Monetary Systems
Money is a set of assets that people in a community use to exchange goods and services. Money has three functions:
- Medium of exchange: an item that buyers give to sellers when they want to purchase goods and services
- Unit of account: the yardstick people use to post prices and record debts
- Store of value an item that people can use to transfer purchasing power from the present to the future
Liquidity refers to how easily an asset can be converted into money, and wealth refers to all monetary and non-monetary assets.
- Commodity Money has intrinsic value, and is used as the medium of exchange. Gold Standard is an economy that uses gold as its commodity money, or an economy where money can be easily converted to ownership of gold.
- Fiat Money has no intrinsic value, and its success depends upon the socio-economic status of the country.
Measuring Money Stock
Money Stock is the total amount of money that is present in an economy. This includes not only the currency (money in hands of the public) but also other assets which have a reasonably high liquidity. We divide money stock into categories M1 and M2. Here, M2 is more relaxed, meaning that assets can have lower liquidity than the assets in M1. (Do understand that all assets that belong to M1 will belong to M2 as well.)
Credit Cards do not count as money or assets!
- M1: Currency, Travel deposits, cheque-able deposits .etc
- M2: Everything in M1, Savings Deposits, Mutual Funds’ deposits, small time deposits .etc
Banking and money supply
Banks have the following balance sheet made, in order to identify assets and liabilities; and to see how much funds are present in each sub category. (assets = liabilities as a whole by definition)
| Assets | Liabilities |
|---|---|
| Reserves | Deposits |
| Loans | Companies’ debt |
| Securities (buy stocks/bonds) | Owner’s equity (capital) |
Reserve Ratio (R) is the fraction of reserves held out of the total assets. A minimum RR is mandated by the government, but banks can have excess reserves to ensure that they can pay back the deposits. Money Multiplier is the maximum multiplier that the money supply can increase to. \(\text{Money Multiplier} = \frac{1}{R}\)
Central Bank
The central bank is an institution which oversees the banking system and regulated the amount of money in the economy aka money supply. It does so by altering monetary policies as the need arises. The central bank firstly acts as a last resort lender of money for banks in financial crisis, a bank’s bank. The interest rate offered to banks by the central bank is called as the Discount Rate.
- A higher discount rate decreases the money supply
- A lower discount rate increases the money supply
It also alters the money supply predominantly by Open Market Operations (OMOs).
- To decrease the money supply, the central bank sells bonds. The acquired funds are out of the hands of the public.
- To increase the money supply, the central bank buys bonds. The new funds are in the hands of the public, and a new dollar as currency increases the money supply by 1$ but a new dollar in a bank increases the money supply by $1$\times 1/R$ .
The reserve ratio (R) is altered by the central bank in these ways:
- Altering Reserve Requirement: Self explanatory, change the minimum required R. A larger requirement decreases the money supply.
-
Changing Reverse Repo Rate: The central bank can offer interest on the reserves that bank have, encouraging the banks to have larger reserves. A larger interest would reduce the money supply in the economy. Measured in Basis Points, where 1 basis point corresponds to $0.01\%$. The Repo Rate is the rate at which banks borrow money from central bank after depositing securities (unlike discount rate).
- Change Federal Funds Rate: The federal funds rate is the interest rate that a bank-to-bank loan has. The loans are for very short durations of time, such as one day. These ensure that a bank can repay its depositors if it runs out of reserves. Increasing the interest rate would decrease the money supply.