Money and the Monetary System
Chapter 2, Melicher & Norton, Introduction to Finance, 17th Edition
1 June 2024
Money and the Monetary System
The monetary system is responsible for creating and transferring money. The central bank is an entity that defines and regulates the money supply in an economy, whereas the banking system is responsible for creating money and facilitating the transfer of money by processing and clearing checks.
Banks create money by taking deposits from depositors and then lending these deposits to borrowers. When a depositor puts money in a bank, the bank keeps a fraction of the money as reserves, and lends the rest to other borrowers. As long as the borrower puts the money back into another bank in the system, the total money supply in the economy increases. This process is called the money multiplier effect.
Money is a financial asset with three key functions:
The key thing to remember about money is that it is perfectly liquid, meaning that it can be directly converted into goods and services. Money can also be characterised by its purchasing power, which is the amount of goods and services that can be bought with a given amount of money. Purchasing power is inversely related to the price level: when the price of goods and services increases, the purchasing power of money decreases.
Money appear in many forms. Commodity money is money that has intrinsic value, in addition to its value as a medium of exchange. Gold and silver are examples of commodity money. In the past, people used government-issued physical coins which were made of gold and silver. However, since gold and silver are commodities, their value fluctuates with supply and demand. This can lead to problems if the intrinsic value of the coin rises much higher than its face value, as people may melt the coin into bullion which is more valuable. To address this problem, the government replaced gold and silver coins with token coins, which contained metals that were less valuable than gold and silver (usually copper and nickel). Token coins have a face value that is much greater than their metallic value, that is, their primary value comes from their use as a medium of exchange, not as a commodity.
Paper currencies are also used as money. Paper currencies are easier to produce than physical coins, and they are more convenient to carry around. The first paper currencies were backed by a commodity. Gold and silver certificiates are paper currencies that are backed by gold and silver. Owners of these certificates could exchange them for a certain amount of gold or silver. However, they ran into the same problem as physical coins: the value of gold and silver fluctuates with supply and demand. Fiat money is an alternative to representative full-bodied money. Fiat money is money that is not backed by any commodity, but is declared legal tender by the government. Their value comes solely from the trust people have in the government that issues the money. Since fiat money is not backed by any commodity, it is easier to produce than representative full-bodied money. However, the government must be careful not to issue too much money, because this can lead to unexpected outcomes such as inflation. Fiat money can also become worthless if people lose trust in the government. They are also susceptible to counterfeiting, since they are so easily reproducible.
Fiat money is a specific type of credit money. Credit money is money backed by the creditworthiness of the issuer. In the case of fiat, the issuer is the government. Another example of credit money is deposit money, which is issued by depository institutions such as banks. When a depositor puts money in a bank, the bank creates a demand deposit for the depositor. This deposit can be transferred to other individuals or organisations on demand by writing checks or through electronic transfers such as debit cards.
Money market securities are debt securities that mature in less than a year. They are called money market securities because they are highly liquid and can be easily converted into cash. Some examples of money market securities are:
There are two ways to measure the money supply in the economy: M1 and M2. M1 measures money as a medium of exchange, and it consists of currency (~0.4), demand deposits (~0.4), traveler's checks (~0.001), and other checkable deposits (~0.2). M2 is M1 plus highly liquid financial assets, such as savings deposits and money market mutual funds. M2 is a broader measure of the money supply than M1. Credit cards are not included in the money supply (they provide a means of borrowing money, not a medium of exchange), but they can contribute to the money supply by increasing the demand for money.
Economists believe that the money supply is an important factor in determining the level of economic activity in an economy, though they don't necessarily agree on the exact relationship between the money supply and economic activity. Monetarists believe that an increase in the money supply leads directly to an increase in GDP and inflation. Keynesians believe that the increase in the money supply leads to a decrease in interest rates (supply higher than demand), which leads to increased investment and consumption, and eventually an increase in GDP.