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Money and banks (part 8)

How commercial banks "create money"

Commercial banks obviously cannot influence the amount of currency in the economy or the monetary base, since they are not allowed to print money. They can, however, influence the money supply through the second component of the money supply - the deposits. A bank will increase the money supply simply by lending money to a customer. In the same way, when a loan is repaid or amortized, the money supply decreases.

It may sound odd that the money supply increases by 1 million the same instant a bank agrees to lend this amount. The bank has created money but no wealth (keep in mind that these are different concepts). The bank has simply converted one asset (cash) into another (the promise of repayment), while there is no change in the individual’s net wealth. However, after the loan, there is an additional one million available for immediate consumption. It makes no difference if the borrower keeps the money in her account or withdraws them in the form of currency.

If, for example, the borrower uses the money to buy an apartment, the fluids are transferred to the seller of the apartment. Tins will not affect the money supply - now it is the seller of the apartment that has a million available for consumption. If the seller uses the funds to repay the loan he got when he bought the apartment, the money supply will again decrease.

How much money can banks create?

Does tins mean that banks can create an unlimited amount of money? The answer is no - that would require them to lend an unlimited amount of money and that is not possible.

Banks use deposits to create new loans but there is an important difference between deposits and loans. When individuals deposit money in a bank, they can withdraw the money whenever they like. A bank, on the other hand, has no right to cancel a loan and get then money back whenever they like. Banks therefore need reserves so that they can deal with large withdrawals. A bank with small reserves will therefore be less inclined to lend money.

That`s all folks! I`m proud to be ending this story and hoping you`ve got some good and useful iformation about money and banks.

Money and banks (part 7)

Commercial banks

Currency inside banks is not money

The fact that currency inside commercial banks is not money may strike you as odd, but it is an important principle. The 100 dollar bill in the ATM will become money only at the instant you withdraw it. The reason is this. We want the money supply to measure how much is available for immediate consumption. But currency inside a bank cannot be used for consumption and this is why it is not counted in the money supply. Cash in the bank is not money, but the binary bits in the bank's computer system representing the balance in your checking account are!

An example may also illustrate this important fact:

• Eric has 100 euro - this amount is obviously part of the money supply as it is immediately available for consumption.

• Eric deposits 100 euro into his checking account. He still has 100 euro available for immediate consumption using Ins debit card and the money supply should not be changed by tins deposit (it is not - deposits are included in the money supply).

• Eric’s bank now has 100 euro more than before deposit. If we count currency inside the bank as money, the money supply would have increased by 100 euro by his deposit. This does not make sense as the amount available for immediate consumption has not changed.

• In the same way, withdrawing money from the ATM does not affect the money supply. When you withdraw money, currency outside banks increases while your checking balance decreases by the same amount.

Even though currency inside a bank is not money, it is still part of the monetary base. 100 euro inside the bank is obviously still worth 100 euro to the bank even though we do not include it in the money supply.

Money and banks (part 6)

Monetary base

The monetary base is defined as the total value of all currency (banknotes and coins) outside the central bank and commercial banks' (net) reserves with the central bank. The monetary base is a debt in the balance sheet of the central bank. Its assets are mostly comprised of the foreign exchange and gold reserves and bonds issued by the national government. Currency inside the central bank has no value - it is comparable to an “I owe you” written by yourself and held by yourself.

Since the central bank has a monopoly on issuing currency, it is in complete control of the monetary base. Soon i will describe exactly how they change the monetary base. However, the central bank does not completely control the money supply. This is due to the second component of the money supply - bank deposits - which it cannot control. Fortunately, it has methods of influencing the total money supply and these methods will be discussed in the nearest future.

In many countries, the central bank imposes reserve requirements. Tins means that commercial banks are obliged to hold a certain percentage of deposits as reserves either as currency in their vaults or as a deposit at the central bank. Reserve requirements are usually rather small (typically between 0% and 10%) which means that the monetary base is quite close to the value of all currency outside the central bank.

Money and banks (part 5)

Central banks

Introduction

A central bank is a public authority that is responsible for monetary policy for a country or a group of countries. Two important central banks are the European Central Bank (for countries that are members in the European Monetary Union) and the Federal Reserve of the United States.

Central banks have a monopoly on issuing the national currency, and the primary responsibility of a central bank is to maintain a stable national currency for a country (or a stable common currency for a currency union). Stability is sometimes specified in terms of inflation and /or growth rate in the money supply.

Other important responsibilities include providing banking services to commercial banks and the government and regulating financial markets and institutions. In this sense, a central bank is the “bankers’ bank'' - other banks can borrow from or lend money to the central bank. Therefore, all banks in a country have an account in the central bank. When a commercial bank orders currency from the central bank, the corresponding amount is withdrawn from tins account. Tins account is also used for transfers between commercial banks. Central banks also manage the country’s foreign exchange and gold reserves.

Money and banks (part 4)

Economic functions of money

Money is generally considered to have three economic functions:

• A medium of exchange. This is its most important role. Without money we would live in a barter economy where we would have to trade goods and services for other goods and services. If I had fish but wanted bread, I would need to find someone who was in the precise opposite situation. In a monetary economy I can trade fish for money with one individual and money for bread with another. Money solves what is called the double coincidence of wants.

• A unit of account. In a monetary economy, all prices may be expressed 111 monetary units which eveiyone may relate to. Without money, prices must be expressed in units of other goods and comparing prices are more difficult. You may find that a grilled chicken costs 2 kilos of cod 111 one place and 4 kilos of strawberries in another. Finding the cheapest grilled chicken is not easy.

• Store of value. If you are a fisherman and have a temporary surplus of fish that you want to store for the future, storing the fish might not be a sreat idea. Money, 011 the other hand, stores well. Other commodities, such as gold, have this feature as well.

Money and banks (part 3)

Money, wealth and income

Money is not the same as wealth. An individual may be very wealthy but have no money (for example by owning stocks and real estate). Another individual may have a lot of money but no wealth. This would be the case if prices are very high, e.g in Uganda, where u have to pay more than a million to eat in a restaurant or

an individual with no wealth borrows money from a bank. She will have money (for example in the form of a deposit in the bank) but no wealth since this deposit exactly matches the outstanding debt. Be careful with this distinction: do not say “Someone has a lot of money” if you mean that Anna is wealthy.

Money is not the same as income and income is not the same as wealth. Income is a flow (for example is currency units per month) while money or wealth is a stock (measured at a particular point in time). Again, it is very possible to have a high income but no money and no wealth, or to be very wealthy and have a lot of money but no income. This is another distinction to be careful with. Do not say that “Sam makes a lot of money” if you mean that Sam has a high income. Money has a very precise definition in economics!

Money and banks (part 2)

What is money and what is not money

What is money? It is a medium of exchange. What does it do? It ensures the success of exchange by being the one item on offer that is ALWAYS acceptable. Why is it necessary? Because human beings must exchange to live together in peace, and to prosper. How important was the discovery of the idea of money? Look around you.

That covers the concept or idea of money. But an idea, as such, does not exist as a physical entity. Money must be a physical entity. Neither the "electronic" money of today nor the notes and coin which circulate as cash has any official or legal connection with Gold and Silver. But they once did, and most people think that they still do. As long as that situation persists, the modern monetary system will function.

If you are trying to determine if something is money, simply consider whether it would be accepted in most stores as payment. You then realize that stocks, bonds, gold or foreign currency are not money. These must frsst be exchanged for the national currency before you can use them for consumption. Note that in some cases, foreign currency will be money. For example, in some border towns, the currency of the bordermg country may be accepted virtually everywhere.

You also realize that some bank deposits are money. If you have money in an account in a bank and a debit card, you can pay for goods and service using the card in most places. Funds are withdrawn directly from your account when you make the purchase, which makes the deposits as good as cash in your pocket. Counting deposits as money is also consistent with the idea that money measures how much is available for consumption.

Not all deposits can be counted as money. With most savings accounts, you cannot connect the account to a debit card and these deposits should not be counted as money. We also note that what is money has nothing to do with the commodity or token itself:

Money and banks (part 1)

Money

Everybody knows what money is. People think this is so easy. To make sure you know everything you should read this post. 

In fact money has a long and interesting history and an understanding of how we came to use money is useful for anyone. Soon I’ll give you more info describing how money was “invented” and how it evolved over time. But if you are curious, there are many excellent descriptions on the Internet.

“Money” in economics is actually not as simple to understand as you may think and many use the term money in a way inconsistent with how it is defined in economics. Money is defined as any commodity or token that is generally accepted as payment of goods and services.

·         Ther`re two types of money:

In most countries, one can identify two "types of money”:

•                     Currency and coins

•                     Bank deposits

The total value of all the money in a country at a given point in time is called the money supply and this is an important macroeconomic variable. The reason for the importance of the money supply is that it measures how much is available for immediate consumption. There is an important relationship between the supply of money and inflation, which will be investigated later on.