International Financial Management

Chapter 2 The history of money and finance

Michael Connolly
School of Business Administration,
University of Miami

Michael Connolly 2007

Chapter 2

Summary

The role of money

Money and exchange rates
The history of monies
Foreign exchange history
Banks and banking
The international monetary institutions
History of stock exchanges

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The role of money

Money serves three important roles in an

economy:
It is a unit of account a yardstick by
which to measure the value of goods
and assets.

A medium of exchange to facilitate

transactions, avoiding barter.
A store of value in which to
temporarily hold liquid wealth.

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Money and exchange rates

The Bank of England and the Banque de France, had gold

windows where they bought and sold gold at a fixed currency
price in the 19th century. In doing so, their currency rates
were fixed. For example, if the Bank of England sets ten
pounds per ounce of gold as the buy/sell rate and the
Banque of France 100 francs, the equilibrium exchange rate
is set at 100 francs per 10 pounds or 10 francs a pound.
Arbitrage in gold kept the exchange rates within a narrow
band of gold points. Lets say the exchange rate falls to
9.5 francs a pound. A gold arbitrageur purchases 10
pounds for 95 francs, presents the 10 pounds to the Bank
of England gold window in exchange for an ounce of gold.
The arbitrageur then insures and ships the gold to the
Banque de France, selling it for 100 francs, pocketing 5
francs less insurance and shipping as profit.
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Money and exchange rates

With floating exchange rates, the exchange rate

moves roughly according to the relative purchasing
power of monies. This is known as purchasing power
parity.
Countries with high money growth experience higher
rates of inflation and consequently,
Greater depreciations in their exchange rate.
A fixed exchange rate serves as a monetary anchor, while
a floating exchange rate permits independent money
growth.
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The history of monies

Ancient Chinese monies: Circa 900-500BC

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The history of monies

Ancient Chinese monies: copper coins used

before 221 BC

Coin issued in 221 BC by the Qin Dynasty, the

first feudal dynasty to unify China and its
coins.

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The history of monies

The Lydian Lions Head: circa 600-575 BC is

thought by many to be the worlds first coin.

It was made of electrum, a precious alloy of

gold and silver that consisting of about 54
percent gold, 44 percent silver, and 2 percent
copper.
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The history of monies

Ancient Chinese monies: The Yibi Circa 500BC

Made of copper and known as the creeping

ant-nose coin.
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The history of monies

Ancient Chinese monies: The Guinian (Ghost

face) copper coin circa B.C 400 to 300

Both the Yibi and the Guinian coin have the

shape of shells, the earliest currency in China.
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The history of monies

Ancient Chinese monies: Issued in 621 AD

under the Tang Dynasty.

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The history of monies

Ancient Chinese monies: The first uniform

paper money in the world, the Jiaozi, issued
in 1023 under the Song Dynasty.

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The history of monies

The first world money, the Spanish silver dollar

or pieces of eight minted in Spain, Mexico and
Peru.

The Spanish peso contained 0.821791 troy ounce

(25.560 grams) pure silver and was also used as
domestic money in Asia, Latin America, America
and Europe.
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The history of monies

The last paper monies of the feudal dynasties: 1875 to1908

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Seigniorage

The early definitions of seigniorage referred

to the difference in the value of a money,
and its mint costs.
For example, say a silver coin has value $10
and its silver content and cost of manufacture
is only 50 cents, then seigniorage is $9.50.
Seigniorage on paper money is generally
greater due to the higher nominal values as
money and the lower costs of printing in terms
of paper, ink, anti-counterfeit measures such
as filaments, water marks, color changing ink
and the like.
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Seigniorage

For example the US $100 bill costs about

12 cents to manufacture. Consequently
seigniorage is $99.88. These profits to
the Treasury can be spent, just as with
any other tax receipt.
The issue of money is usually the right of
the sovereign government (i.e. the
seigneur), so that the right to strike
money has historically been used to
finance wars and emergency expenditures
by the printing press.
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Seigniorage

More formally, seigniorage is the residual

finance of any fiscal deficit that is not
completely covered by new borrowing. That is:
*

dM
dB dB

G T

dt
dt
dt

Where dM/dt is new seigniorage, (G-T) the

fiscal and quasi-fiscal deficit, dB/dt new
domestic borrowing, and dB*/dt new foreign
borrowing.
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Seigniorage

It is often instructive to express new

seigniorage as a percentage of GDP, that is:
*

dB
dB
dM

dt
dt G T dt
GDP
GDP
GDP

When deficits become large as a percent of

GDP, say above 5 or 6%, it may become
difficult to finance it by new borrowing, so
resort to the printing press may take place,
causing high inflation.
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Seigniorage

There are, however, limits as to the amount

of seigniorage finance may take place.
This is because the demand for money
collapses when inflation is high, so that real
seigniorage collections, M/P, decline after a
certain point, yielding what is known as a
Laffer curve in seigniorage.

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Seigniorage
Real seigniorage revenue
as a percent of real money balances
M M

P
P

CHINA
M
M

13.8%

14.6%

1/

100 Seigniorage
tax rate (%)

Between 1952 and 1995, China has issued new seigniorage at a 14.6
collecting 13.8% in new real seigniorage revenue.M
M is
Note: Technically speaking, the seigniorage tax rate
so that in
1

limit it approaches 1 or 100% when money growth approaches infinit

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Seigniorage
Real seigniorage revenue per annum
as a percent of real money balances
M M

P
P

USA
M
M

3.1%

6.7%

1/

100 Seigniorage
tax rate (%)

1960-1995, averages.
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Seigniorage
Real seigniorage revenue
as a percent of income
M M M

Y
M Y

CHINA
M
M

1.2%

14.6%

1/

100 Seigniorage
tax rate (%)

As a percent of GDP (Y), this represents an annual collections rate of

of GDP in China from 1952 to 2005.
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Seigniorage
Real seigniorage revenue
as a percent of annual income
M M

Y
M

USA
M
M

0.36%

6.7%

1/

100 Seigniorage
tax rate (%)

As a percent of GDP (Y), this represents an annual collections rate of

of GDP in the United States from 1960 to 2005.
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The revenue maximizing rate of seigniorage

In equilibrium, money demand, L, equals money supply, M. The demand
for money, however, is inversely related to its rate of seigniorage issue
(and inflation), so that we may write real revenue as determined by the
rate of seigniorage issue times real money balances.
M

For simplicity, define

so that the real revenue collected from
M
seigniorage is:

M

R
ky e
P

Which is the money demand equation according to Philip Cagan, The

Monetary Dynamics of Inflation, in Milton Friedman, editor Studies in
the Quantity Theory of Money, Chicago: University of Chicago Press
1956.
k is a constant is the income elasticity of demand for money
y is real GDP
is the semi-elasticity of the demand for money
with
respect to the rate of seigniorage issue
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The revenue maximizing rate of seigniorage

The rate of seigniorage issue that maximizes real revenue from
seigniorage is given by:

dR
ky e kyy e 0
d
Or

dR
1 0
d

Which yields the revenue maximizing issue of seigniorage equal to:

The greater the semi-elasticity of demand for money, the lower is the
revenue maximizing rate of inflation, as illustrated graphically.

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Seigniorage
The reason why a relatively high percent of seigniorage can be collected in
China is due firstly, to the high real rate of growth in income, leading to
increased demand for money, and secondly to a high income elasticity of
demand for money. Thus, virtually no inflation has resulted.

Summary Monetary Statistics for China: 1952-2005

Income elasticity of demand for money

1.8

Money growth

14.6%

Money/GDP

9.8%

Real seigniorage

Data sources:

13.8%

Inflation

0.1%

Real growth

8.1%

Seigniorage/GDP

1.2%

Money growth less real growth

6.5%

Increase in Cambridge K

6.3%

Comprehensive Statistic Data and Materials on 50 Years of New China, China Statistics Press, 1999:189-190.
"China Statistic Yearbook 2005", China Statistics Press, 2006, chaps. 20,28.
"Statistic Communique of the People's Republic of China on the 2005 National Economic and Social Development", Feb.28, 2006.

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Foreign exchange history

Bills of exchange were used primarily in international

trade, and is a written order by one person to pay
another a specific sum on a specific date sometime in the
future.
Since carrying large amounts of coins was risky, bills of
exchange were used in order to facilitate currency and
trade transactions.
The bill of exchange allowed trade to take place without
the use of coinage, a precursor of the modern letter of
credit (L/C).

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Foreign exchange history

Furthermore, the bills were traded as financial

instruments in trade fairs. They were discounted and
converted into foreign exchange.
The trade fairs were the precursors of modern stock
and foreign exchanges.
An important feature of the foreign exchange market
was an interest-bearing loan disguised as a foreign
exchange transaction. Merchants and financiers were
able to make loans evading usury laws using a sequence
of two bill transactions a precursor of todays foreign
exchange swap.

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Foreign exchange history

An important 16th century development was the

appearance of a system of betting on future exchange
rates: a non-deliverable forward market. The betters
made forecasts on future exchange rates.
The difference between the realized rate and the
forecasted rate determined who won the bet and how
much the loser would pay the winner.
This form of forward exchange still exists today in the
form of non-deliverable futures (NDFs) in the Chinese
yuan (formally Renminbi, the Peoples Currency) in
Singapore and Hong Kong.

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Foreign exchange history

The 1944 Bretton Woods sytem of pegged but

adjustable exchange rates triggered foreign
exchange intervention in spot markets to
maintain exchange rates near their par
values.
Floating exchange rates began in the early
1970s, and global markets were being
integrated. The resulting need of
multinational businesses to hedge their
currency exposures caused the rapid growth of
foreign exchange trading in the 1980s and
1990s.
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Foreign exchange history

London is still by far the largest FOREX

market today in terms of daily foreign
exchange turnover.
In 2004, daily turnover net of double-counting
on the London foreign exchange market was a
staggering $753 billion in currency spots,
swaps, forwards and options.
This represents 31% of daily foreign exchange
transactions, compared to 19% in the United
States, and 8% in Japan.

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Banks and banking

The first modern bank was the Bank of

Amsterdam, founded in 1609. The Amsterdam
bank was quickly followed by other major
cities.
The Bank of Hamburg was formed in 1619 and
the Bank of Sweden in 1656. Sweden issued
the first European paper bank notes in 1661.

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Banks and banking

The Bank of England was founded in 1694 as

a commercial bank by William Paterson with
the right to issue notes up to the amount of
its capital, initially 1.2 million.
It was nationalized by Parliament in 1946.
The shareholders received compensation and
the Bank of England thereafter ceased its
private business, becoming the banker of
government

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Banks and banking

Since 1977, The Bank of England has the

responsibility for setting monetary policy.
Prudential oversight of the British commercial
banking system was simultaneously transferred
to the Securities and Investments Board.

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Banks and banking

In the United States, the Federal Reserve Act

established the Federal Reserve System (the
FED) in 1913 with 12 districts.
The Federal Reserve Banks provide liquidity,
clear transactions, and control the money
supply.
The FED was established primarily as a reserve
institution, a lender of last resort to prevent
bank runs and liquidity crises.
The Federal Deposit Insurance Corporation
(FDIC) insuring deposits was begun in March
1933.
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The international monetary institutions

The International Monetary Fund (IMF) was

established in 1944 at the Bretton Woods
Conference in New Hampshire.
Its purpose was to establish orderly exchange
rate arrangements based on a par value
system, to eliminate exchange controls, and to
provide temporary short term balance of
payments assistance via conditional loans to
member countries that are short of foreign
exchange reserves.

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The international monetary institutions

The World Bank, a sister institution of the IMF

created in 1944 at the Bretton Woods
Conference initially made long term development
loans for projects such as dams, airports, rubber
and concrete production, water systems, and the
like.
It got involved in Structural Adjustment Loans
(SALs) in the 1990s in tandem with the IMF
requiring structural adjustments to economic
policy. This could mean privatization of state
enterprises, lifting price and exchange controls,
and improving monetary and fiscal policies, for
instance.
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The international monetary institutions

The Bank of International Settlements (BIS)

is often referred to as the bank of central
banks. Located in Basel, Switzerland,
It was established May 17, 1930 at the
Hague convention. As such, it is the oldest
international monetary organization.
It does not do business with private
individuals or corporations; only with central
banks and international institutions.

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The history of the stock exchanges

The New York Stock Exchange established

May 17, 1792 on Wall Street. Traders met
at the old wooden wall, no longer in existence,
but giving its name to the street.
The Dow Jones Industrial Average (DJIA)
started out with 12 stocks in October 1928.
Only General Electric remains of the original
twelve. The S&P 500 Index covers the 500
most widely held companies.

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The history of the stock exchanges

The London Stock Exchange was established in

1773, formerly Jonathans Coffee House
where trades met. Trading has since moved
off the floor with the introduction of the
Stock Exchange Automated Quotations
(SEAQ) system.
The Footsie 100 Index is the Financial Times
Stock Exchange Index of the 100 largest
companies listed on the London Stock
Exchange.

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The history of the stock exchanges

The Tokyo Stock Exchange was established on

May 15, 1878. Japan's Nikkei 225 Index is
an average of stock market prices similar to
the Dow Jones Industrial Average.
The Paris Bourse was established in Paris by
the order of the Royal council in 1724. In
1986, the futures exchange Le MATIF was established .
The CAC 40 Index is the acronym for
Compagnie des Agents de Change 40 Index,
40 French companies listed on the Paris Stock
Exchange.
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The history of the stock exchanges

The Frankfurt Stock Exchange dates from the

9th century when trade fairs were authorized.
In 1585 it was organized as a bourse to fix
exchange rates and by 1894 had became a
formal stock exchange.
Its main index, the DAX consists of the 30
largest issues traded on the exchange.

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The history of the stock exchanges

The Shanghai Stock Exchange (SSE) was

founded in 1904, mainly dealing in rubber
shares. The Japanese occupation brought an
end to its operations.
The modern Shanghai Stock Exchange was
founded in 1990 but suffers from transparency,
disclosure and monitoring issues that have put it
into a serious slump from which it is just now
recovering.
The Shanghai Composite Index is a composite of
hard-currency B shares sold to foreigners and
yuan-denominated A shares sold to Chinese.
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The history of the stock exchanges

The performances of the international stock

markets indices are related.
In fact, this is one aspect of the increased
globalization of international trade and
finance.
The following table reports the correlation
between the monthly real rates of return on
major world stock indices
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The history of the stock exchanges

Correlations between the monthly real rates

of return of major stock indices: 1995-2004.

** Correlation is significant at the 0.01 level (2-tailed).

* Correlation is significant at the 0.05 level (2-tailed).
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Conclusion

Money serves as a medium of exchange, a unit

of account, and a store of value. Different
monies must be converted into the same unit
of account by the exchange rate in order to
compare prices and rates of return.
This currency conversion gives rise to foreign
exchange risk in investing and operating
internationally. The foreign exchange markets
have arisen to deal with spot and forward
transactions in different monies, as well as
currency options to either hedge or speculate.
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Conclusion

The largest FOREX market remains London.

accounting for 31% of daily turnover in the
foreign exchanges.
The exchange costs on the FOREX market are
mainly the difference between the ask and
the bid price of foreign currency the bidask spread as well as any commission
associated with the conversion.
These costs are not insignificant, amounting to
approximately a billion USD daily.
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Conclusion

There is increasing financial integration in the

world financial markets, making for a more
efficient distribution of worldwide finance.
The adoption of the euro by twelve countries
as the same currency has removed exchange
rate risk and conversion costs from the
financial landscape of Europe.

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Conclusion

The issue of seigniorage has been the root of all evils in many
emerging markets, especially developing countries in Latin
America and Africa. Money has become worthless, so that
currency reforms a change of the monetary unit have been
necessary in Argentina, Bolivia, Peru, Mexico and Ecuador (which
has officially dollarized)
It is often the finance of last resort when a government runs
a high fiscal deficit it cannot finance by borrowing at home and
abroad. Its last resort is to print money the printing press.
China and the United States have since the 1950s restrained
the issue of seigniorage and consequently have had low inflation.
At the same time, Chinas high income elasticity of demand for
money and its high growth rate have allowed 1.2% of GDP to be
collected as seigniorage revenues.
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