(Reprinted from HKCER Letters, Vol. 4, September 1990) 


Money and Legal Restrictions

Luk Yim-Fai


Monetary economics was highlighted by the debate between monetarists and Keynesians in the 1960s and the evolution of the New Classical school in the 1970s. In the 1980s a new intellectual trend has emerged and has been dubbed the New Monetary Economics. This latter development raises fundamental questions about the basic assumptions of monetary thinking and thus could revolutionize economic ideas on money and monetary policy.

One basic tenet of the New Monetary Economics is that the continued existence of money in a modern economy is the result of legal restrictions. As such, monetary analyses are institution-bound, and a change in the legal and institutional framework may render existing monetary theories invalid.

The coexistence of non-interest-yielding banknotes with other interest-yielding financial assets has been a central issue in monetary theory. Such coexistence has been explained by the presence of risk on the part of the other assets. However, there are financial assets that are almost default-free, such as U.S. Treasury bills, or the Hong Kong Exchange Fund bills. Another possible explanation for that coexistence is that transaction costs would be high when people exchange other assets for banknotes to make payments, especially if this is done too often. But why do other assets not serve as means of payment as well? According to the New Monetary Economics, the answer lies in legal restrictions.

The first relevant restriction is that financial assets cannot usually be issued in small denominations. If the Exchange Fund bills, for example, are issued in very small denominations and are accepted as a means of payment, they would dominate the banknotes, and nobody would hold the latter, which bear no interest.

Large denominations, however, do not sufficiently explain the coexistence of non-interesting-yielding banknotes and other financial assets. It could happen that some firms arbitrage between the interest-yielding large-denomination assets and small-denomination notes. In particular, they could buy the Exchange Fund bills and issue their own notes with similar maturity, lower interests, but smaller face values. Free competition in such arbitrage activities would force the interest rate on the small-denomination private notes to equal that of the Exchange Fund bills, minus the cost of intermediation. These notes could then serve as interest-yielding means of payment and drive out the non-interest-yielding banknotes. Yet no such arbitrage exists because the issuance of small-denomination notes is legally prohibited.

One implication of the above arguments of the New Monetary Economics is that money is a creation of regulation. In a laissez-faire economy, money in the usual sense does not exist, but there could still be mechanisms serving the purpose of transactions and exchange. It can be noted that the mutual fund banking suggested by Professor Kroszner (on page 1 of this issue) is a form of the arbritrage mentioned above.

Dr. Luk Yim-Fai is a lecturer in Economics at the Chinese University of Hong Kong.


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