Understanding Money and Central Banking Systems
Understanding Money: Definitions and Aggregates
Types of Money Explained
Fiat money is an asset that has very low intrinsic value as a commodity but maintains its value as a medium of exchange because people have faith that the issuer is liable for any scraps of paper or coins and ensures that the amount issued is limited.
A deposit money bank deposit is IOU money or debt from a bank, as it has to deliver money from the deposit to the depositor and acts as a limit, if requested. It is a medium of exchange because people are willing to accept checks as a form of payment.
Money Supply and Monetary Aggregates
The Money Supply Defined
The monetary aggregate, or money supply, is defined as the sum of money held by individuals and businesses, plus deposits in banks.
Monetary Aggregates Explained
As established by the European Central Bank (see Unit 12), monetary aggregates are variables that quantify the money present in an economy and that central banks typically define for analysis and monetary policy decisions.
The Eurosystem has defined three monetary aggregates for the euro area, with calculations made from the consolidated balance sheet of monetary financial institutions and monetary liabilities of central government:
- M1: Consists of banknotes and coins in circulation (currency in circulation) and demand deposits.
- M2: Consists of liabilities included in M1 plus time deposits of up to two years and deposits redeemable at notice of up to three months.
- M3: Includes liabilities included in M2 plus repurchase agreements, shares in money market funds, money market instruments, and debt securities up to two years, issued by monetary institutions.
The Monetary Base
The cash in the hands of the credit system constitutes bank reserves, and the total of those, along with the cash held by the public, constitutes the monetary base of the system, also known as high-powered money.
Central Banking: Bank of Spain and ECB
The Role of a Central Bank
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
The most important specific functions of the Bank of Spain are:
- Safeguard and manage foreign exchange reserves and precious metals.
- Oversee the operation of banks.
- Promote the proper functioning of the financial system.
- Issue coins into circulation.
- Develop and publish reports and statistics related to its functions.
- Act as the state bank, performing treasury functions and financial debt services.
- Advise the Government.
Functions as a Member of the ESCB
The most important functions of the Bank of Spain as a member of the European System of Central Banks (ESCB) are:
- Define and implement monetary policy.
- Perform foreign exchange operations.
- Promote the smooth operation of payment systems.
- Issue legal tender banknotes.
The European System of Central Banks (ESCB)
The Bank of Spain is not subject to instructions from the government for setting monetary policy; instead, it follows the guidelines of the European Central Bank (ECB).
Key Tasks of the ESCB
The functions entrusted to the ESCB, either by its direct action or through the central banks of member countries, are:
- Define and implement monetary policy in the Eurozone.
- Manage foreign exchange reserves of member countries and conduct foreign exchange operations.
- Promote the smooth operation of payment systems and ensure the stability of the financial system through adequate supervision of credit institutions.
- Authorize the issuance of legal tender notes in the European Union.