone - like President Reagan - who claims to be able to understand it and control it should be regarded with the utmost suspicion.

Cash in transit: a bank in Hong Kong.
Photo: Camera Press

At least tell me how he claims to control it

There are a number of way’s to try’ and adjust the money’ supply’. To increase it you could print more notes and put them into circulation by paying government employees with them. To reduce the supply you tax the whole population more highly and then remove from circulation the money you collect instead of spending it.

But since much of the money is ‘made’ by’ the banks the quickest way for a government to affect the money supply is to control bank lending. If you force them to raise their interest rates, for example, this would discourage borrowing and stop banks making money’ by lending out cash deposited with them.

This may well have some effect. But think what would happen in the case of our printer. If he were worried about the high interest payments he might threaten to stop doing business with the publisher unless he got paid on time, and the publisher might similarly threaten the bookstore. If these threats made everyone pay up smartish then the money supply would have been reduced but the velocity would have correspondingly increased.

Now, at last, having established where money comes from, and how fast it can move, we are in a position to look at prices. The next bit, I warn you, is tricky to grasp, but well worth pondering.

I’ll take it slowly

Good. The Total spending in the whole economy is what we have to look at now. Let’s work out what the money spent in one month will be. There are two ways of approaching this.

One is to look at the number of times the money is used each month. If you buy something the shop-keeper will put the money in the bank. This bank can then hand this out to the next customer who makes a withdrawal. The number of times a given banknote is used in a given period is referred to as its ‘velocity’. So the total spending each month must be the total money supply multiplied by its velocity. Agreed?

I suppose so

An alternative way of calculating spending is to start with the average price level of all the goods and services exchanged during the month. If you multiply this price by’ the total number of transactions that took place you should also get the total spending. Yes?

I’ll think about it. You keep going

Right. What you have now is two good ways of expressing the same thing. So they must be equal.

Money’ x Velocity’ = Prices x Transactions.

This is worth looking at again to really see what the implications are. Assume, for example, that the magazine sales that we looked at earlier are included in the total month’s transactions for the whole economy’. When payment was slow the velocity was low, so the money supply’ was increased to compensate for this. But after a bit of tough talking from the printer the velocity went up and the money supply came down automatically. The number of transactions was the same in either case and nobody changed their prices.

Now look at the equation again. If, for example, the total number of transactions in the whole economy remained the same but the money supply went up would this mean that prices would rise.

Only if the velocity remained the same, I suppose

Quite right, you’re really’ getting the hang of this. So if someone says to you that prices are rising because too much money is being circulated you might reasonably be sceptical.

Mm ... I think I’ve got that. Is this where we start to talk about monetarism?

I don’t think so. It’s been a long day’. Some other time.

Money is a convenient invention which helps lubricate the exchange of goods.

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But there is more money than that printed at the mint. Banks also ‘make’ money by making loans.

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Such money can appear and disappear as needed, depending on what trade requires.

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So prices will depend both on the total money supply and the speed at which it moves.

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The velocity of circulation of money can also move up or down.

New Internationalist issue 134 magazine cover This article is from the April 1984 issue of New Internationalist.
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