How Money Works The Facts Visually Explained
THE FACTSVISUALLY EXPLAINED
345 Hudson Street, New York, New York 10014 above, no part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, inCopyright © 2017 Dorling Kindersley Limited any form, or by any means (electronic, mechanical, DK, a Division of Penguin Random House LLC photocopying, recording, or otherwise), without the prior 17 18 19 20 21 10 9 8 7 6 5 4 3 2 1 written permission of the copyright owner. She has worked as a writer and editor Beverly Harzog (consultant and writer) is a consumer at The Guardian, The Times, and The Telegraph, and a wide range of financial websites and magazines.credit expert and best-selling author.
HOW MONEY WORKS
Without it, the industry and trade that form the basis of modern economies wouldgrind to a halt and the flow of wealth around the world would cease. Over the centuries, money has appered in many forms, but, whatever shape it takes, whether as a coin, a note, or stored on a digital server, money always provides a fixed value against which any item can be compared.
BCE BCE BCE CE(10,000–3000 ) (7000 ) (600 –1100 ) In early forms of trading, specific Pictures of items were used to record Defined weights of precious metals 12 13 The evolution of money
SUPPLY AND DEMAND
How it works Money A universal Money is not money unless it has all of the of money following defining characteristics: Money must have value, be durable, portable, uniform, Since the early attempts at setting divisible, in limited supply, and be usable as values for bartered goods, “money” a means of exchange. 5,000 4,000 1,000 600 600Barter Cowrie shells Athenian drachma Early trade involved Used as currency The Athenians used directly exchanged across India and the silver from Laurionitems—often South Pacific, they to mint a currency The evolution of money 16 17GEORG SIMMEL AND THE PHILOSOPHY OF MONEY Published in 1900, German sociologist Georg Simmel’s book The Philosophy of Money looked at the meaning of value in relation to money.
ARTIFACTS OF MONEYCOPPER 1540-1640
As a result, the amount of money in existence and in circulation increased enormously. Economics as adiscipline emerged, in part to help explain the inflation caused in Europe by the large-scale importation ofsilver from the newly discovered Americas.
THE NEW WORLD 1970
As a result, people spend in circulation in 2016— the “bad” coins and hoard the “good” undebased ones.worth $9 billion 15531694 JOINT-STOCK Early joint-stockBank of England COMPANYcompanies The Bank of England $ Merchants in England was created as a body thatbegan to form companies in could raise funds at a lowwhich investors bought interest rate and manageshares (stock) and national debt.shared its rewards. In the 18th century, economist Adam Smith the discovery of the Americas and the growth of proposed that government intervention—controllingnation states in Europe in the 16th and 17th centuries, wages and prices—was unnecessary because the individuals began to think in more detail about the self-interested decisions of individuals, who all wantidea of economics.
PROTECTIONISM AND MERCANTILISM
In Mercantilism began to go outEurope at the time this took the of fashion in the late 18th more effectually form of mercantilism, which century under the pressure of held that to be strong, a country new ideas about economic than when he really must increase its exports and specialization put forward by do everything possible to Adam Smith and David Ricardo. Laissez-faire An economic❯ theory that holds that the market Seller A drops his price slightly Seller B sees she can raise her will produce the best solutions in in order to regain customers price slightly and her goods willthe absence of government and compete with Seller B.still be in demand.interference.
INVESTMENT AND SPENDING STIMULATING DEMAND
Fisher’s quantity theory of money Marx’s labor theory of value The most common version of this theory was articulated The German economist Karl Marx argued that the real by Irving Fisher, who argued that there is a direct link price (or economic value) of goods should be determinedbetween the amount of money in the economy and price not by the demand for those goods, but by the value of level, with more money in circulation increasing prices. $10 $1 pair 2 hours’ labor $20 Low money Demand for High demand Money buysof shoes at $10 / hour supply money rises increases value more goods$15 $ The evolution of money 22 23How it works Scholars in the early 16th century were the first to note an equilibrium price by itself.
LOW INTEREST$100 $100$100 Interest rates $ $ Interest ratesraised to 1% GDPcut to 0.25% C EEmployee Spends Supermarket Supplier pays E R CTI paid $100 $100 pays supplier $100 employees $100 O N Y R E HIGH INTEREST V$5$50 CO E$ R$5 $ $ €$ $ $ $ $ $$ $ $ $ %$
For example, a way of calculating earnings per share (see “Need to know”), which investors use to weigh up the value a business could be earning plenty of revenue, but also incurring a lot of expenses via investment in of a company and its shares.new markets, premises, or machinery at the same time. Analyzing the balance of revenue earned against In order for investors to work out whether a company the cost of tax, investment, and other expenses is one is financially healthy, therefore, they need to be able to of a number of ways to assess how a company is faringcompared with its competitors, and if it has a sound see how it is managing costs, and whether it isfinancial basis going forward.spending money in the right way.
incomeTOT For investors trying to decide whether AL R a particular company represents a $10 EVE good investment opportunity, net NU 0,00E income helps them to understand the way the business is run and is a guideto the real profit the company is making, rather than just the revenuesit is generating. Revenue earned is Materials the starting point, and the cost of $20,000 tax, banking and interest charges, depreciation of assets, staff costs,and any other expenses involved in operating the business are deducted Expenses from this figure.
So, while net net income in 2016 − income is an important indicator of a company’s financial health, it should not be TSthe highest quarterly used as the only means of assessment. Staff$30,000 Depreciation of assets The❯ Expenses decline in value of assets that the company has bought; this may be a plant for manufacturingprocesses, or specialty machinery.
Some costs, such as When to expense For businesses wanting to have a smoother flow of reported incomeand for start-up businesses, it can be attractive to capitalizepurchases because by keeping costs down, a business canreport a higher income in its early years. An order oran expense that had not yet been paid for was recorded as incomeearned, and as a result company earnings appeared higher than Whether a cost incurred can A business may decide to capitalize a cost, and then spread it over a number of years.
THE BALANCE SHEET
can record an expense as it occurs or at the time of Known as capitalizing, this practice has the advantage payment and reduce the annual profit accordingly. of taking costs out of the business gradually, ratherThis practice, known as expensing, will show up than in one lump sum.
This is likely to lead to Bills must be paid more volatility in reported earnings, at once and can’t but may be useful if the company be capitalized.is trying to keep its profits down, for example for tax purposes. The company can record the reduction in the value of the vehicle in its accounts as depreciation.
5 Calculating amortization
VALUE ($) A company buys the patent for a computer design. The initial ,00 $25,000$21 ,00 cost of this intangible asset can be gradually written off over $18 several years and can be used to reduce the company’s taxable profit.
MI 40,000 COST − SALVAGE VALUE DEPLETION 30,000 X UNITS EXTRACTED = TOTAL UNITS EXPENSE ($) 20,000 Corporate accounting 32 33How it works a physical presence, such as a patent) can be gradually Depreciation is used to calculate the declining value written off over a number of years. It reduction in value of an asset that is a naturalis a measure of how much the value of an asset falls resource.
7 TIME (YEARS)
For Profit and loss account A❯ statements of a company will show example, managers can manipulatefinancial statement showing a regular and steady growth, whichfigures by choosing when to make company’s net profit or loss in aencourages people to invest in it.provision (set aside money) for large given period of 6 or 12 months. Rather than making Volatility The ups and downs❯ illegally, to disguise or hide losses large investments, paying backof income or reported profits.and encourage investors to buy loans, or making provision for biginto a company that is insolvent.costs in a year in which income has Volatile earnings Company A does not keep money in reserve to pay for large expenses or to cover its running costs incase of a downturn in profits.
FAMOUS ACCOUNTING SCANDALS
ENRON (2001) WORLDCOM (2006) BERNIE MADOFF LEHMAN BROTHERS
to have far more assets returns out of their founded in 1850, When the company than it actually owned, own money, and the had $50 billion ofcollapsed, accountants thanks to false entries business was only losses in the form found that the balance detailing sales that sustained by of worthless assetssheet had huge hidden never existed. Some of the world’s biggest corporate finance scandalshave involved hidden losses, loans made to look like income, andmisstated profits to make the company in question appearsolvent when it is not.
IN CASH OUT CASH OUT CASH OUTCorporation tax based on profits shown in annual financialstatements or stockOther revenueGrants, donations, and windfalls❯ SuppliersPayments for materials and services❯ Cost of raw materials needed to manufacture goods for sale ❯ Cost of stock—local or imported ❯ Fees for services (consulting or advertising) to generate revenue ❯ Payments to contractors involved in providing goods and services TaxPayments to tax authorities❯ Payroll tax paid by employers on behalf of employees C A SH See pp.32–33. ❯ Offset by depreciation. Cost of building and equipment, such as computers and phones,office furniture, vehicles, plant, and machinery EquipmentPurchase of fixed assets❯ The type and rate of taxes vary ❯ Sales tax and/or VAT on goods or services ❯ ❯
No matter of when payments are due from ❯ A gap between credit terms—for how profitable a business is, it customers, and of when a business example, outgoings set at 30 daysmay become insolvent if it cannot has to pay its own wages, bills, and invoices set at 60–120 days.pay its bills on time. economic climate, competition, or victim of its own success and If cash flow is mismanaged, a the product becoming outmoded.fail through “insolvency by business may have to hand out Underpriced products , usually❯ overtrading” if, for example, it money before it receives payment, in start-ups that are competing.
CASH INCASH IN CASH IN HAND CASH IN HAND
The doing well may decide that it can afford to increase its investments or pay higher Corporate accounting 38 39 ❯ Factor A third party which, for a ❯ Cash conversion Successful commission, collects payment from businesses convert their product 80 % a business’s customers. to poor cash flowInvesting cash flow Movement of ❯ ❯ Aging schedule A table charting money into and out of a company accounts payable and accounts management from investments in bonds, receivable according to their dates.businesses, or stock markets.
HANDLING THE FLOW
NO CASH IN CASH IN
CASH DRIES UPA business with a cash shortage might: Lower prices to increase sales, or ❯CASH raise them to increase profit. Less cash is flowing into the business If cash flowing out continues to exceedUse an overdraft or short-term ❯ than is flowing out.
COMPANY HAS MORE DEBT
Typical examples of debt are loans and bonds.and risk Capital gearing is the balance between the capital a UITY EQ company owns and the funding it gets from short- or long- term loans. If theLow risk attracts more investors ❯rin level of gearing is high (that is, the a and boosts credit rating e business has taken on large debt g Finance from shares does not have ❯ in relation to its equity), investors to be repaid wwill be concerned about the ability o Shareholders absorb losses ❯ of the business to repay the debt.
Unpaid lenders can seize assets andforce bankruptcy ❯ Tax authorities and lenders are to be paid first in the event of insolvency Debt finance (loans)Highgearing D E BT A low proportion of debt to equity is also described as a low degree of financialleverage. D EB T Repayment is a known amount that can be planned for Company retains control of decision-making Corporate accounting ❯ Overleveraged A situation in ❯Creditors Those to whom a debt is due or a payment needs to be made (shareholders are alwaysbehind loan-holders in the order of repayment).
COMPANY HAS LESS DEBT
If If a lender is concerned about a lump sum of cash, paying back the company then makes a profit,how a company is being run, or the full amount with interest in it may have to pay dividends toits future ability to pay its debt, it regular payments over a fixed shareholders. the loan or ask the company control over its business strategy, Firms may use both methods to reschedule its debt, thereby unlike when shares are sold.to fund investment, and each paying a higher rate of interest By issuing shares, a company is approach has different pros and to compensate the lender for theselling ownership (equity) stakes cons, but without the facility to increased potential risk.in the business.
be funded by small bank loans and seed capital, turning toventure capital when they expand, Too much debt , and it won’t attract any Too little debt , and it may be forced which may involve issuing shares. In five yearsng VS LOAN BANK 2BANK LOAN th B 5% PROFITA $ $$ BANKB Le ngLOAN BANK 3th CAIR 7%Cretain control of The firm opts for a debt package AIR does not need to pay any of its In order toits own decisions, AIR opts for from three different banks.
ASSETS, LIABILITIES, AND CAPITALSYMBOLS FOR DEBITS AND CREDITS
Although it is a good guide to the financial health of a company, doctoredreports can, and in the past have been used to, hide large debts or liabilities, and not reveal them to the auditorswho are checking the annual report or balance sheet. Auditors may be alerted to fraud by a number of “red flags” or warning signs—these could be anything fromnegative cash flows that miraculously become positive the following year, to sales registered before they have WARNING Stock and work in progressDebtorsCash at the bank and in handTotal current assets Corporate accounting 44 45(or non-current assets) cannot easily Fixed assetsbe converted into cash and are usually bought for long-term use.
WHY HOLD FINANCIAL
See pp.78–79 See pp.80–81 How it works shares for capital growth (hoping Shareholders are investors who buy the underlying value or price of the the shares a company creates, and shares will rise) and for income if Listed A share that appears on❯ who therefore own a part of the the shares pay dividends. If a share price fluctuateselectronic, and prices can be seen changing minute by minuteshare issues and other money- in a short space of time it is said to during the course of the day.raising activities, and in some cases be volatile.
How it works Investors may buy derivatives in order to reduce the amount of volatility in their portfolios, since they canagree on a price for a deal in the present that will, in effect, happen in the future, or to try to increase theirgains through speculation. The most common are futures and options—leveraged products in which the investor puts down a smallproportion of the value of the underlying asset and hopes to gain by a future rise in the value of that asset.
TIME (IN MONTHS) PR
1 2 3 DerivativesA type of financial instrument, the value of derivatives is based on the price of an underlying asset or index. Derivatives for speculation Investors may buy or sell an asset in the hope of generating a profit from the asset’s pricefluctuations.
$PROFIT $1 $ An investor notices a company’s If share prices do rise, the investor If share prices fall, the investor share price going up and buys can profit by buying at the fixed can sell the option or let it lapse, Financial marketsThe flow of money around the world is essential for businesses to operate and grow. Investors are not restricted to placing their moneywith companies in the country where they live, and big businessesnow have international offices, so Investors buy via When shares are easy to buy A stock is known money needs to move efficiently brokers, who set and sell, the market is said to be by its “ticker”—between countries and continents.
FINANCIAL MARKETS AROUND THE WORLD
The global markets are closely connected and sharp rises or heavy falls in Asia, or the Checking prices across markets Frankfurt, Germany Financial markets Euronext has headquarters inAmsterdam, Brussels, Lisbon, London, and Paris ($2.56 trillion). Toronto, Canada The New York Stock Exchange (NYSE) is the largest in the world (marketcapitalization—the market value of its outstanding shares: $14.14 trillion),followed by the NASDAQ, which is also based in New York, ($5.63 trillion).
The money marketBanks and companies use the money market to buy and sell financial assets that have short maturity dates, and that are easy and quick to exchange. For instance, banks may sometimes need to borrow in the short term tofulfill their obligations to their customers, and they use the money market to do so.
QUICK ACCESS TO SHORT-TERM
Otherwise, if a large number of customers wish IC A to withdraw their money at the same time, there may T E COMMERCIAL PAPER S O be a shortfall between the money the bank has lent MO F D and the cash deposits it needs to return to savers. This creates a mismatch between the money they have available and the moneythey have loaned out, so the bank will need to borrow in order to be able to fulfill the demand for loans.
NEED TO KNOW Money market funds Collectives that offer “baskets” ❯ of financial instruments to individual investors, allowing COMPANIES INVESTORS them to invest in the money market with a sum of less A company that has a cash Individuals seeking to surplus may “park” money for a invest large sums of than $50,000. It treasury bills and commercial financial instruments.is a very influential interest rate in the US economy—if paper, certificates of deposit, Sums of less than Forex profit and loss A trader wants to sell some UK pound sterling (GBP) and buy euros (EUR)because they think that the value of the pound is going to fall againstthe euro.
DEPOSIT BORROWED MONEY
At one point on that daythe Swiss franc rose by 30 percent against the euro and 25 percent WARNING FOREX INVESTOR ACurrency trading at: Buying £0.79/€1, Selling £0.77/€1 thinks that this is a good price and decides to trade, borrowing £79,000 to do so. This might be in order to travel abroad, to make The forex market is open 24 hours, 5 days a week, investments in another country, or to pay for import which makes it unusual, as equity markets have setproducts or convert export earnings.
MANAGING THE SALE
A private company may decide Prospective buyers of the shares to issue shares because it needs will be able to read about the money to expand and grow, company in its prospectus. A company that is preparing to float will use the services of $2Public several investment banks to gauge and gather support for the sale of $2 its shares from institutional and private investors before setting R a price.
The primary market is where new shares are created They may also underwrite the Initial Public Offering and first issued, whereas the secondary market is (IPO) and guarantee to take on unsold shares. When a company is preparing to different price on the stock exchange (in the secondaryfloat on the primary market, investment banks will market) from the first day of issue.
Secondary marketPrices are not fixed and change with When investors talk about shares the fortunes of the being bought and sold, they are company, supply usually talking about transactions and demand forStock exchangethe shares, and taking place in the secondary financial and Investors can buy and sell shares that market. Investors also need to know how markets and economies are vs behaving, and how that behavior Investors use is likely to affect the performance of fundamental Company B other sectors or companies, beforeanalysis to educate deciding to buy shares of companiesthemselves about a that they think will do well in thecompany’s challenges, hope of achieving capital growth.profits, market position, and COMPETITOR S However, prediction techniques Investors can ga prospective growth.
GLOBAL DATA ANALYSIS
Investors use it to help them determine which way ashare is trending, and to prepare them to respondto market signals that indicate whether theshare is likely to go up or down in value. Because stock, bond, and currency marketsaround the world are intimately linked, what happens on the Asianmarkets can affect markets in theEurozone, UK, or US, and have a bearing on opening prices when thesemarkets begin trading later in the day.
VOL UM ES
For example, if a trader can buy shares in Company A on the US exchangefor $2.99 each and sell them on the UK Company A exchange for £2.30 each, which was equal 9 to $3.01, the trader will make a profit of $2.9 $0.02 per share. Arbitrage, Arbitrage is the practice of buying a tradeable asset as currently practiced in stock and bond markets, in one market and almost simultaneously selling it at is only possible due to the computing power nowa higher price in a different market.
3. Receive profit
carry out large volumes of trades. These trades were also highly leveraged using LL billions of dollars borrowed from other E S financial companies.
2. Sell share at UK = $3.013investors to move their capital to less price to make a small=profit—in this case, risky investments. LTCM sustained huge
The US government had to intervene in order to prevent a collapseof the debt markets and damage to the global economy. The automated program carries outthe transactions within a fraction of a second 60 %OK Cancelof US equity trading was estimated tobe High-Frequency A trader can manipulate the market by processing a lot of small sellorders in an attept to drive down the price of a share.
THE LIBOR SCANDAL
PU SHING SHA RE PR
How it works make profits by trading large volumes of shares in one Investors typically buy or sell a share based on their transaction, or by making multiple trades during the analysis of economic or market trends, research into course of the day. usually “close out” all trades (selling the shares theyUnlike such investors, day traders look for small have bought, and vice versa) at the end of the day to movements in prices that they can exploit to make a protect themselves from off-hours movements in thequick profit.
Public and$ $ $ $investors 70 71 Financial institutions 71 70Invests cash from deposits and interest payments Provides financial services tobusinesses and deals in large transactions,providing loans, mortgages, andsavings products. See pp.72−73 Profits from brokerage and corporate advisory roles$ $$ $ $ $ $ $639 billionvalue of Lehman Brothers investment bank when itfiled for bankruptcy in 2008 ❯The result of the Brexit vote in 2016 led to a sharp drop in the value of the pound.
INTEREST ON LOANS COMMISSION TO BROKER
See pp.72−73 Profits from brokerage and corporate advisory roles$ $$ $ $ $ $ $639 billionvalue of Lehman Brothers investment bank when itfiled for bankruptcy in 2008 ❯The result of the Brexit vote in 2016 led to a sharp drop in the value of the pound. Commercial banks advise and lend to businesses, to retail orsmall-business customers, to business start-ups that need capitalto grow, and to large businesses that need multimillion dollarfunding for major projects.
INTEREST RECEIVED SAVINGSINTEREST PAID
72 73Attracting new customers It is cheaper and easier for banks to sell products to existing customers—apractice known as cross-selling—since they know more about those customers’ individualfinancial circumstances. Capital reserve A sum of money that a bank is not permitted to lend or invest.
INTEREST PAID ON LOANS OVERDRAFT CHARGES ANNUAL FEES AND MONTHLY CHARGES ON CREDIT CARDSINTEREST RATES ON SAVINGS ACCOUNTS DIVIDENDS TO SHAREHOLDERS
INTEREST PAID ON MORTGAGES
It is cheaper and easier for banks to sell products to existing customers—apractice known as cross-selling—since they know more about those customers’ individualfinancial circumstances. Capital reserve A sum of money that a bank is not permitted to lend or invest.
CHARGES FOR TRANSACTIONS ON BUSINESS ACCOUNTS MONTHLY OR ANNUAL FEES ON SAVINGS ACCOUNTS
If the companies to new issue is not popular, the bank may be left holding market the shares on its books and may have to sell them at aInvestment banks can loss in the future; if the new shares are in demand andraise funds for new the open market price rises above the issue price, theissues, underwriting bank will make a profit. HOW BANKS MAKE AND LOSE MONEYBringing Making moneycompanies together Banks receive fees in return for ❯ providing advice, underwriting services,Banks facilitate mergers $ loans and guarantees, brokerage and acquisitions (M&A) services, and research and analysis.by advising on the value of companies, ❯ They also receive dividends from the best way toinvestments they hold, interest from proceed, and howloans, and charge a margin on financial to raise capital.transactions they facilitate.
OFFER PRICE $420
governments in exchange for a fee,to fund the payouts required when Without insurance, individuals or premium, which represents a small proportion of the value of the a small number of those customerswould be exposed to unexpected risk they have agreed to cover. make a claim.events leading to financial hardship, INSUREESInsuring a business Individuals or businesses will each pay a premium—a fraction If a business wants to insure of the financial value of risk against the risk of adverse events, insured—to cover them against such as a fire destroying its fire, death, accidental damage to their house or car, and theft.
Risks that are not covered areclassed as “exclusions.” $ $ $ $ $ Financial institutions 78 79REGULATION NEED TO KNOW It is important for the insurance Premium The amount of money Loss A result of not charging enough❯ ❯ industry to be well regulated in an insurance company charges to in premiums, a fall in the price oforder for it to work properly.provide the cover described in the investments, or by having large Regulators monitor the insurance policy or bond. the maximum amountWARNINGof total assets a diversified Charges Investing in a fund can❯ include administrative charges, 5 %investment company can management fees, and entry and exit fees, in addition to the cost of hold in a single security the units in the fund.
In the UK, banks of customers on their books who are at a medium or are now required to be more stringent about their high risk of not being able to pay back their loan orlending criteria and to hold higher levels of reserve mortgage. NBFIs are not subject to the tougher criteria that traditional banks must meet when they lend toindividuals or businesses, and may also offer lower interest rates and larger amounts of credit than banks are allowed to provide.
$ 42 %of consumers haveused NBFIs in the last12 months PAWNBROKERSThese offer secured loans to people who put up an asset,such as a car or jewelry, as collateral on the debt. For the borrower, terms and conditionsmay be less favorable, while lenders may find it difficultto establish the creditworthiness of those to whom they are lending.
$ $$ $ GOVERNMENT FINANCE AND PUBLIC MONEYThe money supply Managing state finance ❯ ❯Attempting control Why governments fail financially ❯ ❯$ The money supplyThe money supply is the total amount of money in the economy at a given time. This is money in a form that can be readily used as a medium of exchange, and includes bills, James Garfield coins, traveler’s checks, and some types of bank accounts.
FIAT CURRENCY VS REPRESENTATIVE CURRENCY
Similarly, if the customer wants to use theloan to pay money into a different bank account in a different bank—having for example paid for goods with a debit card—the issuingbank must be able to persuade the second bank to accept thetransfer of credit money. This is because the bank can expect to recoup the money ithas issued as a loan, along with the accrued interest, and it has a legalright to enforce the repayment should the customer refuse to pay.
DOUBLE ENTRYBANK BALANCE SHEET: LOANS
When a bankIn accounting, this bookkeeping makes a loan to a customer, the asset to the banksystem requires that every business The balance (the amount of the loan) is balanced exactly by the transaction is entered twice in at sheet liability to the bank (the credit deposited in the least two accounts to demonstrate records customer’s account). unable to honor all withdrawals Reserve requirement or❯ This is the minimum percentage should all of its depositors try to reserve ratio The percentage of total deposits that banks must withdraw their money as cash at of total deposits that a bank musthold as actual currency, in case the same time.
COMMERCIAL BANK CENTRAL BANK SETS
This original sum A is then multiplied many times over $1,000 is deposited in Bank A Bank A holds $50 of this as borrowers deposit their loan into by Customer A, and her account deposit as a 5% reserve.other banks, which, in turn, loan is credited with $1,000.money to yet more borrowers. As Investors fear that company of lending by banks meant that money was harder to get hold of,profits, and the value of stocks, some loans were going to riskier spending slowed and the global 92 93 The money supply How it works A recession is a period during which the economy, as measured by its GDP, is shrinking, meaning thatless is being bought and sold in that economy.
CLOSED WALL STREET BLACK TUESDAY
The money supply 94 95How it works defaults and bankruptcies, and unemployment levels A depression occurs following a protracted period of rise as individuals and businesses stop spending. deep recession, and when an economy is stuck in a Government attempts to stimulate the economy by perpetual cycle of decline there can be catastrophic pumping more money into it no longer work, andresults.
ET RE ST LL
40%WA NEW DEAL the amount theaverage US income fell between 1929and 1932 6. The depression spreads 7.
D. Roosevelt introduces the
People tend to hold on to money having lent a lot of money toNew Deal, to fight the depression in economically unstable times European countries, recalls loans, through economic and socialbecause it is a reliable store of pulls out of foreign investments,reforms. When the desire to save is so great that it overwhelms normalspending activity, the economy can become stuck in a liquidity trap.
8. Countries that leave
However, this hoarding the gold standard early, and so can depreciateslows the economy further and can their currencies to combat deflation, tend to begin recovery sooner. Balancing the books Government spending today is largely to meet demand, and typically accounts for around one-third of a country’seconomy.
CENTRAL BANK PRINT MONEY
means of raising In the US, the central bank is theBORROWING Modern governments money, but is Federal Reserve, known as the Fed.very rarely print currency unpopular as it This is a costly option as A country’s central bank managesto finance themselves, represents a loss of interest will be charged, the currency and money supply,since doing so carries money to the and money borrowed holds central bank reserves, andsignificant risks. Since money $6.7 depends on trust, when a government issues increasing amounts of currency, people may have less confidencein the value of that currency.
CONSUMPTION AND INVESTMENTThe government budget balanceis the overall difference betweenits revenues and its spending. Government spending is a $ mixture of paying for theimmediate costs of running services, and investment in things
GovernmentsAlthough it is difficult to control the supply of money may also control the flow of money via taxes and other directly, government monetary policy can help to capital controls, and by restricting borrowing andinfluence it. However, these mechanisms are imperfect in monetary policy is the central bank (see pp.100−103), the modern monetary system, since commercial bankswhich is critical in determining interest rates and are largely free to decide the terms of their lending.can be used to inject more money into the economy Attempts to directly control money supply tend to fail.
By altering the amount of the reserves, and the cost ofborrowing from them (via the rate of interest, known as the reserverate or base rate), central banks can assert control over the country’smoney supply. The base rate is usually the cheapest rate of interest availablefor its currency, and because central bank reserves arefundamental to commercial banks’ ability to lend, the centralbank helps to set interest rates for the entire economy.
LENDER OF LAST RESORT
Central bank The central bank creates and supplies reserve money to commercial banks, giving it huge powerover the day-to-day workings of the banking system. Commercialbankreserves The central bank pumps more of its money intocommercial bank reserves, lowering the interest rateand bringing it back in line with the target interest rate.
TARGET RESERVE INTEREST RATE
PUSHING RATE DOWN
PUSHING RATE UP
The central bank sucks reserve moneyout of the system, bringing the baserate up and back in line with its target. Commercialbankreserves The central bank pumps more of its money intocommercial bank reserves, lowering the interest rateand bringing it back in line with the target interest rate.
THE CENTRAL BANK
Managing the monetary system By raising or lowering its reserve rate of interest, a central bank can ❯ Secondary market The forum in ❯ Credit guidance A form ofwhich investors buy and sell bonds cheaper lending by the central influence the size of commercialissued by the government. bank that is designed to meet wider banks’ reserves, and thus theirgovernment objectives such as Inflation A general increase in borrowing and lending rates and ❯ boosting key industries.prices and fall in the purchasing the amount of money in circulation.value of money.
CENTRAL BANK CONTROLS
Higher interest rates make central bank loans more expensive$ $ $ $ $ $ $ $ $ $$ Open market operations The central bank sells bonds back to the market in exchange for money, causing investors to make withdrawals to buy the bonds, lowering the amount of moneyin the banking system. BUDGETSpending and the deficit Ideally a government’s spending commitments (inside the circle) The should be covered by tax revenue government and other forms of income.p aneeds to raise reym However, when a proportion of estmoney in order torene spending is not covered (budget meet its spending t t scommitments.
This seemingly simple solution is rare becauseof the risks it entails (see pp.144–5). How it works Governments have the unique Direct and indirect taxes privilege of being able to demandPeople have to pay taxes on either their income, or on that anyone in their country paywhat they spend.
Taxes can be levied as a FICA tax 15.3% share of spending or income, or asThis tax is a combination of social security tax a flat rate. A progressive tax system(12.4%) and Medicare (2.9%), both half paid by is one in which richer individualsthe employer and half by the employee.pay proportionately more tax.
TAXES AND BEHAVIOR
Because a newly-levied orOnce taxes on earnings increased tax on a product puts uphave been paid out, the its price, that item becomes lessamount remaining is attractive to buy. This can make some taxes very appealing for Managing state finance 106 107 Tax return A document used❯ by individuals and businesses to $21 trillion record income.thought to be hidden Tax rate The amount at which an❯ individual or a company is taxed; in tax havens abroad rates vary according to a person’s income or a company’s returns.
INDIRECT TAXESOther variables There are a variety of taxes in the
TAX EVASION AND
Because tax systems vary so $ widely from country to country, Excise tax it is possible to exploit theAn indirect tax that applies to differences in international taxspecified goods, such as rates in order to reduce the totalgasoline, or activities, like amount of tax due. A certain level of debt repayment must always be Repaying the deficit maintained by the governmentThe higher the deficit, the more money of to avoid default or excessa government’s budget is required in order interest incurred onto pay it off.
Any money it borrows The total amount borrowed by a country’s government to cover this is then added to the public debt. A state that becomes unable to pay its debt is If a government spends more than it collects in taxes said to “default,” and will find it hard to borrow again.
INFLATION DEBTDEBT DEBT DEBT DEBT Inflation can reduce debtRising prices reduce the value Weakof money,economylightening the A strugglingweight of debt economy isrepayment.liable to default.
However, since then the policy and the banking system’s role init have been subject to more rigorous examination, and taxation and spending plans now tend to dominate thedebate during national elections. By reporting their decisions to the public and to democratic institutions, they can be made more accountable to the people.
MONETARY IMPACTCentral bank decisions on monetary policy affectgovernment spending due to the impact of interest Auditors inspect public financesMany countries have an independent Managing state finance 112 113
TRANSPARENCY AND ACCOUNTABILITY IN CENTRAL BANKS
Increased openness is expected to Rigorous standards of conduct❯ ❯ It is essential that an autonomous lead to better-informed decisions. Central bank also oversees EXTERNAL FACTORScommercial banks Oversight Central bank decision-making of commercial banks gives themust also take into account factors central bank large power insuch as social attitudes, business shaping the economy.considerations, and the volatility of the financial markets.
IMPACT ON THE PUBLICIMPACT ON MONEY MARKETS
These feed through into rate, which affect consumer and decisions.output and employment, then business demand and the return Attempting controlGovernments can attempt to manage the economy by adjusting policies such astaxes and influencing interest rates. Based on thetheory of national income, it showed the connections between the differentparts of the economy using a system of tanks, pumps, and tubes, and couldbe used to make simple forecasts resulting from policy changes.
National income accounting is a method that a nationalgovernment uses to measure the level of a country’s economicactivity in a given time period. $4.29 trillionJapan’s Gross NationalIncome (GNI) in 2015 The idea of national income means that every penny spentin one part of the economy must equate to a penny earnedelsewhere, and the total earnings of the economy mustmatch the total spending of the economy.
DOMESTIC EXPENDITURESee pp.136–139National income See pp.136–137ExportsPurchases by the rest of the world.
See pp.128–129ImportsPurchases from the rest of the world. Total earned by households, firms, the government, and theforeign balance.
NATIONAL INCOME ACCOUNTING
National income accounting is a method that a nationalgovernment uses to measure the level of a country’s economicactivity in a given time period. $4.29 trillionJapan’s Gross NationalIncome (GNI) in 2015 The idea of national income means that every penny spentin one part of the economy must equate to a penny earnedelsewhere, and the total earnings of the economy mustmatch the total spending of the economy.
Inflation is typically definedaccording to the percentage increasein price of a “basket selected by lookingat what products people typicallybuy over 116 117 Attempting control How it works The main indicators governments use to monitor the economy are based on surveys of individuals,businesses, and government departments. The “headline indicators” generally relateto parts of the economy that have the most impact on people’s daily lives, and might include assessmentsof the likelihood that individuals will find employment, whether their pay will go up or down, and whetherbusinesses will be able to expand.
The 2016 inflation target for the US, Central bank The government’s inflation target is noted by the central bank, whothen sets the base rate—the interest rate that the central bank chargescommercial banks to borrow from it. The central bank does this inorder to encourage commercial banks to adjust their rates in linewith the base rate, as bank rates determine the ease with whichcustomers and businesses can borrow and so affects investment,spending, employment rates, and wage levels in the wider economy.
NEGATIVE INTEREST RATE POLICY (NIRP)
How it works Governments use a number of tools to try to manage the growth of the economy in a stable and balancedway. The aim is to increase the liquidity of money in the economy which will inturn lower interest rates and make lending easier and more attractive.
Central bank creates new money$ $ $ $ $ $ Attempting control 124 125DANGERS OF QUANTITATIVE EASING CASE STUDY QE is a new strategy and its effects are hard to measure. The economy may Inflation may occur Banks don’t always The Bank of England believes QE not respond as due to increased pass on the money has boosted growth, but at the cost expected even to verymoney supply, but it to businesses in need, of higher inflation and increasinglarge amounts of new is unlikely to lead to but hoard it or invest inequality of wealth, as prices rise.money being created.hyperinflation.
D E COMPANY R EC$ $O N O M Y $ $REDUCED Increased reserves reduce Individuals and businesses Increased spending interest rates(see pp.101- use loans to buy goods and and business investment 101), leading individuals and services and invest in boosts economic activity. As shown Orango Jones 5.1g m to the right, a government could impose a tax on sugar to o Cafteen o 6.6g ze match the cost to public health services of obesity.
THE LAFFER CURVE
Controversy surrounds the idea becauseSome US cities are assessing the ❯ it is very hard to know where this optimum point might tax by the ounce. $$$ payment of taxes by high net-worth individuals, and tax ❯ Consumers may turn to sugary avoidance by ordinary people who start to participate in untaxed drinks such asthe “gray economy.” milkshakes and smoothies.
24%estimated percentageof economic activityin Greece that went undeclared and untaxedin 2013 Government spending and cutsTypical government spending How a government spends money depends on its political priorities,the size of the government relative to the economy, and its level of debt. Governments today spend a large part of what an economy produces, using taxes to prioritize political commitments and potentially boosting their country’s economy in the process.
SPENDING VS CUTS
trillionthe United States federal $4.15 Attempting control 128 129GOVERNMENT SPEND RELATIVE TO ITS ECONOMY The size of a government’s budget, relative to its economy, can vary. South Korea’s government spends 30 percent of GDP, but Denmark’sspends 58 percent.
24 SOUTH KOREA
30%ity urec AUSTRALIA 36%l s cia RUSSIASo 39% JAPAN 43% GERMANY 45% Y NTR UK U 45% O CO % ITALY 3th 51%nero FRANCE 2ti 57%a 4% c DENMARK 58%u d EGREECE 61% How governments provide for the futureGovernment spending can help to shape how an economy develops. By investing in productive activities, as well as day-to-day items, governments can help their economies to grow.
Sometimes this return is paid directly (for instance in passengerfares) and sometimes it appears indirectly (for instance in theeconomic benefits of a new road, helping businesses to trade andresulting in more tax revenues). Governments justify spending by showing the returns it will produce.
CAPITAL SPENDING AND BORROWING
In some cases this means full privatization, in which a governmentallows a private firm to build and run the investment outright. When thisis not possible or desirable, private investment may take the form of adeal between government and private investors to split the costs,risks, and profits of building and running the investment.
SOCIAL HOUSINGSCIENCE AND
A business’s pull inflation, but if there is also anthe value of money decreases, and costs might go up for a number of oversupply of money in the economy, day-to-day living becomes more reasons, such as a rise in the price of consumers will continue to payexpensive. Attempting control 132 133“Inflation is always and everywherea monetary phenomenon”Milton Friedman $Price of product rises Rate of inflation accelerates Manufacturers respond If the price of goods and $ to higher production services increases across costs by passing some the economy, a higher rateof this on to customers.
CAUSES OF COST-PUSH INFLATION
Labor costs Strikes, low unemployment—meaning that❯ companies need to pay more in order to attract skilled labor—strong unions, and staff expectation that general ❯ Nominal values Prices, wages, and other economic prices will rise can all result in the company’s increasing variables that are not adjusted in order to take accountwages and shifting the cost to customers.of inflation. This can happen ifIt is not just the supply of money Market power A company’s❯ the economy expands too rapidly, that affects growth in an economy,capacity to raise a product’s price perhaps due to a sudden increasebut also the rate at which money by manipulating levels of supply,in money supply as a result of changes hands.
CAUSES OF DEMAND-PULL INFLATION
How high a price risesdepends on consumer demand for the product; if price elasticity ofdemand is inelastic—the item is something that customers needand cannot do without—the price ❯Government spending Increased $$ ❯ Monetary policy A cut in interest When an economy expands too rapidly, or unsustainably, an excess moneysupply can cause customer demand to overtake the supply of goods andservices. The BOP account has three parts:includes transactions by individuals, the current account, which measures goodsbusinesses, and the government.and services; the capital account, which Tracking these transactions helps the tracks the movement of capital and government determine how muchmoney is coming into and leaving nonfinancial assets; and the financialthe country, and in which economic account, a subdivision of the capital account,areas there is a deficit or surplus.which looks at investment.
CURRENT CAPITAL FINANCIAL
ACCOUNT ACCOUNT ACCOUNT
and political and commercial This in effect pushes down the events that will affect economic value of the local currency by HIGH INFLATION performance—such as elections, increasing the supply of it and Inflation increases the cost$ the crash of a financial institution, reducing the demand for it. Measuring how well pension funds In most countries, it is the current Governments need to ensure there are likely to meet current and future working generation that is funding is enough moneyto go around, a liabilities is key to the successfulthe pensions of those who have task that is all the more challenging management of state pensions.reached retirement age, as well as because in most developed the pensions of those who are due countries the population is aging,to retire.
INVESTMENTS MONEY MARKET$$ $$ GOVERNMENT$ BONDS$
STOCKS AND EMPLOYEE SHARES
INFRASTRUCTURE ASSET INVESTMENTS
❯Funding level The amount of money in a pension Sufficient money must come in to the pension fund to maintain or improve it. The fund’sperformance can be assessed in two ways: can influence the way pension contributions are invested—notnecessarily in the best interests of the pension poolor its future ability to make payments.
SOCIAL SECURITY BENEFITS LIABILITIES
The first is when it loses the ability to meet its obligations to repay its debt, potentially leading to a default. The second is when it fails to reassure the public that the value of its currency, or money itself, can still be trusted, potentially leading to hyperinflation.
BT DEBWhen a government and the T DE institutions of government lose trust through their ownincompetence, corruption, or
UNPAYABLE DEBTS DEBT DEFAULT
The government The government as a result of losing a war, there cannot pay its debts cannot keep is a major crisis. To prevent and higher interest up with debt this loss of trust payments are repayments.becoming disastrous, demanded by It has to default, a democracy may lenders who no failing to pay longer trust it.
OM TCA U O GOVERNMENT TRUST THE REST OF THE ECONOMYUncontrollable debt and default If a government has taken on excessive borrowing and 142 143 Why governments fail financially
THE IMPORTANCE OF TRUSTLOSS OF TRUST
How it works Prices can thus rise very rapidly as citizens refuse toTrust in the value of a currency is essential to maintain believe that money has any value, and so they demandprice stability in modern economies. A weak government, hyperinflation sets in, and it can be very hard for for example, may be unwilling to raise taxes to pay for governments to regain control.$ Case study: Hyperinflation in Germany, 1921–24 Germany experienced an infamous period of hyperinflation after World War I.
COLLAPSE IN TRUST
France and Belgiumprints money to pay for war debts, foreign currency, causing a collapse in occupy the Ruhr to enforce payment reparations, and public services. the value of the German mark.
MARKS HYPERINFLATIONSTOPPING HYPERINFLATION
Credibility Because hyperinflation is based on expectations about the future, with people believing prices will carry on rising rapidly, it can also be haltedrapidly (in theory). If the government can credibly commit to ending inflation (for example, by introducing a new currency and tight rules onissuing it), it can stop hyperinflation with limited costs.
8. A new government is formed in November 1923, with a new
PR president of the German central bank. The Rentenmark is backed by mortgages on land, whilethe new central bank president promises to fix its exchange rate 163 MARKS against the dollar.
Governments that default on a debt will find it very difficult to borrowin the future, since trust in the country’s economic stability will be low. Argentina owed a large amount of money, and was borrowingmore from other countries and theInternational Monetary Fund (IMF), until a recession prevented it fromrepaying its debts fully and the country defaulted.
Following a periodof hyperinflation during the 1990s, Argentinaattempts to implement IMF rules. It finds itself having to borrowsubstantially from official institutionssuch as the IMF, and from other countriessuch as the US.