Money, Banking and the Euro

Posted on Nov 4, 2024 in Economy

MONEY AND ITS TYPES

Money is anything that constitutes a commonly accepted medium of exchange or payment.

  1. Commodity Money: The goods chosen as money must have the following qualities: durable, transportable, divisible, homogeneous, and limited supply. Gold and silver were historically chosen as money.
  2. Fiat Money: Fiat money is an asset that has very low value as a commodity (e.g., paper) but maintains its value as a medium of exchange because its value is endorsed by the entity that issues it.
  3. Cash and Paper Money: These arose from the activity of goldsmiths in the Middle Ages, who would safeguard precious metals and issue a receipt to the depositor, promising to return their belongings.
  4. Gold Standard: This is a system where paper money is convertible into gold.
  5. Promissory Note: A medium of exchange used to pay debts of a company or person.
  6. Bank Money: This is a debt of a bank, which has to give the depositor a specified amount of money upon request. It functions as a medium of exchange.
  7. Legal Tender: This is issued by an institution that monopolizes its issuance and takes the form of coins or banknotes.

MONEY SUPPLY

Money supply is the sum of cash in the hands of the public (notes and coins), i.e., the amount of money held by individuals and businesses, plus bank deposits.

MONETARY BASE

The cash in the hands of the credit system is bank reserves, and the total of those reserves plus the cash held by the public constitutes the monetary base of the system.

The European Central Bank controls the monetary base but not the money supply, which is neither constant nor predictable with accuracy.

DEMAND FOR MONEY

The demand for money is driven by the need for a medium of exchange and depends on:

  1. Income: As income increases, the demand for money (Dm) increases.
  2. Interest Rate: As interest rates rise, the demand for money (Dm) decreases.
  3. Inflation: As inflation increases, the demand for money (Dm) decreases.

THE FUNCTIONS OF MONEY

  1. Medium of Exchange: This is the most important function of money.
  2. Unit of Account: Money is used to measure the value of goods and services.
  3. Store of Value: Money can be saved and used to make purchases in the future.

CENTRAL BANK

The central bank of a country is the institution responsible for supervising the banking system and regulating the amount of money in the economy.

Specific Functions:

  • Save and manage foreign exchange reserves and precious metals not transferred to the European Central Bank.
  • Supervise the operation of credit institutions and financial markets.
  • Promote the proper functioning of the financial system.
  • Put coins into circulation.
  • Develop and publish reports and statistics related to their functions.
  • Act as the State Bank.
  • Advise the Government.

Functions as a Member of the European System of Central Banks (ESCB):

  • Define and implement monetary policy.
  • Conduct foreign exchange operations.
  • Promote the proper functioning of payment systems.
  • Issue legal tender notes.

EUROPEAN SYSTEM OF CENTRAL BANKS (ESCB)

The ESCB comprises the European Central Bank (ECB) and the national central banks of all European Union member states.

Features:

  • Define and implement monetary policy in the euro area.
  • Manage foreign exchange reserves of member countries and conduct foreign exchange operations.
  • Promote the proper functioning of payment systems, ensuring financial system stability.
  • Authorize the issuance of legal tender notes in the European Union.

BALANCE SHEET OF A CENTRAL BANK

Assets:

  1. Gold and Foreign Exchange: Currently, gold is not in circulation, but central banks hold a certain quantity of gold, and as such, it appears on the balance sheet. These constitute the reserves.
  2. Credits to the Banking System.
  3. Financial Assets or Collateral.

Liabilities:

This consists of two sections:

  1. Monetary Liabilities: These include cash held by the public and cash in the credit system, plus cash assets of the banking system. All of this constitutes the monetary base.
  2. Non-Monetary Liabilities: These include public sector deposits and the capital and reserves of the Central Bank.

MONEY MULTIPLIER

Bank money multiplier = 1 / Reserve Ratio = New Deposits / Increase in Reserves.

MONETARY BASE, MONEY SUPPLY, AND MONEY MULTIPLIER

Monetary Base = Cash held by the public + Reserves = Total bank assets of the Central Bank – Non-monetary liabilities of the Central Bank.

We can also define it as:

Monetary Base = Gold and foreign exchange + Credit to the banking system + Financial securities – Other Accounts.

Money Supply (Money) = (1 / Reserve Ratio) * Monetary Base.

The money multiplier (the term 1 / Reserve Ratio) indicates how much the money supply changes for every unit change in the monetary base.

The Central Bank can influence the money supply in two ways:

  1. By altering the monetary base.
  2. By changing the reserve ratio.

Therefore, the money supply depends on the Central Bank’s policy.

MONETARY POLICY, AGGREGATE DEMAND, AND INFLATION

When the Bank of Spain increases the money supply, it increases the capacity of the banking system to lend. Banks offer loans at lower interest rates, so the increase in the money supply causes a shift in the aggregate demand curve to the right. This is known as an expansionary economic policy. It leads to an increase in national income and the general price level.

If an economy is experiencing strong inflationary pressure due to excess aggregate demand, policymakers can resort to a restrictive economic policy aimed at shifting aggregate demand to the left. This measure will limit the ability of banks to grant loans, which will lower the money supply, leading to higher interest rates and a decrease in consumption and investment, ultimately reducing national income.

EXPLANATORY THEORIES OF INFLATION

The monetarist explanation of inflation, which follows the approach of classical economists, argues that changes in the money supply do not affect real variables such as production or employment but only affect prices. They also argue that the primary cause that explains the behavior of aggregate demand and prices is an increase in the money supply.

In graphical terms, the monetarist stance on inflation can be explained by saying that the long-term aggregate supply curve is almost vertical.

Keynesian Qualifications to the Monetarist Explanation

In the very short term, assuming that the aggregate supply curve is completely horizontal, an increase in the money supply has no impact on the price level.

EFFECTS OF INFLATION

Expected Inflation and Taxes

Inflation causes taxes to rise without real income growth. This is known as the inflation tax.

Expected Inflation and Interest Rates

During inflationary periods, lenders require compensation for the depreciation of the purchasing power of money, where:

Nominal Interest Rate = Real Interest Rate + Inflation Rate

Unanticipated Inflation

We can classify the effects of unanticipated inflation on the economic system as follows:

a) Effects on Distribution: Inflation hurts individuals who receive fixed incomes. It favors debtors and hurts creditors in nominal terms. Inflation benefits the state, firstly because it increases tax revenue and secondly because some of its costs tend to decrease.

b) Impact on Economic Activity: Inflation undermines economic efficiency because it distorts prices. Countries experiencing higher inflation rates will see their products lose competitiveness, negatively affecting exports.

c) Uncertainty: The uncertainty generated by inflationary processes also adversely affects production.

BALANCE OF PAYMENTS

The balance of payments is the record of economic transactions occurring during a given period between residents of a country and residents of the rest of the world.

Transactions that provide foreign exchange are recorded as revenue.

Transactions involving foreign exchange outflows are recorded as payments.

The balance is given by the difference between receipts and payments.

It is structured in three blocks:

  1. The Current Account: This consists of:
    • Trade Balance (Goods): This records the export and import of goods. Exports are recorded in the income column, and import payments are recorded in the payments column. The balance is obtained by the difference between receipts and payments. A positive balance means that more goods are exported than imported, so income is higher than payments. A negative balance indicates the opposite.
    • Services Account: This includes transactions of non-tangible goods (transport, travel, etc.). It produces the same effects on national income as the trade balance. The balance is calculated similarly to the trade balance but with services.
    • Income Account: This records income earned in countries other than the residence of the capital owner and labor income earned in a country other than the employee’s residence.
    • Current Transfers Account: This includes all transactions that have no direct financial compensation, such as remittances from migrants, official current transfers, and private and public donations. Revenue increases gross national income, while payments decrease it.
    • Current Account Balance: The sum of the account balances of goods, services, income, and transfers is the current account balance. When the economy has a surplus, it is providing resources to the rest of the world, and when there is a deficit, the economy is borrowing from abroad.
  2. The Capital Account: There are two types of transactions:
    • Unilateral Transfers of Capital: These are transfers without compensation and do not alter gross national disposable income, such as movements of funds generated by liquidating the assets of migrants, debt forgiveness by creditors, and cohesion funds from the European Union.
    • Acquisition and Disposal of Non-Produced Non-Financial Assets: These include land or subsoil resources and transactions associated with intangible assets. Acquisitions are recorded in the income column, and disposals are recorded in the payments column.
  3. The Financial Account: This includes the following:
    • Foreign Direct Investment (FDI): This occurs when the investor intends to maintain a stable presence in the invested company, reaching a high degree of influence over its administration or management bodies.
    • Portfolio Investment: These are transactions in securities (stocks, bonds, and promissory notes). Capital inflows from abroad to buy domestic assets are recorded with a positive sign in the change in liabilities column, and outflows to buy foreign assets by domestic residents are recorded with a positive sign in the change in assets column.
    • Other Investments: This includes loans linked to trade (trade receivables) and financial loans.
    • Variation of Reserves: Reserves are a country’s holdings of foreign exchange and other assets that can be used to meet foreign exchange demands. They represent claims on the rest of the world, making the country an external creditor. The change in reserves measures the increase or decrease in international means of payment determined by the inflow or outflow of foreign currency, reflecting the change in the creditor or debtor position against the rest of the world. Capital inflows are recorded with a positive sign in the change in liabilities column, and capital outflows are recorded with a positive sign in the change in assets column.

EXCHANGE RATE

The exchange rate is determined in the foreign exchange market through the interplay of supply and demand. Like any other price, its value can fluctuate upwards or downwards.

Exchange Rate Depreciation: A decrease in the exchange rate, meaning that, for example, fewer dollars are obtained for one euro.

Exchange Rate Appreciation: An increase in the exchange rate, meaning that, for example, more dollars are obtained for one euro.

DEMAND FOR THE EURO

The demand for the euro comes from individuals or entities wishing to exchange dollars (or other currencies) for euros. They demand euros because they are interested in exchanging dollars for euros.

Motivations to Demand Euros

There are three main motivations: exports, the inflow of tourists, and financial capital inflows.

Variables that Affect the Demand for Euros

  • The Real Exchange Rate: Demand for euros depends on the exchange rate and, therefore, on the following variables:
    • Nominal Exchange Rate: An increase in the exchange rate makes exports more expensive, reducing exports and, hence, the demand for euros. A decline in the exchange rate makes European exports cheaper and, therefore, increases demand for euros.
    • Domestic Prices: An increase in European prices makes goods and services more expensive, reducing euro area exports and, consequently, the demand for euros. The opposite occurs when prices decrease.
    • Foreign Prices: An increase in foreign prices makes European goods and services cheaper, increasing exports and the demand for euros. The opposite occurs when foreign prices decrease.
  • Foreign Income: A country’s exports and the demand for its currency grow when foreign income increases and decrease when foreign income falls.
  • Interest Rate Differential: The inflow of capital depends on the remuneration of assets in which these funds can be invested compared to other countries. The greater the interest rate differential, the greater the inflow of capital, and vice versa.

Euro Demand Curve: The euro demand curve shows the inverse relationship between the quantity of euros demanded and the euro exchange rate when other variables are held constant. An increase in the exchange rate reduces the quantity of euros demanded because it makes exports more expensive and causes them to shrink.

SUPPLY OF EUROS

The supply of euros comes from individuals or entities who want to change euros for dollars.

Reasons for Offering Euros

There are three main reasons: imports, the outflow of tourists, and financial outflows.

Variables that Affect the Supply of Euros

The variables that affect the supply of euros are the same as those that affect the demand, but with opposite effects.

EXCHANGE RATE SYSTEMS

The three main exchange rate systems are:

  • Flexible Exchange Rates: The exchange rate depends exclusively on the supply and demand of foreign exchange, and the balance of payments adjusts automatically.
  • Fixed Exchange Rates: The value of the currency is fixed by the Central Bank without taking into account the supply and demand of currencies, which involves buying or selling euros to maintain the fixed rate.

ADVANTAGES AND COSTS OF THE EUROPEAN UNION

The advantages of creating a single currency are:

  • Greater confidence in the markets.
  • Stronger financial markets.
  • Greater price stability.
  • Reduced interest rates.
  • Improved public finances.

The creation of the single currency entails costs due to the considerable differences between member states. The most representative costs are:

  • Differences in the legal systems of member countries.
  • Differences in tax systems, pay systems, and educational systems.
  • Differences in economic development.

GLOBAL ASSESSMENT OF SPAIN’S ENTRY INTO THE EU

For the Spanish economy, entry into the EU has been positive in many respects. Before joining the European Monetary Union (EMU), the Spanish economy had structural imbalances that had to be overcome to meet the Maastricht criteria. Although there are still some problems to overcome, such as the high unemployment rate, Spain has benefited significantly from EU membership.