Monetary circuit theory

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Monetary circuit theory is a heterodox theory of monetary economics, particularly money creation, often associated with the post-Keynesian school. [1] It holds that money is created endogenously by the banking sector, rather than exogenously by central bank lending; it is a theory of endogenous money. It is also called circuitism and the circulation approach.

Heterodox economics schools of economic thought or methodologies that are outside "mainstream economics", contrasting with or going beyond neoclassical economics

Heterodoxy is a term that may be used in contrast with orthodoxy in schools of economic thought or methodologies, that may be beyond neoclassical economics. Heterodoxy is an umbrella term that can cover various schools of thought or theories. These might for example include institutional, evolutionary, Georgist, Austrian, feminist, social, post-Keynesian, ecological, Marxian, socialist and anarchist economics, among others.

Monetary economics is the branch of economics that studies the different competing theories of money: it provides a framework for analyzing money and considers its functions, and it considers how money, for example fiat currency, can gain acceptance purely because of its convenience as a public good. The discipline has historically prefigured, and remains integrally linked to, macroeconomics. This branch also examines the effects of monetary systems, including regulation of money and associated financial institutions and international aspects.

Money creation is the process by which the money supply of a country, or of an economic or monetary region, is increased. In most modern economies, most of the money supply is in the form of bank deposits. Central banks monitor the amount of money in the economy by measuring the so-called monetary aggregates.

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Contrast with mainstream theory

The key distinction from mainstream economic theories of money creation is that circuitism holds that money is created endogenously by the banking sector, rather than exogenously by the government through central bank lending: that is, the economy creates money itself (endogenously), rather than money being provided by some outside agent (exogenously).

Mainstream economics is the body of knowledge, theories, and models of economics, as taught by universities worldwide, that are generally accepted by economists as a basis for discussion. Also known as orthodox economics, it can be contrasted to heterodox economics, which encompasses various schools or approaches that are only accepted by their proponents, but not by economists in general.

These theoretical differences lead to a number of different consequences and policy prescriptions; circuitism rejects, among other things, the money multiplier based on reserve requirements, arguing that money is created by banks lending, which only then pulls in reserves from the central bank, rather than by re-lending money pushed in by the central bank. The money multiplier arises instead from capital adequacy ratios, i.e. the ratio of its capital to its risk-weighted assets. [2]

In monetary economics, a money multiplier is one of various closely related ratios of commercial BANK money to central bank money under a fractional-reserve banking system. It measures the maximum amount of commercial bank money that can be created, given a certain amount of central bank money and ignoring leakages into currency held by the non-bank public. That is, in a fractional-reserve banking system, the total amount of loans that commercial banks are allowed to extend when there are no leakages is equal to a multiple of the amount of reserves. This multiple is the reciprocal of the reserve ratio, and it is an economic multiplier. The actual ratio of money to central bank money, also called the money multiplier, is lower because some funds are held by the non-bank public as currency and most banks hold excess reserves

The reserve requirement is a central bank regulation employed by most, but not all, of the world's central banks, that sets the minimum amount of reserves that must be held by a commercial bank. The minimum reserve is generally determined by the central bank to be no less than a specified percentage of the amount of deposit liabilities the commercial bank owes to its customers. The commercial bank's reserves normally consist of cash owned by the bank and stored physically in the bank vault, plus the amount of the commercial bank's balance in that bank's account with the central bank.

Circuitist model

Circuitism is easily understood in terms of familiar bank accounts and debit card or credit card transactions: bank deposits are just an entry in a bank account book (not specie – bills and coins), and a purchase subtracts money from the buyer's account with the bank, and adds it to the seller's account with the bank.

A debit card is a plastic payment card that can be used instead of cash when making purchases. It is similar to a credit card, but unlike a credit card, the money is immediately transferred directly from the cardholder's bank account when performing any transaction.

Coin piece of hard material produced in large quantities to facilitate trade

A coin is a small, flat, round piece of metal or plastic used primarily as a medium of exchange or legal tender. They are standardized in weight, and produced in large quantities at a mint in order to facilitate trade. They are most often issued by a government. Coins often have images, numerals, or text on them.

Transactions

As with other monetary theories, circuitism distinguishes between hard money – money that is exchangeable at a given rate for some commodity, such as gold – and credit money. The theory considers credit money created by commercial banks as primary (at least in modern economies), rather than derived from central bank money – credit money drives the monetary system. While it does not claim that all money is credit money – historically money has often been a commodity, or exchangeable for such – basic models begin by only considering credit money, adding other types of money later.

Hard currency, safe-haven currency or strong currency is any globally traded currency that serves as a reliable and stable store of value. Factors contributing to a currency's hard status might include the long-term stability of its purchasing power, the associated country's political and fiscal condition and outlook, and the policy posture of the issuing central bank.

In circuitism, a monetary transaction – buying a loaf of bread, in exchange for dollars, for instance – is not a bilateral transaction (between buyer and seller) as in a barter economy, but is rather a tripartite transaction between buyer, seller, and bank. Rather than a buyer handing over a physical good in exchange for their purchase, instead there is a debit to their account at a bank, and a corresponding credit to the seller's account. This is precisely what happens in credit card or debit card transactions, and in the circuitist account, this is how all credit money transactions occur.

For example, if one purchases a loaf of bread with fiat money bills, it may appear that one is purchasing the bread in exchange for the commodity of "dollar bills", but circuitism argues that one is instead simply transferring a credit, here with the issuing central bank: as the bills are not backed by anything, they are ultimately just a physical record of a credit with the central bank, not a commodity.

Fiat money Currency established as money by government regulation or law.

Fiat money is a currency without intrinsic value that has been established as money, often by government regulation. Fiat money does not have use value, and has value only because a government maintains its value, or because parties engaging in exchange agree on its value. It was introduced as an alternative to commodity money and representative money. Commodity money is created from a good, often a precious metal such as gold or silver, which has uses other than as a medium of exchange. Representative money is similar to fiat money, but it represents a claim on a commodity.

Monetary creation

In circuitism, as in other theories of credit money, credit money is created by a loan being extended. Crucially, this loan need not (in principle) be backed by any central bank money: the money is created from the promise (credit) embodied in the loan, not from the lending or relending of central bank money: credit is prior to reserves. [3]

When the loan is repaid, with interest, the credit money of the loan is destroyed, but reserves (equal to the interest) are created – the profit from the loan. Another explanation of the interest, in a simple, non-growth model is the interest enjoyed by the bank is from the spending of interest income of the bank in previous circuit. The same simple model applies for profit as well, in a simple model of non-growth non-modern-bank model composed only by entrepreneurs and the employed workers, entrepreneurs's spending on profit on previous circuit will compose the profit this group enjoy in new circuit.

The failure of monetary policy during depressions – central banks give money to commercial banks, but the commercial banks do not lend it out – is referred to as "pushing on a string", and is cited by circuitists in favor of their model: credit money is pulled out by loans being made, not pushed out by central banks printing money and giving it to commercial banks to lend.

History

Circuitism was developed by French and Italian economists after World War II; it was officially presented by Augusto Graziani in ( Graziani 1989 ), following an earlier outline in ( Graziani 1984 ). [4]

The notion and terminology of a money circuit dates at least to 1903, when amateur economist Nicholas Johannsen wrote Der Kreislauf des Geldes und Mechanismus des Sozial-Lebens (The Circuit Theory of Money), under the pseudonym J.J.O. Lahn ( Graziani 2003 ). In the interwar period, German and Austrian economists studied monetary circuits, under the term Kreislauf , with the term "circuit" being introduced by French economists following this usage. The main protagonists of the French approach to the monetary circuit is Alain Parguez. Today, the main defenders of the theory of the monetary circuit can be found in the work of Riccardo Realfonzo, Giuseppe Fontana and Riccardo Bellofiore in Italy; and in Canada, in the work of Marc Lavoie, Louis-Philippe Rochon and Mario Seccareccia.

Modeling difficulties

While the verbal description of circuitism has attracted interest, it has proven difficult to model mathematically. Initial efforts to model the monetary circuit proved problematic, with models exhibiting a number of unexpected and undesired properties – money disappearing immediately, for instance. These problem go by such names as:

See also

Further reading

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References

  1. Zazzaro, Alberto, How Heterodox is the Heterodoxy of the Monetary Circuit Theory? The Nature of Money and the Microeconomy of the Circuit
  2. "The Myth of the Money Multipler". Money: What it is, how it works. Retrieved 2012-01-21.
  3. Realfonzo, Riccardo, Money and Banking. Theory and Debate, p. Money and Banking. Theory and Debate, Edward Elgar, Cheltenham (UK) and Northampton (USA), 1998.
  4. Aréna, Richard; Graziani, Augusto; Salvadori, Neri, Money, credit, and the role of the state, p.  p. 137