ABSTRACT
Technological innovations in the twentieth century mean that virtually all countries now use bank deposits as their dominant medium of exchange, so that cheque and EFTPOS (electronic funds transfer at point of sale) accounts are the primary mechanism used by households and firms to pay for commercial transactions and to settle debts involving anything other than very small amounts (see Chapter 2). In line with these developments, this chapter presents a model in which all commodity and fiat-money has disappeared, and the only available medium of exchange is credit-money created by the lending activities of the economy's financial institutions. Chapter 3 has explained that there are divergent views on inflation in such a world. Some have argued that such a banking system would never create an excess supply of credit-money, since unwanted bank deposits can always be eliminated by using them to retire bank loans (see, for example, Tobin, 1963; Black, 1970; Glasner, 1992). Another tradition has argued that in the absence of reserve requirements there would be no limit on the ability of banks to create deposits and hence inflation (see, for example, Gurley and Shaw, 1960: p. 255; Patinkin, 1965: p. 309; Friedman and Schwartz, 1969: p. 5). In contrast to both these views, this chapter will use the framework presented in Chapters 5 and 6 to produce a theory of positive but finite credit-money inflation. Chapter 10 will reintroduce fiat-money into the model, and it will be the means by which the central bank is able to influence interest rates in order to maintain price stability. This current chapter also marks a transition from the previous two chapters' process analysis to analysis based on the concept of money market equilibrium. In contrast to most money market theory, however, the analysis in this chapter continues to acknowledge the close connection between real and money flows that were revealed in Figures 5.4 and 6.1. This produces a model in which the quantity theory of money turns out to have a role to play, but in a way that is significantly different from the role proposed in models such as Fisher's (1911) equation of exchange.
