Money and Banking: Functions, Standards, and Modern Systems
Money and Banking
Money is the generally accepted medium of exchange for transactions and payments for goods and services.
Money originated from the need to replace bartering. Initially, communities accepted any currency, but later, especially to encourage international trade, a standard measure was adopted. The “gold” initiative, mainly led by Venetian bankers, involved receiving gold deposits in escrow from merchants and issuing credit or promissory notes backed by this gold, which served as payment.
Subsequently, a monetary system based on the gold standard functioned as follows:
1. Gold was adopted as backing for each country’s currency, stored in bank vaults. Each country issued coins, their value tied to the gold reserves. For international trade, the “pound sterling” became the standard “hard” currency.
2. If England had a ton of gold and issued a thousand pounds, each pound was convertible into a kilo of gold. If another country with only half a ton of gold also issued a thousand coins, their currency’s backing was half a kilo of gold, making one pound equivalent to two of their coins. Since international prices were in pounds sterling, foreign trade transactions were paid in respective currencies but pegged to the sterling exchange rate.
3. The gold standard was eventually abolished because it failed to meet the evolving needs of international trade.
Today, we have a trust-based monetary system where currency is backed by the production of goods and services within an economy.
For money to fulfill its objectives as a means of exchange or generally accepted payment, it must have four functions:
1. Medium of Exchange: It must be accepted by the community; otherwise, people will seek alternatives.
2. Unit of Account: It must set prices for goods and services and allow for the measurement of economic and financial events, such as corporate balance sheets and GDP.
3. Store of Value: It should enable future operations, facilitate saving (e.g., insurance, pensions, savings accounts).
4. Standard of Deferred Payment: It should allow for setting future payments, such as credit sales or purchases.
It’s crucial to distinguish between the price and the value of a good or service.
The price is the ratio of a good or service to the existing currency, while the value is relative to other goods, services, and money. Monetary policy should aim to maintain money’s value, ensuring stable prices. For example, if money loses value due to inflation (rising prices), its relation to other goods and services diminishes.
However, it’s normal for the value of certain goods and services to change. If a property’s value increases, so will its price, and vice versa. This doesn’t necessarily mean the currency has gained or lost value.
A country’s money supply is categorized as follows:
- M1: Notes and coins in circulation plus current account deposits in banks.
- M2: Deposits in the banking or financial system.
- M3: Savings deposits. While M2 and M3 are not strictly money, they are accepted as payment methods and contribute to money creation.
Quasi-money, also accepted for some transactions, includes financial instruments from the Central Bank, such as bonds and promissory notes.
How can we have such a large money supply relative to M1? The answer lies in the bank multiplier, the creation of money through the banking system.
Banks, after approval by regulatory agencies, must meet capital requirements under the Basel agreements (recommendations on banking laws and regulations issued by the Banking Supervision Committee of Basel) and the Superintendent’s provisions. They can accept deposits up to approximately 12 times their assets, paying “call deposit interest.”
The Central Bank sets a reserve requirement on deposits, which banks must keep in cash at the Central Bank or invest in central bank notes.
Banks lend the remaining deposits to customers at a higher interest rate. The difference between lending and deposit interest rates is the bank’s operating profit.
M1 + M2 + M3 gives us the total money supply. Although only M1 is strictly money, M2 and M3 are also used for payments.
Near-money, including documents issued by the Central Bank, promissory notes, and bonds, also serves as a means of payment and represents assets on a company’s balance sheet.
Banking begins with issuing shares sold on the stock market, providing capital for infrastructure and implementation. However, the main objective is lending, achieved by attracting deposits. Deposit capture is limited to about 12 times the bank’s capital. Banks offer interest on term savings (“catchment interests”), while current accounts typically pay no interest.
Banks work with third-party money (current and term deposits), a debt owed to customers. They must set aside a reserve (lace) as determined by the Central Bank, differing for current and term deposits, and for domestic and foreign currencies. Banks often attract foreign currency deposits from abroad, especially when interest rate differentials are favorable.
If the central bank has an expansionary monetary policy (using money as a control variable to maintain economic stability; increasing the money supply), the reserve ratio is low. Conversely, under a contractionary monetary policy (reducing money supply growth and/or increasing interest rates), the reserve ratio will be high, reducing bank lending, raising interest rates, and making credit less available and more expensive.