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Financial markets and institutionsMoney & creation of money
1.1. Origin & characteristics
Definition :
• A product that is generally accepted in exchange for goods and services, i.e. it is a means
of exchange
• based on convention, it is an explicit or implicit agreement.
o Explicit: by law
o Implicit: whatever the economic agents agree to use as means of exchange
Function:
• Means of exchange.
• Investment.
• Unit of account.
• Standard for future payments.
Characteristics of money:
• Valuable in comparison to its weight.
• Durable.
• Divisible.
• Standardised quality.
• Easily recognisable.
• Stable Purchasing power..
Evolution :
• Barter trade.
• Commodities used as “money”.
• Precious metals
• Means of payment: coins (minted) or paper money.
• Legal tender.
• Fiduciary money.
Development of banks:
• Money exchange.
• Deposit banks.
• Commercial banks – Central banks
,Forms of money:
• Paper money and coins.
• Sight deposits.
• E-money.
• Alternative forms
1.2. Money Supply
2 components of money
• currency: coins and notes minted by the government and issued by the central bank.
• cashless money:
o (narrow sense) amount of money on sightdeposits
o (large sense) savingsdeposits + term accounts + financial assets with a longer
maturity
% currency in total moneysupply (M3): 9,5%
• fiduciary money = money based on trust:
value of the money token > the physical value of the money token (e.g. a 50 euro banknote)
Money supply concepts: M1 - M2 - M3
Definition
M1 : money in circulation +
“overnight” deposits with Euro area Main Financial institutions.
M2 (near money) : M1 + deposits with a maturity till 2 years
deposits refundable with a notice period of 3 months
M3 (near, near money) M2 + repurchase agreements +
money market fund +
money market paper +
securities with a maturity up to 2years
Currency is issued by the government. This need not be the case.
Taxonomy of monetary system (source: ESB)
fully centralised fully decentralised
"Full money" full reserve banking narrow banking current system private money cryptocurrencies
assets with Central bank assets with Comm. Banks assets with Comm. Banks
commercial creation of
backed by government banks issue money by
guarantee from the taxpayer backed by central bank reserves bonds & CB reserves money everyone
,In our economic system currency is issued by the government and specifically the European
Central Bank (ECB).
The total money supply however is endogenous and determined by the money creation of
commercial banks.
M = m. B
Lets discuss both m and B
Currency is issued by the government (ECB).
Assets liabilities
International currency (CP) base money: B=CP+R
reserves
Bank Reserves (R)
Claims cash held by the bank
Deposits from banks
, The money creation of commercial banks(denoted by “m”)is a function of
• Monetary policy via the reserve coefficient and
• Portfolio decisions of the public and the commercial banks (preferences for cash and
reserve coefficient)
Fractional reserve system: working –simple example
Starting point: minted: 100 & in hands of person 1
Money creation by commercial banks (fractional reserve system)
Simple example
∆𝐷 = 𝐷0 + 𝐷0 (1 − 𝑟)+𝐷0 (1 − 𝑟)2 + …
𝐷0
∆𝐷 = with
𝑟
D0 initial money supply (= initial amount of overnight deposits)
r : reserve coefficient (captures the behaviour of policy & commercial banks).
It is set by banks in function of their expectations about maximum cash withdrawals
by clients + by what the regulator imposes.
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