Understanding Money, Banking, and Monetary Policy
Financing Process
Offerers of financial resources, based on their income and consumption/saving/investment plans, have a certain capacity to supply these resources. Individuals needing financial resources seek funding for their plans. The financial system encompasses all institutions involved in connecting these two groups.
Money
Money serves as a medium of exchange and is generally accepted as legal tender. It is issued by an institution that monopolizes its creation, typically in the form of coins or bills. Bank money refers to bank deposits accepted as payment.
Functions of Money
- Facilitates Exchange: Eliminates the need for bartering, reducing transaction costs.
- Measure of Value: Used to set prices and keep accounts, allowing for comparisons of goods and services.
- Financial Asset: Stores value over time, representing a way to hold wealth.
The Cost of Money
The cost of money represents the interest sacrificed by holding liquid money rather than less liquid or riskier assets with potentially higher returns.
Demand for Money
Money demand increases as interest rates decrease, as the opportunity cost of holding money is lower.
Money Supply
The money supply is the total value of generally accepted payment methods. It includes cash held by the public (banknotes and coins) and deposits in commercial banks.
Types of Money Supply
- M1: Cash + Demand Deposits (immediately available to the holder)
- M2: M1 + Savings Deposits (similar to demand deposits but may not be used for checks)
- M3: M2 + Time Deposits (funds locked for a fixed term)
- ALP: M3 + Long-term Securities + …
Monetary Base
The monetary base (BM) equals cash held by the public plus bank reserves.
Banks and Money Creation
The Financial System
The financial system comprises markets, institutions, and assets that channel economic resources from surplus units to deficit units. Its primary function is to facilitate this flow efficiently, offering attractive returns to encourage saving. Financial assets vary in liquidity, risk, and return.
- Liquidity: The ability to convert an asset to cash quickly without loss of value.
- Risk: The probability of not recovering the invested amount.
- Return: The nominal gain from the asset, both direct and indirect.
Financial Assets
- Primary Assets: Issued directly by entities needing financing.
- Secondary Assets: Involve financial intermediaries in transferring resources between savers and borrowers.
Bank Financial Intermediaries
Banks transform direct assets into indirect assets. Examples include the central bank, private banks, savings banks, and credit unions. Non-bank intermediaries also mediate but do not create money.
Creation of Bank Money
Banks hold only a fraction of deposits as reserves. This reserve ratio is mandated by monetary authorities to ensure liquidity. Increasing the reserve ratio reduces the money supply and raises interest rates; decreasing it has the opposite effect.
Monetary System
The Central Bank
The central bank is the cornerstone of the monetary system, controlling the banking system and monetary policy. It has the unique power to control the money supply.
Functions of the Central Bank
- Issues legal tender within established limits.
- Acts as banker to the state, managing treasury operations.
- Serves as the bank of banks, holding reserves and acting as lender of last resort.
- Executes monetary policy, aiming for price stability and exchange rate management.
- Manages foreign reserves.
- Provides central information and balances.
Monetary Policy
Monetary policy refers to decisions made by monetary authorities to influence the money supply. Instruments include interest rates, open market operations (buying and selling securities), reserve requirements, and short-term loans to banks for liquidity.