Central bank money

Central bank money is a liability on the balance sheet of the central bank that is held as a credit balance in the holder's account at the central bank or as a physical object and is denominated in units that are given the name that defines the currency. The sovereign political authority defines it as legal tender and entrusts the central bank with the power of issuing it as sole supplier.

As a physical object, central bank money is called cash or currency and consists of banknotes and coins (note that coins are typically issued directly by the treasury office of governments). Cash provides a means of extinguishing debt with no intermediary and is typically preferred for small-value payments when the transaction cost of alternative means is proportionally large or to prevent the tracing of transactions when parties desire anonymity of payment for privacy, tax evasion or other illegal reasons.

Central bank credibility

For neoclassical economists, central bank credibility means avoiding high inflation rates degenerating into low economic growth and high unemployment rates (Barro and Gordon, 1983). A credible central bank fulfils its low inflation announcement, and agents believe its commitment to price stability. A central bank's credibility is therefore measured by the difference between the central bank's inflation plan and what the public believes about these plans (Cukierman, 1992), or, in the framework of inflation targeting, by the gap between inflation expectations (or current inflation) and the inflation target (Svensson, 2011).

Theoretical foundations of the neoclassical view of central bank credibility (see Barro and Gordon, 1983) are the vertical Phillips curve, the rational expectations hypothesis and the game-theoretic approach of time inconsistency: the central bank has private information on its type ("hawk" or "dove" on inflation) and plays a game against economic agents. A non-credible central bank plays a fooling game by violating its announced inflation target. It fools agents' expectations to exploit the Phillips curve and boost employment, the cost being higher inflation ("inflation bias").

Fisher effect

The Theory of Interest (Fisher, 1930) is grounded in neoclassical economic thought. According to Fisher (ibid., p. 495), the interest rate is determined by three conditions: (i) market equilibrium; (ii) "at the margin of choice", the equalization of the rate of time preference with the market interest rate; and (iii) the equalization of the "rate of return over the cost" with the market interest rate. The equilibrium interest rate is therefore determined by real (non-monetary) variables: the rate of time preference that determines savings (an upward-sloping function), and the marginal return on investment that deter- mines the demand for loans (a downward-sloping function).

Friedman rule

There is some terminological variety, and hence confusion, in the academic literature and the economics profession regarding "the Friedman rule", which should rather read "the Friedman rules". Indeed, there are at least three distinct meanings, or versions, of what has been referred to as the "Friedman rule" (or "Friedman's rule"). These three versions basically correspond to the evolution of Milton Friedman's own ideas on the appropri- ate rules to govern monetary (and fiscal) policy. He himself admits the contradictory prescriptions to policy makers embodied in his earlier and later work, for instance in the heading and content of his concluding section, "A final schizophrenic note", of one of his major essays (Friedman, 1969, pp. 47-8).

Bullionist debates

The bullionist controversy took place during the Napoleonic Wars, in particular after the policy measures of 1797 according to which Great Britain abandoned the gold stand- ard and thereby the convertibility of banknotes to gold. The commitments of Great Britain to its allies and the remittances of gold bullion to foreign countries dangerously depleted (from 10 million to 1.5 million British pounds) the Bank of England's (BoE) gold reserves. The rising military expenditures of the British government coupled with rumours of an imminent French invasion triggered a run on the banking system and led the BoE to the suspension of the gold standard and payments in metal. The prohibitions of payments in gold increased the price of the specie from its mint parity of £3/17s/10½d per ounce to £5/10s in 1813. The British pound depreciated with respect to foreign cur- rencies and the domestic price level increased. Hence, the purchasing power losses of the pound (domestically and internationally) became the focal point of the debate (Viner, 1937 [1965]).

Financial crisis

The global financial crisis of 2008-09 led to some questioning of the neoclassical orthodoxy on the grounds that it had failed to foresee this momentous event (see The Economist, 2009; Krugman, 2009; Colander, 2010). Such criticism is justified. The main- stream's principal notions - the rationality of its homo oeconomicus, the self-balancing propensity of markets, money's neutrality, and macroeconomic models devoid of any sig- nificant role for finance - all combine to make it conceptually hard to imagine how finan- cial crises may ever develop from within the growth dynamics of capitalist economies. If financial crises arise at all, in this view, they do so as exogenous shocks in response to which asymmetric information problems between lenders and borrowers (for instance, adverse selection and moral hazard) intensify to the point of destabilizing credit. (An early proponent of the information-asymmetry school of financial crises is Mishkin, 1991.) Corollary to this benign view is a theory of finance known as the efficient-market hypothesis (Fama, 1970), according to which financial markets always price the various claims correctly, making it impossible to conceive of sudden financial-market crashes as a recurrent feature.

Dollar hegemony

Today, the world economy operates under the artifice of US hegemony, fortified by the US dollar as an international reserve and vehicle currency. How did the United States arrive at achieving such pre-eminence?

From 1944 to 1973, the financial architecture of the world economy centred on a US- engineered Keynesian accumulation agenda as a response to the devastation wrought by the Great Depression. The capitalist institutional structure, or social structure of accu- mulation (see Kotz et al., 1994), rested on finance being subservient to the promotion of industrial enterprise.

With socially-engineered capital-labour compromises in developed countries, neo- colonial governing institutions in the Third World, active State regulation in decisions with respect to capacity utilization, and a co-respective form of competition among large corporations set by regulations that brought together monetary authorities and large banks as well as large industrial capitalists, the post-World-War-II system was the era of "regulated capitalism". Altogether, the world system was underpinned by the Bretton Woods arrangement, which called for globally fixed exchange rates against the US dollar tied to the price of gold and capital controls.