ECON120 Study Guide

Unit 3: Money Market History (16th–19th century)

3a. Describe the monetary advance in Antwerp in the 16th century 

  • What were traveling merchant fairs?
  • Why was Antwerp considered the "continuous fair"?
  • Why did bills of exchange not have liquidity before Antwerp?
  • What is the practice of discounting?
  • How did promissory notes affect the monetary landscape?
  • How did the Antwerp Bourse affect monetary history?

During the Antwerp Bourse in 1531, the money market described the market for second-layer monetary instruments such as bills of exchange, gold deposits, and other promises to pay precious metal.
Before the money market, you had to wait a month before presenting the bill to collect cash. If you needed cash faster, you found a banker willing to purchase the bill before it matured. The banker would split the difference between your purchase price ($98) and the face value ($100) and pay you $99. This process of a banker buying the bill for $99, which is "discounted" from the $100 par value upon maturity, is called discounting.
To settle any outstanding balances at the end of the day, bankers issued another form of credit, called promissory notes or notes. These notes were promises to pay the bearer, meaning that whoever held the piece of paper was due the promise. These instruments were the direct predecessors to paper cash today.
To review, see Time Value of Money.

3b. Explain the reasons for the creation of the Bank of Amsterdam, its innovations, and privileged lending

  • How did the formation of the Dutch East India Company affect money?
  • What impact did the Amsterdam Bourse have in forming the Bank of Amsterdam?
  • What were the major innovations of the Bank of Amsterdam?
  • How did the BoA monopolize the second layer of money?
  • How did debt issued to the Dutch East India Company rise to the first layer of money?
  • What is privileged lending from a layered-money perspective?

The Bank of Amsterdam (BoA) was created thanks to the world's first joint-stock company, the Dutch East India Company. It was the first example of equity investors providing capital in exchange for a share of ownership in the form of a paper certificate. The Amsterdam Bourse was founded shortly after the first signs of a market for Dutch East India Company shares. The Dutch East India Company created it to facilitate the exchange of its shares on a secondary market.
In 1609, the Bank of Amsterdam was founded to outlaw cashiers and their notes and mandate all gold and silver coins be deposited at the bank. The BoA monopolized the issuance of second-layer money by eliminating public access to first-layer money.
The Bank of Amsterdam allowed instant transfers among its depositors. The BoA didn't charge a fee for internal transfers. The Bank of Amsterdam was the first central bank because, by law, the bank was central to all money dealings. It was a regulatory response to stock trading and a way for the government to monitor every transaction taking place amongst its depositors.
The BoA eventually eliminated the ability to withdraw precious metal altogether yet managed to maintain the public's trust in its second-layer money. By suspending convertibility to first-layer money, the Bank of Amsterdam proved that precious metal wasn't necessarily required to operate a monetary and financial system.
To review, see Bank of Amsterdam.

3c. Outline the founding of the Bank of England and identify key differences between BoE and BoA 

  • How did war affect the finances of the English government?
  • Why was the Bank of England formed in 1694?
  • How did the Bank of England purchases of English sovereign debt mirror the Bank of Amsterdam's purchases of debt issued to the Dutch East India Company?
  • How did the Bank of England's actions as a liquidity provider make it different from the Bank of Amsterdam?

In 1694, the Bank of England (BoE) was created to purchase new government bonds. The BoE issued second-layer money and was tasked with taking custody of precious metal, issuing deposits, effecting transfers between depositors, and circulating notes as cash. The BoE discounted bills of exchange and increased liquidity in the London money market. London allowed competing versions of paper money, and the BoE discounted bills when customers needed liquidity. This became the archetype of central banking today.
To review, see Bank of England.

3d. Describe the origins of the international gold standard and how it functioned 

  • Why did gold and silver both function as money?
  • How did Isaac Newton change the monetary system as Master of the Mint?
  • From a layered-money perspective, what relationship did gold and pound currency have?
  • How did other countries react to the English gold standard?

Shortly after the creation of the Bank of England, English mathematician and physicist Sir Isaac Newton set a new exchange rate between gold guineas and silver shillings in 1717. Newton studied the flow of gold and silver throughout Europe and the exchange rates outlined in other countries' bimetallic standards, specifically France, the Netherlands, and Germany. He created an exchange rate that made it profitable for arbitrageurs to export silver and import gold, and before long, silver stopped being used as money in England. This brought the world under one money pyramid with gold at the top. Eventually a gold standard, where the English pound became valued only in gold, became law.
To review, see Bank of England.

3e. Summarize the three-layer monetary system in England during the 19th century 

  • What monetary instrument exists on the third layer of money, and why?
  • What instrument do deposits promise to pay?
  • What instrument does currency promise to pay?
  • What are the advantages of holding second-layer money versus first-layer money?
  • What are the risks to holding second-layer money versus first-layer money?
  • What are the advantages of holding third-layer money versus second-layer money?
  • What are the risks to holding third-layer money versus second-layer money?

During the Bank of England era, bills were promises not to pay gold but to pay pounds and therefore existed on the third layer of money. The private sector issued promises to pay second-layer money. Liabilities of the private sector exist on the third layer of money.
To review, see Bank of England.

3f. Explain the origins of the "lender of last resort" function of central banking 

  • Why is the central bank positioned to be the lender of last resort?
  • How does the lender of last resort affect the second layer of money during a financial crisis?
  • How does the lender of last resort affect the third layer of money during a financial crisis?
  • What happens to a layered money system in a financial crisis?
  • Is a higher or lower layer of money more demanded during a financial crisis?
  • What effect does the discounting of bills by the central bank have during a financial crisis?

Financial crises correspond with sudden surges in demand for cash. Those issuing or holding third-layer money required liquidity in second-layer notes. When the demand for cash swells, the central bank must create second-layer money to satisfy that demand. It should flex its power of elasticity while still maintaining the discipline to not encourage moral hazard, which occurs when a financial institution takes on excessive risk because it anticipates being rescued by the government or central bank if its financial position worsens.
To review, see Bank of England.

Unit 3 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • discounting
  • gold standard
  • money market
  • notes
  • promissory notes