Key Concepts in Monetary Economics and Financial Markets
Functions of Money
Money serves as a means of exchange, widely accepted by the community for daily transactions and to settle debts. It facilitates exchange and eliminates the need for bartering.
As a unit of account, money is used to calculate the value of various goods and services.
Money also functions as a store of value, meaning it can be saved and retrieved later without significant loss of purchasing power.
Money Creation
Money is primarily created when a bank grants a new loan. Three main agents are involved in this process:
- The Monetary Authority (e.g., the Bank of Spain) creates the monetary base, from which banks and other financial intermediaries generate money and credit.
- The banking system, whose behavior leads to an expansive process of money and credit creation.
- The public (individuals and companies) decides how to distribute their financial assets.
Financial Intermediaries
The Bank of Spain
Grants funding to the rest of the world, the public sector, and other financial intermediaries.
Private Banking
Keeps a portion of its funds in cash and grants funding to the private and public sectors.
Savings Banks
Tend to be similar to commercial banks, specializing in raising funds through deposits from small savers, often via savings accounts.
Credit Cooperatives and Rural Banks
Lend their funds to the public sector; their operations are very similar to commercial banks.
Non-Bank Financial Intermediaries
Official Credit Institute (ICO)
A public financial intermediary that complements private funding channels, obtaining resources through budgetary allocations or by issuing fixed-income securities.
Insurance Companies
Provide indemnities in case an insured event occurs.
Pension Funds
Supplement or replace Social Security payments for pensions after retirement.
Investment Companies
Capture resources by issuing shares and invest the sums received in equity and fixed-income securities.
Leasing Companies
Engage in financing goods for their customers, providing equipment in exchange for a fee schedule.
The Securities Market
The securities market is where new securities are issued and existing securities are traded.
Primary Market
Where savings are channeled towards investment through the issuance of new securities.
Secondary Market
Aims to strengthen the primary market by providing liquidity to existing securities.
Fixed-Income Securities
Any debt instrument whose interest rate is precisely fixed and does not depend on the issuing company’s results. Holders are creditors.
Equity Securities
Any share of a corporation, whose profitability is not fixed in advance but depends on the issuing company’s profits.
Expected Inflation Costs
The costs associated with expected inflation are of two main types:
- Shoe-leather costs: Resources wasted when inflation encourages individuals to reduce their money holdings.
- Menu costs: Costs arising from the need to change prices too often, which involves altering price lists and menus.
Unexpected Inflation Effects
Unexpected inflation can have several significant effects:
- Effects on Distribution: Inflation harms individuals with fixed nominal incomes or those whose incomes grow less than inflation. It favors debtors and hurts creditors in nominal monetary terms. It can also benefit the state due to fiscal distortions (e.g., increased tax revenue and decreasing real value of expenses).
- Effects on Economic Activity: By altering the structure of relative prices, it distorts resource allocation and makes economic information difficult to interpret.
- Uncertainty: Negatively affects production calculations. It manifests as increased investment risk premiums and can prevent certain capital projects from meeting acceptable financial criteria.
Classical Economic Theory
Classical economists argue that variations in the money supply primarily affect prices, not real variables such as production or employment.
Keynesian Economic Theory
Keynesian theory posits that the demand for money can absorb increases in the money supply without altering prices, and that changes in the quantity of money can have significant effects on production.