I always suffer self-doubt when I teach the Money part of Intro Economics. Perhaps I'm over-thinking it, and it would be better for my students if I told myself to shut up, and just give them some simple clear story. But how to get it simple and clear, yet not horribly wrong or incomplete?
I'm writing these notes mostly for myself. (To try to organise my thoughts, because I don't actually use notes when I teach.) But I might as well do it in public. Read at your own risk. Because I haven't got it right yet.
When my kids were little they asked me what Economics was. I thought for a bit, then lied to them. "It's all about money" I said. That simple answer works very well at one level. And works very badly at another level.
It is now nearly half way through the second term of Intro Economics. We have spent a lot of time talking about the demand and supply of different goods. When we demand something we nearly always buy it with money. And when we supply something we nearly always sell it for money. So money has been in the background implicitly all along, as the other side of almost every exchange. But we haven't actually talked about the supply and demand for money. Which is very strange, when you think about it.
What is money?
Different peoples at different times have used very different things as money. Shells, metals, cigarettes, bits of paper, etc.. If people use something as money, it is money, for them. That's a "functional definition" of money.
People use money as:
A medium of exchange. They sell everything else for money, and then use that money to buy everything else.
A unit of account. They talk about prices in terms of money.
Nearly always, those two defining functions go together. It's easy to understand why. It's more convenient. If the supermarket wants you to buy food with Canadian Dollars, they will put Canadian Dollars on the price tags. If they put US Dollars on the price tags, you would need to look up the exchange rate and do some extra arithmetic to figure out how many Canadian Dollars you need to pay.
Textbooks normally add a third function: people use money as a store of wealth. It's true that a medium of exchange is always used as a store of wealth to some extent, because there's always a time-lag between getting money and spending it again. But lots of other things are used as a store of wealth too, and many are better than money at this job, so this function doesn't help us define which good is used as money. Being a medium of exchange and unit of account is what makes money different from all other goods.
Why monetary exchange?
Suppose you were visiting some unknown country, and you wanted to figure out whether the people there used a medium of exchange, and what particular good they used as a medium of exchange.
You could make a table, with a list of all the different goods for the columns, and the same list of all the different goods for the rows. So it's a square table, with n columns and n rows, if there are n different goods. If you observe someone exchanging apples for bananas, you put a tick in row A column B. (Obviously you can ignore the main diagonal, because people don't exchange apples for apples, unless they are different varieties of apples, and you can ignore everything North-East of the main diagonal, because it's just a duplicate.)
In a pure barter economy, where any good can be exchanged against every other good, you would have ticks everywhere. With n different goods, there are n(n-1)/2 functioning markets.
In a pure monetary exchange economy, where apples (say) were the medium of exchange, there would be ticks everywhere in the A column or row, and no ticks anywhere else. With n different goods, there are n-1 markets, where in each market apples are exchanged for one of the other goods.
A monetary exchange economy has a lot fewer markets operating than a pure barter economy, for n > 2.
Most economies are a lot closer to the pure monetary exchange economy than they are to the pure barter economy. That's a puzzle. Why? If you were a banana grower who wanted to swap bananas for carrots, why wouldn't you just do that? Why would you first sell your bananas for money, and then sell that money to buy carrots? Why use two exchanges when one exchange would do the same job?
The reason is that you would need to find someone else who wanted to swap carrots for bananas, and that might be difficult. You can even imagine circumstances where 2 person barter is impossible. Like if the apple growers wanted to eat bananas, and the banana growers wanted to eat carrots, and the carrot growers wanted to eat dates,...and the Z growers wanted to eat apples. You would need to get all 26 people in the same place at the same time to do a 26-way swap.
Or you could use money.
A pure barter economy is a very unstable arrangement, so it is not surprising we rarely observe barter, just like we rarely observe eggs standing on end. Suppose one good, say apples, is just slightly more liquid (easier to buy and sell) than any of the others. People would tend to use apples as a medium of exchange, if they couldn't do a direct swap. And that would make apples even more liquid, because more people would want to buy and sell apples. So it snowballs, until apples get very easy to buy and sell, and everything else is bought and sold for apples.
Which good gets used as money?
Almost any good could be used as money, but some would be easier to use than others. So those goods are more likely to get the snowball rolling, and be used as money. Used cars would not be easy to use as money. Each used car is different, and it takes a skilled mechanic an hour to figure out the value of any particular used car. So used cars aren't very liquid. Portability, storeability, divisibility, etc., could also be a problem with used cars.
Historically, shells have been one of the most common forms of money. And gold and silver. And IOUs. Nowadays most money is IOUs.
Suppose I wrote "IOU 1 apple, signed N. Rowe" on a bit of paper. And suppose everyone recognised my signature, and trusted my promise. My IOU is a valuable, marketable, asset. It might work very well as money. It would probably work better than apples as money, because it's more convenient than real apples. If apples were already used as money, my IOU, as a promise to pay apples, would be even more likely to be used as money.
Intrinsically worthless money.
Apples, pretty shells, and metals, could all be valuable even if they weren't used as money. But how can intrinsically worthless bits of paper be used as money?
The difference isn't as big as it first appears. If there is a demand for apples, shells, and metals, to be used as money, that increases the total demand for those goods, and makes them more valuable than they otherwise would be. Intrinsically worthless bits of paper are just a more extreme version of the same thing. But it's still a puzzle how it all got started in the first place. If the supply is limited, and there's a demand for the bits of paper to use as money, they will have a positive market value, and so can be used as money. But if they didn't have value in the market, they couldn't be used as money, so nobody would demand them, so they wouldn't have value in the market. How come we are in one equilibrium, and not the other?
Maybe the bits of paper started out as IOUs, promising to pay real goods that did have a market value. And people started using those IOUs as money. That's "convertible money", because the bits of paper can be converted into real goods by the person who signed the IOU. And then convertibility is temporarily suspended, but the IOUs are still valuable, because people expect convertibility to be restored soon. So they continue to be used as money and people continue to demand them. And then the expectation of restoration of convertibility fades away, but people keep on using them as money, and demanding them, because everyone else does.
Words don't really mean anything either. But people use "cat" to mean cat, because everybody else does too. Sometimes which equilibrium we are in depends on history.
The supply of money.
If we had a movie camera we would watch money circulate from one person to another as people bought and sold goods. If we only have a still camera we can take a snapshot which shows who owns the total stock of money at any point in time. What determines that total stock of money? What causes it to increase or decrease?
If we used apples as money I would now start talking about orchards. If we used shells as money I would now start talking about people collecting shells at the seaside. But we use IOUs as money, and most of those IOUs that are used as money are signed by things that call themselves "banks". So I'm going to talk about banks.
Some IOUs are used as money. Other IOUs are not used as money. A "bank" is something that has (mostly) monetary IOUs as liabilities, and (mostly) non-monetary liabilities as assets, on its balance sheet.
Canadian dollar banknotes are IOUs of the Bank of Canada. But the Bank of Canada isn't really a bank, because its IOUs aren't really IOUs. You can't go to the Bank of Canada and demand it convert your $20 note into gold, or US Dollars, or anything.
But the Bank of Canada does try to keep CPI inflation close to 2% per year. So you might say that Bank of Canada IOUs are indirectly convertible into CPI baskets of goods, at a sort of fixed price. Because if the Bank of Canada printed too many it would be forced to buy them back to prevent CPI inflation rising above 2% (the value of banknotes falling faster than 2% per year). But the Bank of Canada might change its mind about targeting 2% inflation.
Suppose the Bank of Canada wanted to increase the supply of Bank of Canada money. How would it do it?
There are only two ways: 1. print money and give it away; 2. print money and buy something with it. Either way you increase the stock of Bank of Canada money in circulation, because someone gets the money the Bank of Canada gave away or used to buy something.
The Bank of Canada never gives money away, though it could in principle. (But it can and does buy IOUs from the Canadian government, and it gives its profits to the government, and the government can and does give money away, and since the Bank of Canada is owned by the government, it amounts to the same thing.)
The Bank of Canada uses the second method: it increases the supply of money by buying things.
It makes no difference what the Bank of Canada buys. If it prints money and uses it to buy a bicycle the seller of the bicycle now holds more Bank of Canada money. It's the same if it buys cars and computers. But the Bank of Canada doesn't buy many bikes, cars, or computers. It does buy a lot of IOUs. Mostly government IOUs.
And if the Bank of Canada wants to reduce the supply of its money in circulation it sells something. If the Bank of Canada sells a bicycle, and gets a $20 banknote in return, the supply of its money in circulation falls by $20. But the Bank of Canada mostly sells IOUs, rather than bikes, cars, or computers.Interest rates (a digression).
When I lend you money you give me an IOU in return. And when next year you repay the loan I give you back your IOU. We could redescribe the same thing as me buying your IOU, and then next year you buying it back.
When a bank lends me money to buy a car, it is buying my IOU. When I repay the loan it sells me my IOU back.
Suppose a bank wanted to increase the supply of its money. It needs to buy something to do this, and it normally buys more IOUs. If it lowered the rate of interest, that would persuade people to want to sell it more IOUs (borrow more), so it would be able to buy more IOUs, and increase the supply of its money. If it raised the rate of interest, that would persuade people to buy back more IOUs (pay back loans), so it would be able to sell more IOUs, and reduce the supply of money.
Banks' lowering interest rates is just a way for banks to buy more IOUs and so increase the supply of money. Banks' raising interest rates is just a way for banks to sell more IOUs and so reduce the supply of money.
That is true whther we are talking about a central bank like the Bank of Canada, or a commercial bank like the Bank of Montreal.
So when you read that "the Bank of Canada has reduced its target for the trend-setting overnight rate of interest", that's what's happening.
Central Banks vs commercial banks.
I use Bank of Canada IOUs as money. I also use Bank of Montreal IOUs as money. Bank of Canada monetary IOUs are printed on bits of paper. Bank of Montreal monetary IOUs are not printed on bits of paper. Electrons in a computer somewhere keep a record of how much the Bank of Montreal owes me in the balance on my chequing account. But it's just the same as if it were recorded on paper.
Sometimes it's more convenient to pay for something by taking a $20 Bank of Canada note out of my pocket and putting it in your pocket. Sometimes it's more convenient to write a cheque or use my debit card to instruct the Bank of Montreal to reduce its IOUs in my account by $20 and increase yours by $20.
The Bank of Montreal can increase the supply of its money in exactly the same way as the Bank of Canada. If the Bank of Montreal "prints" a $20 Bank of Montreal monetary IOU, and buys something with it, the supply of Bank of Montreal money increases. The only difference is that Bank of Canada IOUs are written in ink on paper, and Bank of Montreal IOUs are written in electrons on a computer.
Ordinary people and firms bank at commercial banks, like the Bank of Montreal, and TD Bank. We can't open an account at the Bank of Canada. But we do use Bank of Canada banknotes as money. Which is the same thing, just with paper instead of electrons.
The commercial banks do have accounts at the Bank of Canada. If I buy something from you, and pay by a $100 cheque, and I have an account at the Bank of Montreal, and you have an account at TD, this is what happens. Your account at TD goes up by $100, the TD's account at the Bank of Canada goes up by $100, my account goes down by $100, and Bank of Montreal's account at the Bank of Canada goes down by $100. Or BMO might borrow $100 from TD so that both their accounts at the Bank of Canada go back to where they were.
The Bank of Canada is the central bank. Central banks are the bankers' bank.
But how is it that the Bank of Canada is the one that controls Canadian monetary policy? If both the Bank of Canada and the Bank of Montreal issue IOUs that people use as money, shouldn't we say that both partially control the supply of money in Canada?
There's one big difference.
Bank of Canada monetary IOUs aren't really IOUs. They aren't a promise to pay anything. The Bank of Canada might choose to target 2% CPI inflation, in which case they are indirectly convertible into the CPI basket of goods. But the Bank of Canada might change its mind.
Bank of Montreal monetary IOUs really are IOUs. They are promises to pay Bank of Canada IOUs on demand, at a fixed exchange rate. It's the Bank of Montreal's job to ensure that one Bank of Montreal Dollar = one Bank of Canada Dollar. It's not symmetric. The Bank of Canada can make its dollar worth whatever it wants, and the Bank of Montreal has to follow along and make its dollar worth the same amount.
That's what gives the Bank of Canada the power to control the total supply of money in Canada.
Central banks and commercial banks together.
Suppose the Bank of Canada wants to increase the supply of money in Canada. It buys something, and pays for it with $100 in Bank of Canada monetary IOUs. The stock of money has increased by $100.
But it doesn't stop there. If that $100 lands in my pocket, and if I decide I would rather have $100 in my Bank of Montreal chequing account, I give it to the Bank of Montreal in exchange for an electronic Bank of Montreal IOU.
If the Bank of Montreal had to keep 100% reserves of Bank of Canada monetary IOUs against Bank of Montreal monetary IOUs, it would stop there. The total money supply has only increased by $100. (We don't count the $100 in the Bank of Montreal's reserves plus the $100 in my chequing account, because that would be double-counting.)
But it doesn't stop there. Because the Bank of Montreal isn't required to keep 100% reserves, and isn't required by law to keep any reserves nowadays, so probably doesn't want to keep that Bank of Canada IOU either. It will want to buy something.
If the Bank of Montreal buys an IOU (makes a loan) from one of its clients, in exchange for a $100 Bank of Montreal monetary IOU, that increases the total supply of money by another $100. If that client spent the loan to buy a bike from someone who banks at TD, that $100 Bank of Canada IOU gets transferred from BMO to TD.
But it doesn't stop there either. Because TD probably doesn't want to keep that $100 Bank of Canada IOU either. So TD buys something with a $100 TD monetary IOU, which increases the total supply of money by another $100.
And so on.
What stops this cumulative expansion of the money supply?
There are three things that could bring this cumulative expansion of the money supply to an end.
1. Commercial banks choose (whether or not they are required by law) to keep some fraction of Bank of Canada money in reserve against their own money.
2. People choose to keep some ratio of Bank of Canada money to commercial bank money.
3. The Bank of Canada chooses to stop it, because it thinks that inflation will rise above 2% if it doesn't stop it. It stops the cumulative process by selling something.
The demand for money.
At this point I would normally start talking about people holding inventories of money, and how the stock of money in inventory rises and falls whenever they sell or buy something. And I would define the "demand for money" as the average desired stock of money in inventory. And I would talk about the demand for money depending on: the price level; real income; and the spread between the rate of interest on money and the rate of interest on other assets.
Then I would put the demand and supply of money together.
But I'm going to stop here. Because this post is already too long.
And because I am beginning to think that "the demand for money" is a misleading concept that should be abolished.
Because once you start talking about "the demand for money", in the same way you talk about "the demand for apples", you end up with (orthodox) nonsense like the idea that the stock of money is determined by the quantity demanded at the rate of interest set by the central bank. Which makes sense for a good like apples, which is traded in only one market, and which people either buy or sell. But doesn't make sense for a good like money, which is a medium of exchange traded in n-1 markets, that everyone both buys and sells. The quantity of money will be determined by the demand for loans at that rate of interest, but the demand for money is not the same as the demand for loans. But that's a topic for another post.
This is far too complex and too abstract.
How is a first year student supposed to understand all that?