BEE Partner, South Africa Economy Watch

The endogenous determination of the interest rate

In a boom, banks will lend more and will seek to create new deposits or issue additional notes. To support these activities, they will have to attract additional reserves. This will lead them to bid up interest rates, as they seek to attract idle reserves from one another and from hoards. In a slump, they will issue less and lend less, and will seek to shed reserves, lowering interest rates. In other words, while long-term average rates are determined by costs and competition, current interest rates reflect the balance of supply and demand in the market. They move pro-cyclically.

This is illustrated by a simple model. On the one hand, the rate of interest (in relation to the rate of profit), is likely to affect investment inversely, and investment, in turn, will have an impact on prices and employment. Changes in prices and employment will call for changes in reserves. Read the rest of this entry »

In its earliest and simplest forms, the gold standard meant that the money in circulation, including the money the government minted, consisted of gold coins. When the US officially joined the gold standard in 1879, the value of the dollar was set as equal to the value of 23.22 fine grains of gold, where 480 fine grains made a fine troy ounce. This was equivalent to $20.67 per ounce.

Under the gold standard, the constraint on the creation of bank money posed by reserves is critical. Bank money consists of notes issued as claims to real money, that is, to gold or silver coins, money with intrinsic value. But at any time, most of the public would prefer to use the more convenient paper money, provided they are confident that they can convert the (intrinsically worthless) paper to gold at a moment’s notice. For this purpose, reserves are kept in proportion to the note issue. Read the rest of this entry »

Reserves

The deposits and currency created by the Federal Reserve are the reserves of the modern system. It would seem that if the Fed could control the amount of these reserves, it could thereby limit the ability of banks to lend, and thus control their ability to create deposits. By controlling reserves, the Fed could control the total quantity of money. As we saw earlier, real reserves did constrain banks. It has seemed plausible, and monetarists everywhere have believed, that modern, nominal reserves could provide a similar constraint. But central banks all around the world, including the Federal Reserve, have tried to exercise such control, most recently in the late 1970s and early 1980s, and, in virtually every case, their attempts have failed. Read the rest of this entry »

Now let us look at modern money, which is not anchored in gold or precious metals, and consider how money that is purely a matter of convention or fiat obtains and keeps its value. In the older economy, money was anchored to metal that had ‘intrinsic value.’ Such money is an asset to its possessor, but it is no one’s liability. This connection is broken in modern systems in which money has no intrinsic value. It is an asset to its possessor, and a liability to its issuer. Between these, we have a system in which paper money and bank deposits are loosely tied to intrinsic value by being convertible into bullion, plate or coins. Such money is also a liability to its issuer. The implications of the change from money of intrinsic value to modern money are striking. Read the rest of this entry »