4.5.2.1Drivers of the Quality of Money as a Unit of Account and Medium of Exchange

Changes in the perceived quality of money arise from how well it is performing its three core roles. The unit of account role remains stable and reasonably predictable in a situation of low and stable inflation. However, this can change suddenly when an economy experiences hyperinflationary conditions, pushing users to commence recording the value of goods in an alternative manner that does not use the domestic currency. For example, during the mid-1920s, Germans calculated the value of goods using foreign currencies due to massive hyperinflation that resulted from flooding the economy with newly-printed domestic currency, exacerbated by a loss of productive capacity. In recent times, Zimbabwean hyperinflation reached a monthly inflation rate of 80 billion percent by November 2008, forcing suppliers to price goods in a more stable standard, that is, U.S. dollars or gold, at the expense of their devalued local currency. Furthermore, the domestic currency received from a sale at the start of the business day would be almost worthless by the close of business, which leads to the discussion of money’s value as a medium of exchange.

In terms of the medium of exchange function, the following necessary conditions are put forward by classical economists: lower transportation and storage costs, easier divisibility, greater recognizability, stronger durability, and superior homogeneity of the money units. Although historically many currencies were linked with a gold standard, modern economists argue that fiat money meets these conditions. Of course, as noted above with the Zimbabwe and Germany examples, money loses its value as a medium of exchange when it is thinly traded due to devaluation.

4.5.2.2Drivers of the Quality of Money as a Store of Value

Individuals keep their wealth in a way that is efficient, allowing them to defer future purchases of goods and services or obtain cash in order to facilitate current consumption. The better a good conserves its value, the better it will execute a role as currency, holding all other things constant. Even with wide demand, perishable goods like fish or potatoes perform poorly as store of value, as trading these items can only be completed in a limited timeframe before they lose all their value. With the recent advent of cryptocurrency, this might pose significant impacts on the potential store of value of these commodities.

There are five ways through which the quality of money can change in its effectiveness as a store of value. First, changes in the quantity of money substantially influence money’s quality. Quantities of issued fiat money (in the form of paper currencies) can be dramatically increased, if the central bank decides to run its printing presses. If the supply of goods remains the same, the prices of these goods would eventually increase to reflect the increased amount of cash circulating in the economy available for consumption (more money chasing the same amount of goods). The store of value function is affected by the present quantity of money and the quantity anticipated in the future. Expectations about the evolution of the quantity of money are not the only determinant of money’s store of value function.

Second, changes in the redemption ratio2 may determine the quality of money even when holding expectations about the future quantity of money constant. For example, a dollar bill can currently be converted to 1/20 of an ounce of gold and at a future date this redemption ratio may be altered to 1/35 of an ounce of gold, or 1/20 of an ounce of silver, or redemption may be suspended altogether. Under this situation, the quantity of money in circulation is the same, but money’s function as a store of value is adversely affected, as it can be used to obtain a smaller amount of valuable goods. Redemption changes may affect the valuation of the currency unit relative to other goods even if expectations about future quantity of money remain unchanged. The valuation of the currency unit in relation to other goods may not be as high as it might be with the change in the backing of the currency. Also, in an extreme case, a war can affect the value of a currency; if users expect that a government will fall and no longer be able to back the fiat currency, the currency will experience massive depreciation.

Third, the general condition of the banking system also determines the quality of currency as a store of value. For instance, an illiquid banking system triggers the risk of a bail-out that finally raises the quantity of money. Signs of an imperiled banking system can be noted on the central bank’s balance sheet through sharp rises in overnight lending or loan rates. This leads to a decrease in the quality of money, and creates expectation-based inflationary pressures.

Fourth, the configuration of the monetary authority is an important driver of the quality of money. A central bank that is not independent from the government is more likely to be inclined toward monetizing government debts. Attempts to influence the decision of an independent central bank may harm the quality of money, even in the absence of commensurate changes in the quantity of money in circulation, as individuals may become worried that monetary policy will be directed toward fulfilling certain political goals rather than improving the whole economy in an efficient manner.

Amendments to a central bank’s constitution in regard to its philosophy or doctrine may result in changes in the quality of money. For instance, if a central bank alters its stated target growth rate of the money supply from 5 to 10 percent, this announcement immediately changes the quality of money through increased inflationary expectations. Similarly, if a central bank terminates a rule-based monetary policy and switches to targeting asset prices, this action will instantly affect the quality of money as a store of value. Other policies supported by the central bank—such as full employment or financing educational expenditures—will also affect the quality of money. If the original constitutional objective is focused on price stability, and it is amended to entail other aims like achieving full employment, increasing asset prices, or maintaining a currency union (a pact among members of that union-countries to share a common currency and a single monetary policy and foreign exchange policy), this will influence the quality of money: the aim of price stability might be less of a priority relative to another goal. This leads to uncertainties among the business community as to what the dominant aim of the central bank will be.

The credentials, experience and ability of central bank employees is also an important driver of the quality of money. Chairmen of central banks set monetary policy based on building consensus, a role which directly influences the credibility of a proposed monetary policy. Particularly in an economy where the central bank lacks independence, a weak chairperson will be viewed as incapable of enacting efficient policies. The normative economic preferences of a chairperson can also affect the quality of money. Replacing a chairperson with a record of favoring conservative monetary policy with a new chairperson who is known to prefer expansionary monetary policy may decrease the quality of money on the day the replacement is announced, regardless of any changes in the money supply.

4.5.2.3The Quality of the Central Bank’s Balance Sheet as a Driver of the Quality of Money as a Store of Value

Changes to the reserves and assets of the central bank are another determinant of changes in the quality of money. In relation to the soft factors mentioned above, the assets of the central bank are objective variables that can be assessed directly in analyzing its balance sheet. For instance, the monetary base is directly observable as the central bank’s non-equity liabilities.

Therefore, indirect analysis of the quality of money can be investigated through the assets (domestic assets) that support the monetary base. The average-supporting asset of the monetary base is critical for the quality of money and is observable on the balance sheet. In a fractional-reserve banking system, the average backing of the currency in circulation can fall or rise based on changes in the monetary base. The average quality of the backing assets (domestic assets) rises when newly purchased assets are of a higher quality than the average of the existing assets. The average quality of the backing assets falls as newly purchased assets are of a lower quality than the average existing assets, a process known as “qualitative easing.” Quantitative changes to the monetary base affect the quality of money as its backing reserves may be diluted. On the other hand, the quality of assets of the central bank can deteriorate even with a constant money supply as the central bank replaces its high quality assets by buying lower quality assets.

Central bank assets are crucial because they act as collateral for its liabilities and “back” the currency. In almost every fiat money regime, no legal obligation is imposed to redeem the currency against the central bank’s assets. The central bank assets reflect the capacity of the central bank to safeguard the price of the currency domestically and globally in foreign-exchange markets. For instance, the central bank can utilize its reserves to back its currency through foreign-exchange interventions. It can also use its reserves as a de facto redemption tool; reserve assets are used to purchase currency and holders redeem their currency units against the reserves.

Furthermore, the central bank may utilize its assets to support the banking system by purchasing troubled assets from the banking system to restore confidence in the banking system’s solvency. This will only reassure investors if the central bank owns sufficient amounts of high quality assets that can be exchanged for the banking system’s troubled assets.

The quality of the central bank’s assets is significant for its ability to credibly assist a struggling banking system. In rare cases, its assets can be utilized for monetary reform (such reforms were noted in ex-Soviet bloc countries after 1992–1993, and in the dissolution of Czechoslovakia in 1991). Higher asset quality indicates that a new currency will be stronger and less volatile (and individuals will be confident in its ability to fulfill the three aforementioned roles of money) (see Box 4.1).

The importance of the central bank’s assets becomes readily apparent when a currency collapses in value. The decomposition of the monetary system lessens the value of currency. Temporarily, its assets may retain value, and can be allocated to creditors and currency holders, or used in exchange for imports. Currency holders in a normal situation prefer a central bank that holds liquid assets (i.e., foreign exchange or gold) as its main reserves to a central bank that holds illiquid assets (i.e., subprime mortgages) in the case of a monetary breakdown.

Insolvency will happen only in rare situations; the domestic government or foreign creditors like the International Monetary Fund (IMF) can be approached to recapitalize the central bank. The government recapitalizes the central bank through debt-finance funded monetary expansion. A fall in quality of the central bank’s assets triggers the danger of a recapitalization by monetary expansion. Hence, the quality of money decreases as a store of value as inflationary pressures ensue.

Expectations about the quality of currency’s backing are another important factor. Suppose that a central bank sells gold reserves to purchase mortgages of dubious quality; this leads to a change in the quality of money in the absence of concurrent change in its quantity. In this case, currency users will expect that central bank liabilities (mainly currency and member bank reserves) will be supported by assets of lesser average quality.

In summary, the relationship between central bank assets and the quality of money is crucial. While the quantity of money is naturally an important determinant of the usefulness of cash as a store of value, medium of exchange, and unit of accounting, we must not ignore the importance of qualitative factors, which can affect the ability of money to perform its three core roles, despite any changes to the money supply.