THE MONETARY SYSTEM
GLOSSARY
appreciation and depreciation A currency appreciates when it increases in value in comparison with other currencies. A currency depreciates when it decreases in value.
blockchain technology The technology that enables cryptocurrencies to operate. It involves global networks of computers constantly updating the transactions in the currency’s digital ledger.
Bretton Woods System A system of monetary and exchange rate management in which participating countries agreed to mutually fix their exchange rates and to intervene, when necessary, to maintain those rates. The original agreement was made at Bretton Woods, New Hampshire, in July 1944. The system failed in the early 1970s after the United States and other countries moved to floating exchange rates.
cryptocurrency A virtual or digital currency usually with no central control. Cryptography is used to make the transactions secure.
equity The net worth of an individual or company, equal to their assets minus any debts. Also refers to owning stock in a company.
Global Financial Crisis 2008 International banking crisis caused by the crash in the US mortgage market that began in 2007, high borrowing by banks and other financial institutions, and overreliance on short-term lending markets. The crisis worsened after the collapse of investment bank Lehman Brothers in September 2008. This led to a global economic downturn and the failure or bailout of many financial institutions.
gold standard Monetary system in which the value of a country’s currency is directly linked to the price of gold. The gold standard was abandoned by most countries in the twentieth century in favour of fiat currencies.
government bond A bond issued by a national government, usually in the country’s currency, with the aim of raising funds for the government. Interest is paid periodically and the face value is paid on the maturity date.
Great Depression A worldwide economic depression that began with the Wall Street stock market crash in October 1929 and lasted through the 1930s. It was the worst depression of the twentieth century and had a devastating effect on many countries.
hedge fund An investment fund formed by groups of individuals or institutions who pool their capital to invest in stocks, bonds, derivatives, currencies, and other assets. Managers typically receive a regular management fee and a share of profits.
hyperinflation A very high and accelerating inflation that occurs when a rapid increase in the amount of money is not matched by growth in goods and services. This leads to escalating prices and the devaluation of savings and investments.
inflation An increase in prices representing a rise in the cost of living. Inflation is measured by tracking a ‘basket’ of goods and services.
interest rate On a loan, the interest rate is the cost of borrowing money, expressed as a percentage of the sum borrowed. For savings, the interest rate is the money earned from savings or bonds.
miner (of cryptocurrency) Individual who uses computer software to solve maths problems in exchange for cryptocurrency. Miners approve peer-to-peer transactions and add them to the public ledger, thus helping to keep the network secure.
mint An official facility that produces coins.
quantity theory of money Economic theory that relates the money supply to economic activity, prices and the velocity at which money gets spent. If velocity stays constant, prices rise whenever the money supply grows faster than economic activity.
recession A period of several quarters in which economic activity declines. The usual indicators of a recession include rising unemployment and declining production.
shadow banking Lending and other traditional bank activities when performed through non-bank institutions, often with much less regulatory oversight.
MONEY
the 30-second statement
Why do people sell valuable assets – houses, cars, their time – in return for pieces of paper and electronic ledger entries? Because money is a scarce medium of exchange and thus a store of value. Before money existed, people and businesses would exchange goods and services. Besides being cumbersome – a farmer had to carry bushels of wheat to the barber, who in turn had to exchange it for bread with the baker – it was also inefficient. Every transaction involved a separate discussion of the rate of exchange (i.e. how much wheat does a loaf of bread or a haircut cost?). Money simplified these transactions. A farmer could sell his wheat to a baker and use the money to buy a haircut. Goods and services become denominated in monetary terms – a euro buys a certain amount of wheat, bread or haircuts – which means money has become the unit of account. Even though it is just a piece of paper, the currency itself has become a store of value – it can be saved to buy goods and services in the future. Money has taken many forms through history: large carved stones, shells, debts (such as the promise of a farmer to deliver wheat), precious metals, cigarettes, paper currency issued by a local bank or a government and, most recently, decentralized digital currencies such as Bitcoin.
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Money acts as a medium of exchange, unit of account and store of value. Money makes it easy to buy and sell, track financial commitments and save for the future.
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Money’s value is defined by its scarcity. Rare precious metals were an early form of money. To maintain scarcity, paper currency was originally backed by precious metals. Most currencies today are fiat currencies, backed only by the credibility of central banks. Their value depends on the central bank limiting the money supply and controlling inflation. During a hyperinflation, when central banks print money with abandon, paper currency loses its scarcity and it no longer acts as a store of value.
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CRYPTOCURRENCIES & BLOCKCHAINS
3-SECOND BIOGRAPHIES
KING ALYATTES OF LYDIA (MODERN-DAY TURKEY)
fl. c. 610–560 BCE
Credited with minting the first official currency out of gold or silver with standardized weights and values
RICHARD A. RADFORD
1919–2006
British-born American economist who wrote about the monetary economy he observed as a prisoner of war, with cigarettes as the currency
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Gerald D. Cohen
Prior to money, people bartered goods and services.
FIAT VS. COMMODITY MONEY
the 30-second statement
What would happen if you took a pound sterling bank note to the Bank of England and asked for a pound of silver? Today they would look at you quizzically and maybe offer to exchange it for a one-pound coin made up of a few pence worth of copper, nickel and zinc. A little over 100 years ago, the clerk would have offered you some gold for the bank note. And 1,000 years ago, you would be carrying 240 silver ‘sterlings’ that weighed a pound. Today, the pound – as well as every other national currency in the world – is a ‘fiat currency’. That means it isn’t backed by a precious metal or any other tangible thing. Rather, a fiat currency’s domestic value is based on the faith that the country’s central bank will limit the money supply and control inflation. Most countries adopted fiat currencies between World War I and the early 1970s. Before that many had linked their currencies to commodities such as gold. This ‘gold standard’ limited the money supply to the amount of gold a country had (though the exchange rate and ability to convert between the currency and gold could vary). For most of recorded history, the currencies themselves were made up of commodities such as precious metals or shells.
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Commodity currencies are backed by commodities such as gold or silver, while fiat currencies are backed by the credibility of a central bank.
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While a gold standard limits the money supply, it creates a rigidity that is harmful to modern economies. A commodity currency cannot respond to greater money demand coming from innovations that drive economic activity. It won’t even allow the money supply to fluctuate around holiday shopping and vacation periods. Instead interest rates will rise, choking off growth. In addition, the money supply is subject to swings based on new gold finds.
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3-SECOND BIOGRAPHIES
KING OFFA OF MERCIA
fl. 757–796
Anglo-Saxon king who introduced the silver sterling, which evolved into pound sterling, the world’s oldest currency still in use
ANNA J. SCHWARTZ
1915–2012
American monetary scholar, economic historian and critic of the Federal Reserve, who argued against US return to the gold standard
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Gerald D. Cohen
Money used to be backed by gold, now it is backed by the credibility of a central bank.
COMMUNITY CURRENCIES
the 30-second statement
Almost all modern countries issue currency through a central government that controls the supply of money. Countries such as Ecuador and El Salvador have even outsourced their currency-making policy by making the US dollar their official currency. Yet some communities are making currency more rather than less local in its origins. Cities such as Exeter and Bristol in the UK have created their own community currencies – the Bristol Pound, for example – that may be exchanged with the British pound at a fixed 1:1 rate. Community currencies can only be used at local businesses or to pay local taxes, though they can often be converted back to the national currency at a local currency exchange. Community currencies exist or have existed in other countries as well, including in the United States in Ithaca, New York, and in African countries such as Kenya and South Africa. The details vary, but a common motivation is the desire to ‘keep money in the community’ by limiting the range of places that a currency can be used. Many community currencies have been short-lived, typically foundering on issues of inconvenience or lack of community interest, and their use has been quite limited so far. But certain communities continue to experiment with their own currencies, including some electronic versions.
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Community currencies are money used only in local areas, with the goal of keeping spending and income within a community.
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Community currencies share common features with other non-fiat money. In each case, the currency serves as both a store of value and as a unit of account. A distinctive feature of community currencies is the availability of a very close substitute (the national currency) that is more widely accepted and hence more convenient. The quite limited spread of community currencies suggests that, in most locales, community residents do not get enough benefit from the community currency to justify its inconvenience.
RELATED TEXTS
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CRYPTOCURRENCIES & BLOCKCHAINS
3-SECOND BIOGRAPHIES
W.E.B. DU BOIS
1868–1963
American civil rights leader whose picture is on the 5 BerkShare note, part of the BerkShares currency used in western Massachusetts
CIARAN MUNDY
c. 1971–
British administrator who helped found the Bristol Pound
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William Carrington
Community currencies aim to keep money in the neighbourhood.
INFLATION & DEFLATION
the 30-second statement
Inflation occurs when prices rise, on average, throughout the economy. As prices rise, money loses its purchasing power. Analysts measure inflation by looking at the prices of a broad basket of goods and services. A consumer price index, for example, would track the price of a basket that represents household spending patterns. The index includes services such as housing costs, health care, broadband service and cinema tickets, as well as goods such as cars, furniture, mobile phones, food and petrol. Inflation is usually reported as the percentage change in prices over a period of time, often a year. When the news reports 2 per cent inflation, that means prices increased by 2 per cent on average over the last year. Some prices rose faster and others slower, and some may even have fallen. If inflation slows from one year to the next, that’s disinflation. Inflation is still occurring, but at a slower pace. If prices fall, on average, that’s deflation. Many economists believe a little bit of inflation, roughly 2 per cent, is actually beneficial for the economy. Too much inflation or deflation is harmful because individuals or firms will start to change their behaviour. When prices are falling people may delay purchases, waiting for prices to fall further. If everybody does this then consumer spending will fall, which can cause or worsen a recession.
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Inflation is when prices are rising; deflation is when prices are falling. Economies work best with low inflation, neither too hot nor too cold.
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Central banks try to control inflation by setting interest rates and/or changing money growth. If the central bank targeted zero inflation, then every price increase in the economy would have to be offset by a price decrease. That means the central bank would have to tighten policy in response to every supply- or demand-driven price increase. A very low inflation environment also makes it more difficult for central banks to stimulate the economy since it is hard to cut interest rates below zero. That’s why some argue central banks should target an inflation rate above 2 per cent.
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3-SECOND BIOGRAPHIES
MILTON FRIEDMAN
1912–2006
One of history’s most influential economists, Friedman developed the quantity theory of money and argued that inflation is ‘always and everywhere a monetary phenomenon’
ZVI GRILICHES
1930–99
Lithuanian-born American economist who studied technological change and its impact on the measurement of prices.
30-SECOND TEXT
Gerald D. Cohen
Inflation is when the price of a basket of certain goods and services rises.
EXCHANGE RATES
the 30-second statement
Exchange rates determine the relative value of national currencies. For example, one Singapore dollar might buy 85 Japanese yen. When a currency appreciates, its purchasing power increases. A stronger Singapore dollar would buy more yen, so Japanese goods and services would be cheaper in Singapore. But Singaporean goods and services would be more expensive in Japan. Singapore would import more from Japan, but export less to it. When a currency depreciates, the reverse happens. The country’s purchasing power declines, but its trading competitiveness increases. Besides trade, shifts in exchange rates can have a meaningful impact on inflation. A depreciating currency raises the prices of imported goods. The impact is largest in countries that rely heavily on imported goods, or ‘small open economies’, such as Singapore. From 1945 until 1971 most exchange rates were ‘fixed’ as part of the Bretton Woods System. Governments bought and sold their currency to ensure that exchange rates didn’t change. Today, most exchange rates are ‘flexible’ or ‘float’ – they constantly change based on market forces. The level of flexibility can vary substantially across countries and time. Countries will intervene on occasion (a ‘dirty float’) to make their currencies more or less competitive or to lessen financial market volatility.
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Exchange rates establish the comparative value of currencies. Today, most exchange rates respond to market forces and adjust to global trade and investment patterns.
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Exchange rates respond to a variety of factors such as competitiveness, inflation and interest rates. If an economy becomes more productive – it produces goods and services more efficiently – its currency will appreciate as global investors seek higher returns in the more competitive economy. The appreciation then works to offset the boost in competitiveness and avoid a significant trade surplus. Higher inflation causes a currency to depreciate to ensure ‘purchasing power parity’ or relatively equal prices across the globe.
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INTEREST RATES & THE COST OF CAPITAL
3-SECOND BIOGRAPHIES
GUSTAV CASSEL
1866–1945
Swedish economist who developed the theory of purchasing power parity
JOHN MAYNARD KEYNES
1883–1946
British economist who advocated the use of monetary and fiscal policy to mitigate business cycles and for international economic cooperation to avoid another Great Depression
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Gerald D. Cohen
A stronger currency leads to increased imports and decreased exports.
COMMERCIAL BANKS
the 30-second statement
Banks are money matchmakers and money creators. They collect money from depositors who want a very low risk place to keep it; depositors get a relatively low interest rate but can take their money out at any time. Banks then loan that money out to people and businesses at higher interest rates and for longer periods. On one hand, banks want to lend money out because that earns profits but on the other hand, banks want to have money available in case depositors make withdrawals. To balance those demands, banks keep a fraction of their deposits on hand and loan the rest out. The result is that banks don’t have enough money at any one time to return all of their depositors’ money. To allay depositors’ concerns that they might not have access to their money, most countries provide insurance for some deposits. Insurance protects depositors from bank failures. Unfortunately, it also protects bankers from some of the consequences of making risky, bad loans and going bankrupt. So banks are regulated. For example, banks are required to keep a certain fraction of their depositors’ money in reserve. By lending out the rest of the money, this matchmaking affects the wider economy as banks are able to put their depositors’ money to work in productive investments.
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Banks hold deposits and make loans. By lending more than their deposits, they create new money.
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To picture how banks create money, imagine there is a bank, and it gets a £1,000 deposit. It must keep 20 per cent in reserve and thus loans out £800 to a business with a separate bank account. To make the loan, the bank credits the business’ account £800. Now, the bank has another £800 in deposits and the bank can lend out a portion of that. If the bank keeps lending out portions of the newly created deposits, the original £1,000 deposit will turn into £1,000/0.20 = £5,000.
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3-SECOND BIOGRAPHIES
JOSHUA FORMAN
1777–1848
Inspired by a Chinese system, he developed America’s first deposit insurance system, the Safety Fund, in 1829 in New York State
AMADEO GIANNINI
1870–1949
Son of Italian immigrants who brought banking to the American middle class and founded what became Bank of America
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Wendy Edelberg
Banks collect deposits from savers. In turn, they loan money out to people and businesses.
SHADOW BANKS
the 30-second statement
Like traditional banks, financial institutions in the shadow banking sector are money matchmakers. They match up investors, who are looking to earn a profit, with people who are looking for money to finance projects. However, there are important differences. Traditional banks face considerable regulation of the risks they take and how they finance those projects. Financial institutions in the shadow banking sector face much less oversight. Shadow banks include a variety of financial institutions, such as investment banks, finance companies, mutual funds, money market funds and hedge funds. Shadow banks finance mortgages, consumer loans and commercial activities. Those are the same kinds of activities financed by the traditional banking sector, so both shadow banks and traditional banks put people’s money to work in productive activities. But shadow banks generally make riskier loans and use riskier capital structures than traditional banks. On one hand, that means that shadow banks can typically earn a higher rate of return than traditional banks can. That benefits their investors. On the other hand, it can create broad risks. As we learned in the Global Financial Crisis, shadow banks can be subject to runs. When they play a central role in the financial system, those runs can threaten the broader economy.
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Shadow banks are lightly regulated financial institutions that take on riskier but, typically, more profitable activities than traditional banks.
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With little regulation, the size of the shadow banking sector is difficult to measure. And the sector has a different role in different countries. Shadow banking plays a central role in the United States, especially for short-term borrowing, whereas traditional banks are particularly important in Asia. By one measure, the share of global financial assets held by the shadow banking sector has risen from about 45 per cent in 2008 to about 50 per cent at the end of 2016.
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3-SECOND BIOGRAPHIES
KOJI NAGAI
c. 1953–
Chief Executive Officer of Nomura Holdings, one of the world’s largest financial services groups and global investment banks
PAUL MCCULLEY
1957–
Credited with coining the term ‘shadow bank’ in 2007 when he was an executive at PIMCO, a large bond investment house
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Wendy Edelberg
Relative to traditional banks, shadow banks are less regulated and typically more profitable.
CENTRAL BANKS
the 30-second statement
Central banks help manage the financial system, promoting economic growth and stability. To do this, they usually influence interest rates. The Federal Reserve does this for the United States, for example, and the European Central Bank does it for countries that use the euro. Central banks influence interest rates by buying and selling financial assets. If a central bank buys short-term government bonds, prices of those assets rise and, thus, short-term interest rates fall. If the central bank buys longer-term securities – typically government bonds but sometimes corporate bonds or even equities – those asset prices increase and long-term rates fall. In addition, central banks buy and sell the currency of other countries. For example, if a central bank sells its local currency in exchange for US dollars, that increases the amount of money in the local economy. That should lower interest rates and reduce the exchange rate. Lowering interest rates and reducing the exchange rate should probably boost economic growth and decrease unemployment, but those changes probably also boost inflation. Central banks try to manage those trade-offs. Some central banks primarily focus on inflation, trying to keep it neither too high nor low. Others have broader mandates, balancing concerns about inflation and the desire for full employment.
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Central banks manage the money supply, set short-term interest rates and oversee the financial system.
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Central banks do more than target interest rates and influence exchange rates. They regulate traditional banks to limit the risks they pose to the broader economy. Central banks provide loans to traditional banks that are solvent but find themselves unable to raise cash when they need it, acting as ‘lenders of last resort’. And in many nations, they coordinate and oversee the payments system. All of those activities promote stability of the financial system.
RELATED TEXTS
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INTEREST RATES & THE COST OF CAPITAL
3-SECOND BIOGRAPHIES
CHARLES MONTAGU, 1ST EARL OF HALIFAX
1661–1715
British parliamentarian and financier who established the Bank of England in 1694
ALAN GREENSPAN
1926–
The Federal Reserve’s most prominent chairman, a position he held from 1987 to 2006
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Wendy Edelberg
Central banks around the world help manage the financial systems of their countries or currency areas.
CRYPTOCURRENCIES & BLOCKCHAINS
the 30-second statement
Bitcoin brings scarcity to the digital realm. Movies, software and other digital assets replicate easily. One copy becomes ten, a hundred or a million. But you can’t copy Bitcoin. To send me one, you have to give one up. That scarcity opens the door to decentralized, digital money. Cash has value because it is hard to counterfeit. Bank accounts have value because financial institutions track every dollar, euro or yen. Bitcoin creates the same scarcity, without physical cash or central authorities. Ownership is tracked on a blockchain, a widely shared, distributed ledger of every transaction. Tools from cryptography protect the ledger from tampering and allow secure transactions. New Bitcoins are periodically released, rewarding miners, the network of people who help operate the system. But the ultimate number of Bitcoins is capped. Only time will tell whether Bitcoin actually functions as money in the larger world. But even if it fails, it has opened a new frontier for cryptocurrencies and digital assets. The ensuing gold rush may change the face of money, finance and commerce. But along the way, we should expect inevitable excesses: price booms, price crashes, hacks, thefts and scams.
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Digital assets exist on blockchains, distributed ledgers that can function without centralized oversight.
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Bitcoin is two inventions in one. Bitcoin the currency grabs headlines with wild price swings, overnight millionaires and shady deals. But it’s the technology – the blockchain distributed ledger – that may disrupt the world of money. Businesses and governments are experimenting with blockchains for financial transactions, health records, supply chain management, citizen and refugee identities, and more. And digital innovators are developing new ways to bypass businesses and governments entirely.
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3-SECOND BIOGRAPHIES
NICK SZABO
c. 1960s–
American cryptocurrency visionary who created bit gold, a precursor to Bitcoin, and developed smart contracts, later incorporated in Ethereum
VITALIK BUTERIN
1994–
Russian-Canadian programmer who invented Ethereum, a public blockchain for hosting applications including smart contracts
SATOSHI NAKAMOTO
fl. 2008
Unknown person or persons who created the blockchain technology and announced Bitcoin in 2008
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Donald Marron
Digital miners earn Bitcoin by adding new transations to the blockchain.
