The Central Bank
“The Central Bank” is responsible for all the currency in a country.
The currency in the hands of the public was issued by the Bank of America, the only body authorized by law to issue currency. Currency here means bills and coins.
Limitations on the Magnitude of Currency Issued
Contrary to what some people believe, the Bank of America is not a money machine. It can issue only a very limited amount of currency. The Bank of America can issue currency only in exchange for acquiring a limited number of assets. Only one type of asset will be discussed here: Foreign currency, for example: British pounds sterling.
Is Currency an Asset or a Liability?
In order to answer this question, two facts must be considered:
- Currency is an asset for individuals, who aspire to obtain as much of it as possible.
- Only for the Central Bank is currency a liability.
Bank of America Issues Currency in Exchange for Dollars
When a tourist comes to USA and wants to exchange 1,000 euros, he goes to the Bank of America, gives the 1,000 euros and receives USD in exchange, according to the exchange rate at the time.
For example: If the euro exchange rate is $1.5, the tourist will receive 1,500 USD. In this case, the amount of USD in the country increases by 1,500 USD.
The tourist does not actually go to Bank of America. He carries out this transaction at any bank branch, which gives the euros to the Bank of America.
Currency is a Letter of Undertaking of the Bank of America
Currency is in fact a letter of undertaking of the Bank of America for the amount listed on it. The signature of the Governor of the Bank of America appears on every bank note (= letter of undertaking), bearing witness to the obligation of the bank.
For example: A 100 USD bill is a letter of undertaking for 100 USD. According to this letter of undertaking, the Bank of America is obligated to give euro to whomever turns in the letter of undertaking (bank notes). The number of USD depends on the exchange rate for the euro at the time that the letter of undertaking is turned in.
If the exchange rate of the euro is 0.66 per USD, a person turning in a 100 USD bill will receive 66 euro.
When an European tourist arrives in the USA and needs USD, they go to the Federal Reserve, gives it the euros and receives a letter of undertaking (bank notes) according to the exchange rate at that time.
For example: If a tourist arrives at Time A, when the exchange rate of the euro is 1.50 USD and pays 1,000 euros to the Federal Reserve, they will receive bank notes with a total value of 1,500 USD (the amount of USD in the country increases by 1,500 USD).
If the tourist has 1,000 USD left at the end of their visit (Time B) when the exchange rate of the euro is 1.50 USD, they will pay their USD to the Federal Reserve, and receive 667 euros for them. The letters of undertaking (bank notes) that are signed by the Federal Reserve obligates the bank to pay the euros.
When the tourist gives the Federal Reserve 1,000 USD, the amount of USD in the country is reduced by 1,000 euros. The act of exchanging euros for dollar bank notes is simply called “buying dollars”. Its opposite is called “selling dollars”.
These terms are used instead of “exchange” which we used in the above explanation.
Issuing New Notes and Accepting Them in Return
Whenever the Bank of America receives euros, it is supposed to issue new bank notes; the amount of currency in the country grows accordingly. Each time the Bank of America receives currency (in exchange for buying euros) it is supposed to destroy them, so that the amount of currency in the country will decrease accordingly.
The Bank of America does not actually destroy the bank notes that it receives from one party, and issue new ones when required to do so by another party. In practice, the currency that the Bank of America receives is placed in a vault and is treated “as if” it was destroyed, and is not counted as part of the currency in the country. When the bank receives euros, it takes the bank notes out of the vault (instead of issuing new ones). These notes then become part of the currency in the country.
A Personal Letter of Undertaking
Every person is entitled to buy euros from a tourist in exchange for a personal “letter of undertaking”.
Assume that the exchange rate of the euros is 1.5 USD. The tourist gives a person 1,000 euros and receives from him a letter of undertaking for 1,500 USD , as follows:
Letter of Undertaking in the Amount of $1,500
I, the undersigned, undertake to at any time deliver Euros equivalent to 1,500 USD, according to the exchange rate of the dollar at that time, in exchange for this letter of undertaking.
For example, if the exchange rate of the euro is 1.5 USD, I will deliver 1,000 euros (and receive the letter of undertaking, which I will throw in the trash).
This letter of undertaking is transferable (like a check).
My undertaking will be valid to anyone who presents me this letter of undertaking.
It would be difficult for the tourist to purchase something from a store or pay for something in a hotel using a letter like this. The bank notes issued by the Bank of America are also letters of undertaking. The major difference is that the tourist can purchase something from a store with them or pay for something in a hotel.
The letters of undertaking issued by the Bank of America (i.e., the currency), have the status of “legal tender of the State”. Everyone is legally required to accept them as a means of payment.
If a person found a tourist willing to accept his private letter, two lines would be added to the issuer’s personal balance sheet: One line on the asset side, and one line on the liabilities side. Each line lists $4,000, as follows:
The Balance Sheet of Alan Avrahami as at January 1, 2001
(1,000 euros - The euros received by the issuer)
$1,500 (“Letter of Undertaking”)
(The letter of undertaking has the status of debt. The issuer will be required to pay it by returning the euros in your possession, as if he had received a loan to purchase the euros).
Receiving the euros for the letter of undertaking does not make a person wealthier at all. There is neither profit nor loss on the transaction.
When a tourist sells Euros to the Bank of America in exchange for currency, the transaction is recorded in the balance sheet of the bank as follows:
Additions to the Balance Sheet of the Bank of America
+ Euros ($1,500)
+ Bank Notes $1,500
These lines are added to the rest of the assets and liabilities of the Bank of America, which are not listed here. Only the additions to the assets and liabilities appear here.
On the one hand, 1,000 euros, worth $1,500 on the day of purchase is added to the bank’s assets. On the other hand, $1,500 was added to the liabilities of the bank. The Bank of America neither profits nor loses on this transaction.
When a tourist buys euros from the Bank of America in exchange for dollars, it is recorded in the balance sheet of the Bank of America as follows:
- Euros ($1,500)
- Bank Notes $1,500
$1,500 is subtracted from the assets of the Bank of America, and the Bank of America’s liabilities are also reduced by $1,500.
The Bank of America neither profits nor loses on this transaction.
Selling Euros Directly to a Private Individual or Firm
If a tourist sells his euros directly to an inhabitant of the country, the amount of currency in the country does not increase; currency passes from one person to another. What does changes is the amount of euros in the hands of the inhabitants of the country (the euros that the tourist sold are added to the total).
The Uniqueness of the Money Market
In all other markets, those interested in a product buy it. Every product has buyers and sellers.
In the money market there are no buyers and sellers; there are borrowers and lenders:
- Those with a shortage of money can borrow it.
- Those with surplus money can lend it.
The amount of money passing from the lender to the borrower is called the “principal”.
The lender demands interest.
A separate chapter will be devoted to interest and its ramifications. Let it be noted here that interest is payment for the use of money.
If the interest is 0%, many people will want to borrow. If the interest is very high, few people will want to borrow.
The word “interest” can cause confusion, because it is used as an abbreviation for both the rate of the interest and the amount of the interest.
- The interest rate refers to the percentage of the principal paid yearly for the use of money.
- The interest amount refers to the amount of money paid yearly for the use of money.
In this chapter, the word interest refers to the rate of interest rate; the term interest rate will be used.