Boffy What Is Money? Money Is Anything

Boffy

What is Money?

Money is anything that is accepted as a form of payment and in the modern world this typically currency. Today's currency is essentially created by governments, and backed by their ability to tax. Thus, money today derives from both the legitimacy of the state and from the revenues of the state. Money is typically issued by a central bank, and it has considerable leeway with respect to how much money it issues. The value of money is determined by the supply of and the demand for money.

The supply of money is controlled, as we've said, by the central bank. Demand for money is based on the need for that currency to make transactions. So demand for Japanese yen is in part related to how much yen people need to buy goods and services from Japan. The same is true of all currencies, including the U.S. dollar

Slide Two: Interest Rate Parity

The concept of interest rate parity is important when analyzing the exposure that a company has to foreign exchange rate risk. The theory is essentially that there is no difference in borrowing in one currency vs. borrowing in another. Thus, a country that has high interest rates will also see its currency decline in value over that period. The investor, therefore, should be neutral between investing at a low rate in a country whose currency is expected to hold its value, and at a high rate in a country whose currency is expected to depreciate.

Slide Three: The Puerto Rico Context

Puerto Rico, as a commonwealth territory of the United States, uses the U.S. dollar as its currency. There are advantages and disadvantages to this. A disadvantage is that the USD is not a local currency, and therefore is subject monetary policy that relates to the economy of the United States. The needs of Puerto Rico are not usually taken into consideration when the U.S. Federal Reserve bank sets its monetary policy. This lack of control is a disadvantage in macroeconomic terms, because monetary policy is a lever that can affect the economy of a country. There is a fair degree of separation between the economy of Puerto Rico and the economy of the United States

The primary advantage of using the U.S. dollar, of course, is that there is no exchange rate risk when dealing with American companies. This is an advantage for Puerto Rican companies, and Puerto Rico in general. If Boffy wants to open a wiper blade factory in Puerto Rico it must accept that it will be dealing with costs in U.S. dollars, and will also accept that the value of the U.S. dollar is going to relate more to the economy of the U.S. rather than the economy of Puerto Rico.

Slide Four: The economy of Puerto Rico is currently struggling, and has declined in each of the past three years. The GDP declined 5.8% in 2012, 3.7% in 2011 and 2.8% in 2010. Normally, when faced with such a decline, the government would be able to initiate actions that would spark economic growth. This would include monetary policy. The U.S. Fed does not base monetary policy on the needs of Puerto Rico but it has initiated and maintained expansionary monetary policy that should encourage investment in the U.S. Thus, there are a lot of U.S. dollars around for investing. However, the Puerto Rico government is responsible for much of the island's fiscal policy, and it has not taken an aggressive approach to stimulus. The result is that Puerto Rico's economy is performing very poorly, is trending downwards, and there is little to no help forthcoming from either monetary or fiscal policy.