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 »

A ‘transformational growth’ perspective (Nell, 1998a) would suggest that these principles are connected in an evolutionary pattern: as technology developed, production and employment took on new forms, and came to require different kinds of financing (Nell, 1998b). To keep pace, the monetary system also had to adapt and develop in new ways.

This took place in several stages. In the first instance, as transactions became more complex, metallic money proved inconvenient. Paper claims to gold could be used more easily, and came to replace gold. But bankers noticed very early that a given supply of gold could support a larger amount of circulating paper, since only a fraction would be presented for conversion at any given time. Convertible paper based on a fractional reserve, however, is fiduciary money. It is based on the trust the public has in the banks. 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 »

In the older economy, the monetary system did provide a constraint, and this constraint helped stabilize the economy; changes in the value of reserves worked in conjunction with the price mechanism. By contrast, the modern monetary system offers no constraint, and, in fact, inflations and asset price booms are self-financing, since price rises increase the value of collateral, on the one hand, and raise the value of bank capital on the other. The modern monetary system also allows for a creative use of the central government’s budget. The shift in money from real to nominal, following the changes in technology, has brought a new role for the government. The government budget is both much larger and plays a stabilizing role in the way it affects the economy. Read the rest of this entry »