Monetary Systems and Financial Intermediaries

Posted on Nov 21, 2024 in Economy

Item 12: Banks, Money, and Monetary Policy

12.1 Money: Concept, Factors, Types, and Characteristics

Concept: Money is a generally accepted means of payment.

Functions: Money has four key features:

  • Medium of Exchange: Universally accepted for payments.
  • Unit of Account: Used to assign value to goods and services.
  • Store of Value: Serves as a means to accumulate wealth.
  • Standard of Deferred Payment: Used to settle debts at a future date.

Types:

  • Legal Tender: Money issued by a central bank (e.g., banknotes and coins).
  • Bank Money: Recorded entries in various accounts, existing virtually within the banking system.

Characteristics of Legal Money:

  1. Manageable: Light and easy to handle.
  2. Difficult to Forge: Secure against counterfeiting.
  3. Durable: Resistant to wear and tear.
  4. Divisible: Can be broken down into smaller units.

12.2 Financial System

Definition: A structure comprising intermediaries regulated by public bodies, channeling savings to finance private consumption, business investment, and public spending.

Savings Resources → Intermediaries → Financing

The financial system operates as a market where money is exchanged, involving supply, demand, prices, and intermediaries.

  • Money Supply: Individuals or companies with excess resources, often held as bank deposits.
  • Money Demand: Individuals or companies needing money for transactions, security, or speculation.
  • Intermediaries: Entities mediating between suppliers and applicants.

a) Banking Intermediaries:

  • Central Bank (e.g., Bank of Spain)
  • Commercial Banks (e.g., BBVA, Santander)
  • Savings Banks (e.g., former Sa Nostra, La Caixa)
  • Credit Cooperatives

b) Non-Banking Intermediaries:

  • Stock Market
  • Insurance Companies
  • Pension Funds
  • Leasing Companies
  • Institute of Official Credit (ICO)

Price: The price of money is the interest rate, directly related to money supply and inversely related to money demand.

12.3 Banks and the Banking Money Creation Process

Banks: Financial institutions authorized to accept deposits and provide loans.

Services:

  • Custody of Deposits
  • Loans
  • Transfers
  • Currency Exchange
  • Other Services (e.g., stock market operations, safe deposit boxes)

Money Creation Process: Banks hold a fraction of deposits as reserves and lend the rest. The reserve ratio is set by the central bank.

New Bank Money = New Deposit / Reserve Ratio

12.4 The Central Bank

Concept: A financial intermediary working with companies, commercial banks, and the public sector.

Features:

  1. Issuing banknotes and coins.
  2. Acting as the bank for banks:
    • Custody of reserves
    • Loans to commercial banks
    • Supervision of commercial banks
  3. Acting as the banker for the state:
    • Managing state payments and accounts
    • Managing public debt (Treasury bills and government bonds)
  4. Managing foreign reserves:
    • Custody of gold and foreign currencies
    • Facilitating international payments
  5. Implementing monetary policy to maintain economic stability by controlling inflation, interest rates, and exchange rates.

12.5 Monetary Policy

Decisions by the monetary authority (Central Bank) to change the monetary base or money supply.

Monetary Base = Cash in public hands + Reserves

Money Supply = Cash in public hands + Deposits

Monetary Policy Instruments:

  1. Varying the reserve ratio.
  2. Providing or reducing loans to commercial banks.
  3. Open market operations (buying or selling debt).

Types of Monetary Policy:

a) Expansionary: Increases money supply.

  • Reduces reserve ratio.
  • Increases loans to commercial banks.
  • Buys debt.

b) Contractionary: Decreases money supply.

  • Increases reserve ratio.
  • Reduces loans to commercial banks.
  • Sells debt.