Financial System, Central Banks, and Monetary Policy Basics

Posted on Dec 14, 2025 in Economy

The Financial System and Intermediaries

Financial intermediaries are banks (those whose indirect financial assets are generally accepted as payment) and non-bank institutions (those that issue non-financial assets, often referred to as narrow money).

The financial system consists of the set of institutions that mediate between applicants and suppliers of financial resources.

Components of the Financial System

  • Financial Intermediaries (Banks): Bank of Spain, private banks, savings banks, credit unions, and rural banks.
  • Non-Bank Financial Intermediaries: ICO, insurance companies, pension funds or mutual funds, investment companies, mortgage companies, leasing (financing assets or property for a periodic fee), and factoring (anticipating funds from commercial debt transfers).
  • The Stock Market: A market where stocks and shares are bought and sold. Spain has four stock exchanges: Madrid, Barcelona, Bilbao, and Valencia.

The Central Bank of a country is the institution responsible for supervising the banking system and regulating the amount of money in the economy.

Functions of the Bank of Spain

  • Specific Functions: Store and manage foreign exchange reserves and precious metals not transferred to the European Central Bank (ECB); oversee the functioning of credit institutions and financial markets; promote the smooth functioning of the financial system; put coins in circulation; develop and publish reports and statistics; act as the Bank of the State; and advise the Government.
  • As a Member of the European System of Central Banks (ESCB): Define and implement monetary policy; conduct foreign exchange operations; promote the smooth functioning of payments; and issue legal tender notes.

Monetary Policy Decisions

The decisions regarding monetary policy are taken by the Central Bank to control the money supply. Policy may be expansionary or contractionary. The Money Supply (OM) is currency in circulation ($L_m$) plus bank deposits ($D$). $OM = L_m + D$.

Understanding Bank Reserves

Bank reserves are bank deposits that commercial banks hold in liquid form and cannot lend to other customers. They are maintained for two reasons:

  • Required by the Central Bank (to maintain the legal reserve ratio).
  • To ensure customer liquidity. These reserves are often referred to as cash in banks.

The Monetary Base (High-Powered Money)

The Monetary Base (BM) is also called high-powered money. It consists of the cash component of the money supply (notes and coins, $L_m$) plus bank reserves ($R_B$). $BM = L_m + R_B$.

Relationship Between Money Supply and Monetary Base

When the Central Bank implements an expansionary monetary policy, there is an increase in the money supply, which typically causes a decrease in the interest rate.

When the Central Bank conducts a contractionary monetary policy, there is a decrease in the money supply, resulting in an increase in the interest rate.

Instruments of Monetary Policy

  • Open Market Operations: The purchase or sale of Central Bank bonds to commercial banks.
  • Interest Rate Policy: When the Central Bank decreases the reference rate, it usually increases the amount of money available to commercial banks. Conversely, an increase in the benchmark interest rate represents a reduction of credit available to commercial banks.
  • The Legal Reserve Ratio (Cash Ratio): This is the percentage of bank deposits that banks must keep as legal reserves. A decrease means commercial banks must hold less money as reserves. An increase means commercial banks have the legal obligation to keep a larger share of bank deposits as reserves.

Adjustment Process to an Expansionary Monetary Policy

Starting from a situation of equilibrium in the money market, an expansionary policy leads to an excess supply of money.

Adjustment Process to a Contractionary Monetary Policy

Starting from equilibrium, a reduction in the money supply leads to an excess demand for money at the initial interest rate.

Effects of Inflation

Expected Inflation Costs

When inflation is expected and institutions have adapted to compensate for its effects, the costs of inflation are basically two types:

  • The Shoe-Leather Costs are the resources wasted when inflation encourages individuals to reduce their money holdings.

  • The Menu Costs are the costs associated with changing prices.

Unanticipated Inflation

Unanticipated inflation has significant effects on distribution, economic activity, and uncertainty.