Money Supply and Financial Intermediation

Posted on Oct 31, 2024 in Economy

Item 1. Money and Money Supply

The Origin of Money

Internal and external money. Financial intermediation and money creation. Money supply.

Source of Money

There is no single, comprehensive definition of money. Its definition is fundamental to understanding the various theories of money and monetary policy. It is usually understood that money is all that is commonly accepted as payment for goods and services.

Functions of Money

A proper way of understanding what money is involves studying its functions:

  • Unit of Account
  • Store of Value
  • Liquidity
  • Medium of Exchange

Medium of exchange: It is the instrument normally used in trade.
Unit of account: It is the unit in which the prices of goods and services are measured and debts are recorded.
Store of value: It maintains value over time. This function is also played by many other non-monetary assets (which together make up the wealth of an individual).
Deferred payments unit: It allows the timing of expenditure and savings, facilitating lending.

Origin and History of Money

Another way to approach the concept of money is to study its origin and history. The satisfaction of needs can be done in two ways:

  1. Straightforward: an operator is provided for all your needs.
  2. Through exchange. This, in turn, can be done in two ways:
    • Barter
    • Currency exchange

Exchange raises issues of efficiency:

  • Requires a double coincidence of wants.
  • Reduces the number of goods that can be exchanged.
  • Has high transaction costs (indirect exchange).

The emergence of money depends on a spontaneous process in which someone is aware of the existence of any property that is especially valued (subjectively) by the community to which he belongs.

The main feature of this property is its marketability and acceptability. Thus emerged the money-commodity: money in the form of a commodity that has intrinsic value. That is, it would have value even if not used as money. They are usually easy-to-transport items, whose value is easy to verify and are not perishable. Examples: salt, gold, cigarettes.

The insights of economic agents generate a process of specialization of goods, which are selected with the characteristics of:

  • Subjective assessment
  • Scarcity
  • Portability
  • Durability
  • Homogeneity
  • Divisibility

This process usually ends with the selection of precious metals as money.

The next step is the appearance of paper money, token money, which maintains its value by being backed by commodity money and the confidence one has that the issuer of that paper money will exchange it for goods. Due to various historical events, this paper money eventually lost its convertibility into commodity money to become fiat money.

Currency and Banking

The distinction between internal and external money refers to, in modern financial systems, money creation done by the Central Bank (inside money) or by the private banking system (outside money).

Money Supply

In modern economies, two different types of payment methods exist:

  1. Cash held by the public (EMP): notes and coins held by the public.
  2. Bank deposits (D): balances of bank accounts that are easily accessible to purchase goods and services (e.g., writing a check or using a card).

CASH = CASH + DEPOSITS, i.e., MONEY SUPPLY (OM) = EMP + D. In our economies, the amount of money depends on what type of deposits are included in the definition. These are the monetary aggregates M1, M2, M3…

Among other liquid assets, M3 includes:

  • Deposits (Dp)
  • Other liabilities of the banking system 1 (OPB1): repos, asset participations, foreign currency deposits, and loans.
  • Other liabilities of the banking system 2 (OPB2) issued by the ICO and limited operational level institutions: deposits and temporary asset transfers.

Another definition of money is M4 or ALP (liquid assets held by the public), including M3 and:

  • Treasury bills and other government-issued securities (Tt).
  • ICO borrowing and EFC calls and other financial liabilities ((POI2).

M4 = E + D + Tt + OPB + POI

The Central Bank and the Creation of Money

Central Bank (BC): An institution that oversees the banking system and regulates the amount of money in circulation.

Features:

  • Acts as a lender of last resort to private banks.
  • Issues legal money: coins and banknotes that are lawful tender.
  • Controls the amount of money that exists in the economy: monetary policy.

Monetary policy decisions of the Central Bank strongly influence the rate of inflation in the economy in the long term, employment, and production in the short term.

The issuing bank balance on the gold standard was of the following type:

Central Bank Balance

The central bank determines the amount of legal money in the economy (coins and banknotes that are legal tender). An increase in the number of coins and bills will be accompanied by an increase in central bank assets.

The Central Bank issues notes and coins (created monetary base) when granting loans to the State or other commercial banks, when they buy government debt securities, etc. The Central Bank destroys the monetary base when canceling loans, selling government debt securities, etc.

Fractional reserve banking means that banks keep as reserves only a fraction of total deposits. This implies a risk of bankruptcy as banks are required to maintain the following criteria:

  • Liquidity
  • Profitability
  • Solvency

How likely is a commercial bank to fail? The State requires banks to maintain reserves in accordance with the legal cash ratio. Banks are also interested in maintaining a voluntary reserve ratio:

  • Uncertainty about the creation or destruction of stocks.
  • The opportunity cost of maintaining these quantities idle.
  • The explicit costs to be incurred to be in a situation of illiquidity (appeal to the Central Bank, which also involves an implicit cost—or interbank market).

Therefore, the reserve ratio is equal to:

The bank’s balance sheet would now be as follows:

Fractional reserve banking allows banks to create money, i.e., means of payment. This money does not create new wealth, as any financial asset is both an asset and a liability, i.e., a debt to someone. Therefore, the economy now has greater liquidity.

The banking system’s ability to create banking money depends on the amount of money that enters it and the cash ratio:

Financial Intermediation

The financial system is a set of institutions, instruments, and markets whose main purpose is to channel savings generated by surplus spending units to borrowing or deficit spending units. It is a means of channeling funds from savers (people who spend less than they earn) to borrowers (people who spend more than they earn).

  • Savers: Give their money hoping to get it back with interest later.
  • Borrowers (investors): Demand money knowing that they will repay it with interest later.

The Financial System

It is fundamental because savers and investors may not coincide spatially or temporarily. A financial asset is a recognition of a debt by the issuer to the acquirer. Assets serve two functions:

  • Transfer funds between agents.
  • Transfer risk.

The financial system has two forms or ways of acting:

  • Direct: Through organized financial markets (primary market issuance of assets). The agent in need of resources issues financial assets or instruments, which it tries to place among those agents capable of providing funding.
  • Indirect: Through financial intermediaries that mediate the process, capturing resources under more favorable conditions of uncertainty for savers and more timely for issuers.

Financial Assets

Financial assets have three main characteristics:

  • Liquidity: Ease and certainty of its short-term realization into money without incurring losses.
  • Risk: Probability that the issuer of the security meets the issued asset amortization provisions.
  • Profitability: The ability of the asset to produce income (interest, dividends, etc.) for the acquirer.

Financial Intermediaries

There are two types of financial intermediaries: bank and non-bank. Their primary function is to convert assets indirectly. Issuing bank financial intermediaries’ indirect assets are accepted as means of payment (deposits). Non-bank financial intermediaries also issue indirect assets, but they are not means of payment.

There are three types of non-bank intermediaries depending on the type of assets they issue:

  • Liabilities with a fixed monetary value and low processing costs: Mortgage companies, credit unions, savings banks.
  • Liabilities with a fixed monetary value but high conversion costs: Pension funds, insurance companies.
  • Liabilities with a variable value: Investment funds.

Financial Markets

A financial market is the mechanism or place where financial assets are exchanged and their prices are determined.

Features:

  • Bringing together the parties.
  • Properly setting prices.
  • Providing liquidity to assets.
  • Reducing the time and costs of intermediation.

Features:

  • Amplitude
  • Transparency
  • Freedom
  • Depth
  • Flexibility

Types of markets:

  • Direct or intermediated
  • Money or capital
  • Free or regulated
  • Primary or secondary

Some Types of Markets

Direct or intermediated:

  • Over-the-counter
  • Commission agents (brokers)
  • Intermediaries (dealers)
  • Auction

Money or capital:

  • Equity
  • Deposit
  • Monetary
  • Forward
  • Mortgage
  • Foreign exchange

Money Supply

Theories that explain the role of money supply are divided into:

  • Mechanical theories
  • Behavioral theories
  • General theories

We will only discuss a simple version of the first of these, the mechanical theory.

Mechanical Theory

To expose the mechanical theory, we will use the following functional expressions:

If we divide the money supply and monetary base by D: