Search

Nicholas Mayhew’s work has made a major contribution to the debates about the expansion and decline of the medieval English economy by claiming for money the significance which for too long was denied it. In doing this he has had to counter some of M.M. Postan’s arguments which his followers still repeat today (Mayhew, 2013b, pp. 6–20). One of them is that if money was such an important influence on prices, wages and credit then ‘fluctuations in the money supply should have resulted in broad uniformity rather than diversity’; wages should have shown ‘broadly similar patterns of rise and decline’, and credit, too, ‘should have dried up everywhere in line with the decline in the money supply’ (Hatcher and Bailey, 2001, p. 61; Langdon, 2010, p. 123; Bolton, 2012, p. 307). These arguments interpret the role of money in the economy in terms only of major changes in its volume, and ignore where, and by what means, it was distributed. They assume that when imports of bullion increased significantly, coin must have flowed like a tidal wave from the mints to the provinces, uniformly affecting prices, wages and credit in every region and locality. If the evidence shows persistent regional and local diversity, this is seen as proof that the money supply cannot have been a major agent of economic change.

Marx’s purpose in Capital is to study the dynamics of the capitalist system; the laws of motion that govern, and tendencies that characterise, it. To understand these dynamics he considers it necessary to understand the movement of capital as a process of value expansion or wealth augmentation. At the very heart of this process is the circulation of commodities (including services) and formation of prices. Marx takes the circulation of commodities to be the exchange of commodities for money and money for other commodities. He depicts this as C-M-C’, where C-C’ represents both a change in the form of the commodity and, as is implied by the commodity as capital, an increase in value. He sees the circulation of commodities as facilitated by the circulation of money as capital. He depicts the latter as M-C-M’, where M-M’ represents an increase in the value of money. Marx argues, that to understand the fundamental nature of this circulation of commodities and accompanying formation of prices in capitalism, one must first abstract from capital; from commodities and money as capital.1 One must begin with the simple circulation of commodities (C-M-C’) and money (M-C-M), where C-C’ represents only a change in form of the commodity and M-M signifies that there is no increase in the money worth of the commodity in the process of circulation.

The assumption made in the Black-Scholes world, in particular in the Black-76 model Equation 9.10, that interest rates are non-stochastic directly contradicts the very existence of interest rate options. If interest rates were deterministic and hence predictable with certainty for all future times, we would know at time t which options will be in or out of the money upon maturity T. The options which are out of the money at maturity would be worthless at all earlier times t < T as well. The options which are in the money at maturity would be nothing other than forward transactions. Thus, the assumptions made in pricing interest rate options using the Black-76 model imply that these very options should not even exist! In spite of this fact, the option prices obtained by applying the Black-76 model are surprisingly good. The results of recent research [94] [126] have shown that the effects of several “false” assumptions (in particular, the assumed equality of forward and futures prices) tend to cancel out each other1.

In this chapter the concept of the yield curve is introduced. The factors which give rise to changes in the shape and position of the yield curve are examined. The practice of gapping in the money market enables profit to be made from expected changes in interest rates.

The job of central banks is to conduct monetary policy. This consists of buying and selling assets from and to the private sector, in exchange for central bank money, a rare commodity used by the financial sector to clear its daily position in the money market. The conduct of monetary policy has a direct effect on the balance sheet of both the banking system and the central bank.

A convertible bond is a hybrid instrument. It has both a fixed income and an equity component. The degree by which it resembles either a straight bond or the underlying equity is largely dependent on how much the derivative is ‘in or out of the money’. Convertible bonds reflect differing sensitivities to changes in prevailing interest rates depending on their equity or straight bond content. Before analysing the characteristic behaviour of convertible bonds, we will focus exclusively on the impact of changing interest rates on straight bonds, but even at this point it needs to be noted that one is ultimately considering convertible bonds (many of which have put and call provisions) as securities with ‘embedded options’. This chapter provides a convenient place to at least outline basic bond theory and relationships which are essential for convertible bond practitioners.

The first product covered in this section is the repurchase agreement, one of the fundamental instruments in the money markets. A repurchase agreement (or repo, as it is commonly known) is essentially an agreement to sell and repurchase a security. The actual repurchase of the security may come as soon as the next day or as far away as one or two years in the future. Repos can also be booked on an ‘open’ basis; that is, the transaction can be ‘rolled’ (rebooked) daily until one of the two parties involved decides to close it out. In a standard repo transaction the bank will sell its securities (perhaps Treasury notes) to a third party, while at the same time entering into a contract to repurchase them at some point in the future. Both sale and repurchase prices are agreed prior to entering the deal. In return for the securities, the bank will receive cash from the third party; the inflow of cash can be used to fund the balance sheet and a repo transaction is thus often thought of as a financing or a short-term, collateralised borrowing.

An alternative approach to the modelling of monetary aggregates is that based upon the notion of ‘disequilibrium money’. Artis and Lewis (1974, 1976) were the first to formulate such a concept, in their attempt to explain the breakdown in the UK money demand function in the 1970s. In the traditional approach to estimating money demand equations, it is implicitly assumed that the actual money supply is always equal to the aggregate short-run demand, so that the money market is continually in equilibrium. Such an assumption is uncontroversial when the money stock is demand determined, as is generally assumed to have been the case in the UK in the 1950s and 1960s. However, the assumption appears to be a less applicable characterisation of the UK money market after 1970, particularly for broad money. Artis and Lewis argue that large independent changes in the UK money supply, in the early 1970s, led to a disequilibrium in the money market in which supply exceeded demand. This expansion in the money stock occurred for a number of reasons. An important factor was the Competition and Credit Control reforms, which created a new spirit of competition in the banking system and abolished the direct controls on bank advances. In addition, budget deficits incurred by the government in the early 1970s were largely financed by money creation.

The central component of monetarism, the quantity theory, has the appealing simplicity that characterises powerful theories. But its very simplicity invites the charge that its domain is highly constricted, that it applies only to a world in which there are just two types of assets: exogenously given currency and chequeable deposits on the one hand, and relatively illiquid assets on the other. Hence, the argument runs, while the quantity theory may be a useful guide for economic historians, it is not applicable to the modern world with its evergrowing multitude of money substitutes. What the monetarists call ‘money’, that is, a medium of exchange without close substitutes, does not exist any more. Further, with the complexity of our financial system increasing all the time, the quantity theory, and hence monetarism are becoming more and more outdated. Our complex financial system requires a complex theory that treats ‘moneyness’ as a continuum, and does not separate out a particular asset that is allegedly ‘money’.

It is to economic writers in the eighteenth century that we credit the first explicit statements of the international balance-of-payments adjustment mechanism. It was no small achievement for Isaac Gervaise, Richard Cantillon and David Hume to integrate three distinct dynamic processes: 1) the effect of the balance of payments on the money supply; 2) the effect of changes in the money supply on expenditure or prices; and 3) the effect of changes in expenditure on the balance of payments. Earlier writers had anticipated certain features of the mechanism but not put everything together. The three equations, implicit in the early literature, are fundamental to an understanding of the adjustment process and, starting from the 1960s, have been the subject of numerous mathematical formulations.

Inflation causes trouble for economic systems in four interrelated ways.1 First, inflation erodes the money unit’s purchasing power— the so-called “inflation tax.” Anticipation of further erosion reduces people’s desire to hold money and other assets denominated in the money unit. This may have certain favorable short-term consequences, but on balance the longer-term consequences are assuredly negative. Second, the inflation rate over any time interval frequently surprises people, so that individuals and enterprises end up with different amounts of purchasing power than they originally planned. The surprise may be agreeable or disagreeable: for example, if prices rise more than originally expected, “economic entities” (i.e., households and firms) that owe money are agreeably surprised, while those owed money are disagreeably surprised.

Economics has always been a ‘divided’ science. Keynes’s predecessors saw the division as one between the theory of value and distribution and the theory of money and absolute prices. Keynes — in Chapter 21 of The General Theory — suggests that the correct division is between the theory of the firm and industry and the theory of output as a whole. Both halves should use the same concepts in order to avoid the ‘double life’ of living on ‘two sides of the moon’ without knowing the route that connects them.1 As we saw, Chapter 21 is a notable attempt to use many of the concepts of the theory of the firm to explain the response of prices to a change in the money supply.

The liberalisation of interest rate had gone through several legislations, as follows: 1. The First Amendment of the Bank Act, Article 33, on 1 September 1947, stated that the maximum interest rates for deposits and lending of banks have to be determined jointly by the associations of banks and financial institutions and the Central Bank. (Bank of Taiwan was then the acting authority.) 2. On 19 December 1947, the ‘Regulations for the Control of Interest Rate’ were promulgated, which stated that the deposit rate of banks should not exceed the lending rate, and which authorised the Central Bank to determine the maximum lending rate. 3. An Amendment to the Bank Act in 1971 stated that the Central Bank had the power to determine the maximum interest rates for various types of deposits, and that the range (maximum and minimum) of lending rate should be proposed by the Association of Banks and approved by the Central Bank. 4. The New Bank Act, Article 41, promulgated on 4 July 1975, restated the aforesaid Amendment. 5. On 7 November 1980, the Central Bank announced ‘the Major points of Consideration of Interest Rates of Banks’, which stated that (i) the Association of Banks could, in consideration of the money-market condition, propose to the Central Bank a range of deposit rates, although the maximum deposit rate was still determined by the Central Bank; and (ii) the Association of Banks could propose to the Central Bank a range of lending rates for the latter’s approval; the range was to be widened to allow flexibility in operation. Moreover, interest rates in the money market and NCDs (Negotiable Certificate of Deposits) are not subject to the limitation of the maximum deposit rate.

Though one or the other of the familiar macroeconomic theories may explain fluctuations in unemployment over the business cycle, none of them explains the often substantial differences in unemployment rates in different areas of a country, or the dramatically different average long-run unemployment rates across countries, or the contrast between the extraordinary severity of unemployment in some historical periods and the near-absence of unemployment in others. All areas of a country, even if it is very large and diverse, experience the same monetary and fiscal policies, so these monetary and fiscal policies can hardly be sufficient to explain the often persistently different unemployment rates in different regions. Most familiar macroeconomic theories understandably focus on unanticipated changes in the money stock or in aggregate demand, but greatly different long-run average rates of unemployment in different countries are not likely to be adequately explained by unanticipated differences in the rate of growth of aggregate demand, because any such long-run differences eventually come to be anticipated. In any case, the observed differences in macroeconomic policies do not appear to be able to explain the long-run average differences in underutilisation of resources across countries without suspiciously elaborate or ad hoc supplementation; neither do they provide, by themselves, an adequate explanation of why average European unemployment rates were considerably lower than US rates in the first two decades after the Second World War, yet have been considerably higher than those in the USA for more than a decade.

‘Money,’ Hicks has declared, ‘is defined by its functions … “money is what money does,’” (1967, p. 1). Harrod notes that ‘Money is a social phenomenon, and many of its current features depend on what people think it is or ought to be’ (1969, p. x). ‘Money,’ Scitovsky adds, ‘is a difficult concept to define, partly because it fulfils not one but three functions, each of them providing a criterion of moneyness … those of a unit of account, a medium of exchange, and a store of value’ (1969, p. 1).

This chapter reviews the changes which have occurred in the UK money markets since 1983, with a particular emphasis on the discount houses and their relationship with the Bank of England and monetary policy. During this period the Bank has revised various aspects of monetary policy and operations in the market, but probably the single most significant event which occurred was the deregulation of the London financial markets on 27 October 1986, known as ‘Big Bang’. So far the impact on the money markets has been relatively limited; the future, however, remains uncertain.

The relationship between inflation and monetary policy can probably be discussed most conveniently by referring to the classical ‘equation of exchange’, developed by Irving Fisher in 1911 and explained in thousands of elementary economics texts. The quantity of money in an economic system multiplied by its velocity (the number of times one unit of money changes hands during some period of time) must be equal to the total transactions taking place during that period multiplied by the average price per transaction. This definitional relationship, the Fisher Equation, MV = PT, does not say anything about causality; by the definition, a change in any of the four variables could cause a change in one or more of the other three. This elementary point is often ignored by ‘theorists’ of various persuasions. Some economists may argue that increases in the money supply will tend to be offset by exactly proportional declines in velocity — thus, ‘money does not matter’, the strict Keynesian view. For others, velocity is a constant, in other words, total transactions in the economy do not change by very much in the short run, and a strong causality running from money growth to the price level is postulated, the so-called monetarist position or ‘classical view’. According to Fisher himself, a 10 per cent increase in the supply of money will, on average, lead to the same 10 per cent rise in the general price level, but few other economists today would argue that the relationship is a direct and proportional one.

Several people, including the Swiss Banking Corporation,2 have in recent times undertaken the task of inquiring whether the Euro-dollar market contributes to world inflation. This activity, of course, presupposes that the theoretical and empirical problem of whether an expansion of the money supply leads to inflation has already been solved, in the sense of establishing a positive correlation between increases in the money supply and price increases, and of knowing the direction and the parameters of that correlation. Granted that this correlation has been found theoretically, the problem then becomes ones of proving it empirically, and that involves deciding what particular magnitude must be defined as the ‘world price level’. After this practical problem has been satisfactorily coped with, it is necessary to consider whether Euro-dollar deposits can be called ‘money’ and, if that much can be said about them, it must be decided what is the relevant aggregate of deposits that must be called ‘Euro-dollar deposits’. When that is done, the remaining part of the job is to prove that Euro-dollar deposits contribute to world inflation. Finally, it is relevant to establish whether Euro-dollar deposits contribute significantly to world inflation.

At the beginning of each year, the Economic Report of the President of the United States makes projections of GNP in nominal and real terms for the coming year, the unemployment rate and the inflation rate, and states the major fiscal and monetary policies required to achieve these target rates. For example, the Report of January 1976 estimates real GNP to be 6 to 6.5 per cent higher in 1976 than in 1975 (p. 19), the unemployment rate to fall by almost a full percentage point and the inflation rate measured by the rise in the GNP deflator to be about 6 per cent (p. 24). The associated fiscal policies include a proposed Federal outlay in fiscal 1977 of $394 billion, a cut in taxes beginning in July 1976 of about $28 billion relative to what they would be under the 1974 law (p. 22). The rate of growth in the money supply M1, as announced by the Federal Reserve, ranges between 5 1/2 and 7 1/2 per cent, but the Report asserts that maintaining a rate of money growth at the upper limit of this range would hinder the progress toward lower inflation rates (pp. 21–2). Assuming that econometric models are being used for policy analysis, this paper presents a systematic approach to apply some recently developed techniques of stochastic control to improve the formulation of macroeconomic policies and the accompanying economic projections.

The purpose of this book has been to analyse critically neoclassical macroeconomics as it is taught. The presentation has gone into considerable detail, and the reader might have lost track of the basic purpose of the critique. The basic purpose has been to refute the fundamental macroeconomic ‘parables’ of neoclassical theory: (1) other things equal, more employment requires a lower ‘real wage’ (commodity wage); and (2) other things equal, increases in the price level are proportional to increases in the money supply. Each parable can be restated in the more journalistic and ideological form in which one frequently encounters them: (1) cutting wages will bring full employment; and (2) inflation is the result of increases in the money supply.

In this chapter we begin our main job of constructing an economic theory which can be used to explain why the economic system behaves as we saw that it did in Chapter 6. We approach this task by developing a model of the economic system. Since the economic system is complicated, the model, to be useful, must necessarily also be complicated. We shall begin, however, by constructing a model of extreme simplicity and introduce complexities later only when the properties of the simple model have been thoroughly understood. Accordingly we start with a system in which (i) there is no government (i.e. no public-sector) economic activity, and (ii) there is no international trade. We also make one additional assumption, namely that the price of a unit of output is constant. This enables us to identify changes in the money values of variables with changes in their ‘real’ values and postpone discussion of the determination of prices. Each of these assumptions is removed later.

Banks are the intermediary in the money system in so far as they accept deposits, either demand or time, interest-bearing or noninterest bearing, from customers and then use these deposits to make loans, or other deposits with other banks, or to purchase investments. At the same time, they are the intermediary in international trade since they enable their financial and commercial customers to buy and sell the foreign exchange which they require. The banks also enable their customers to invest their surplus funds in foreign currency deposits with them. The objectives of the dealing department are to satisfy these needs in a satisfactory manner for both customer and banker.

This paper is arranged as follows. Section I discusses definitions of ‘monetarism’ and proposes a very general meaning which can be derived, with minimal restrictions from a widely accepted model of the economy. We suggest that the two principle propositions to be tested are (a) that there is a stable demand for money and (b) that changes in the money supply have been an independent source of changes in prices. Section II examines the long-run relationship between money and nominal income. It reports previous empirical studies and also presents long-run graphical evidence. Section III examines in more detail the question of ‘causality’. The conclusions are summarised in the final section.

Flexible exchange rates in earlier periods have usually meant that one or more countries left a metallic standard for some time. Three episodes dominate the historical material in this article: Sweden in the 18th century, England in the early 19th century and the period during and immediately after World War I. In all three cases there was a serious economic debate about the causes of the fluctuations in exchange rates. Two main views on this issue can be distinguished. One is that the fluctuations were caused by exogenous shifts in different items of the balance of payments. The other view attributes this role to the money supply. It is shown that theoretically both are possible, but that changes in the money supply probably predominate. This conclusion seems to be consistent with the empirical evidence.

The public sector borrowing requirement, which averaged 7 1/2 per cent of gross domestic product (at factor cost) over the six years from 1973 to 1978, has been the largest single threat to monetary control in recent years. It has posed what has been termed “the flooding problem”, a continuous flow of new debt which has to be absorbed by the private sector. As explained in chapter 3, the PSBR causes increases in the money supply unless it can be matched by sales of debt outside the banking system. The efficiency of the monetary system in maintaining such sales and stemming the inflationary flood has been questioned. Thorneycroft, who had had to rely on it to control the money supply when Chancellor of the Exchequer between 1956 and 1958, compared it to “an antiquated pumping machine, creaking and groaning, leaking widely at all the main valves, but still desperately attempting to keep down the level of the water in the mine”. (1) By far the most important valve, and perhaps also the least trustworthy, is the gilt-edged market. Its role in money supply control is now fundamental.

‘Money,’ Hicks has declared, ‘is defined by its functions … “money is what money does”.’1 Harrod notes that ‘Money is a social phenomenon, and many of its current features depend on what people think it is or ought to be’.2 ‘Money,’ Scitovsky adds, ‘is a difficult concept to define, partly because it fulfils not one but three functions, each of them providing a criterion of moneyness … those of a unit of account, a medium of exchange, and a store of value.’3

The remarkable resurgence of interest in flexible exchange rates — which has even invaded circles, such as central banks, where formerly the subject was close to anathema — is doubtless in considerable measure inspired by the now justly famous ‘Tinbergen Principle’: the rule that, to assure the attainment of policy goals, the makers of policy need as many techniques as they have objectives. According to this criterion, if those in power want full employment and price stability and a high rate of capital formation and international balance without direct controls, they cannot hope to achieve these objectives by relying on only one or two techniques, such as variation in the money supply or in the level of government expenditure. Only by a happy coincidence will all objectives be attained if the number of tools is less than the number of goals and, in the absence of such an unlikely conjuncture, the most that can be achieved is some kind of ‘second-best’ compromise involving ‘trade-offs’ between, for example, employment and price stability, or employment and liberal trade policies.