Money and Banking

You might be able to teach an entire course on the microeconomics of money and banking based on the following thought experiment.

Imagine the following scenario. I want to start a business, but I need to borrow $10,000 to get started. You offer to provide me with that $10,000. However, since you won’t get to consume using that $10,000 and you won’t get to invest that $10,000 in anything else you require that I pay you some interest. I give you a piece of paper that promises to pay you back, with interest, at some future date in time. Intrinsically, that piece of paper that I have given you is worthless. It is just a piece of paper. However, if that piece of paper represents a legally binding agreement, then we call that piece of paper a bond. You are willing to accept that piece of paper from me because you anticipate that I am going to do something productive with your money. In the event that I don’t, you will be entitled to the assets of my business. So, the value of the bond is the expected value of the bond over the duration of the loan plus the value of the option to seize my assets in the event that I cannot/do not pay you back. Now, of course, there is some chance that between now and when I have promised to pay you back you will want to spend money. As a result, a market emerges that allows you to sell this piece of paper to other people.

Now imagine the following alternative scenario. Suppose that you want to save, but you don’t want to deal with trying to figure out how to invest that savings. Fortunately, we have a mutual friend who likes to do this sort of thing. So you give your $10,000 to our friend and he promises to give you your money back plus some interest payment. I also make a visit to our mutual friend, but I ask him to borrow $10,000. He agrees to lend me $10,000, but I have to pay him back with interest (slightly higher than what he is offering you). Since our mutual friend knows that you might need cash for unexpected expenditures in the future, he promises to give you the right to show up and demand your $10,000 (or some fraction thereof) at any moment you want. Thus, to our mutual friend, the value of the loan is the expected value of the loan over the duration agreed upon plus the expected value of the option to seize my assets in the event that I cannot/do not pay him back. The value of the contract for you is the expected value of the loan that you have given our mutual friend plus the value of the option to get your $10,000 back whenever you want plus the value of the option to seize the assets of our mutual friend in the event that the value of his assets decline below what he owes you.

What is the difference between these two scenarios?

Some would say that in the latter scenario the problem is that our mutual friend is offering to give you dollars that he himself does not have to give. Thus, he is “creating dollars out of thin air.” In fact, if he doesn’t have actual dollars, he might give you a piece of paper that promises to give you those dollars in the future. If you are able to trade these pieces of paper in exchange for goods and services, it would appear as though our mutual friend has really created money out of thin air. But has he really? Or is he merely allowing you to transfer some fraction of what he owes you to another individual?

Why might people be willing to accept these pieces of paper printed by our mutual friend and use them in transactions?

Replace “$10,000” with “7.5 ounces of gold.” Do your answers to these questions change?