Understanding Money Creation, Financial Systems, and Markets
Banks and Money Creation
Banks can accept deposits and grant credits. However, they are also required to keep a portion of these deposits as reserves. Reserves are composed of cash in the bank and deposits of banks in the Central Bank. Banks are required to maintain cash reserves to deal with the withdrawal of deposits by customers. The Central Bank requires this, and it is an instrument for monetary policy. The amount of bank money created depends on the reserve requirement ratio (k): the larger it is, the less money is created. The use of private money also affects this, as when money is not deposited in the bank, it is not part of the process.
Monetary Magnitudes
Monetary Base
To create a money supply, one always starts with a monetary base. The monetary base is formed by the cash in the hands of the public (notes and coins) plus liquid assets or reserves of the banking system.
Monetary Base = Cash in the hands of the public + Liquid Assets of the Banking System
Money Supply
The amount of money in an economy, also called the money supply (M), is defined as the sum of cash in the hands of the public plus bank deposits. According to the type of deposits considered, there are five types of money supply.
Demand for Money
There are three reasons that lead to the demand for money:
- Transaction motive: Money is demanded for purchases. In this regard, the demand for money depends directly on income, as the more income one has, the more one consumes.
- Precautionary motive: Traders also keep and demand money to cope with unforeseen expenses.
- Speculative motive: The objective is to obtain a benefit or profitability from that money. This way, money indirectly depends on the interest rate. If the interest rate is high, the demand for financial assets increases, and the demand for money decreases, as higher returns can be obtained.
Financial System
The financial system is the set of legal norms, institutions, assets, and markets aimed at channeling savings towards investment or spending. Within the financial system, we have the set of institutions.
Financial Intermediaries
These institutions receive money from savers and lend it to those who need more money than they have. They facilitate and channel savings between savers and investors. Savers pay an interest rate to those who lend them their money and earn an interest rate on top of the debtors. Financial intermediaries can be of two types:
- Banking: Banks, savings banks, and credit unions that can create money.
- Non-Banking: Mutual insurance, renting, investment funds.
The difference between banking and non-banking intermediaries is that non-banking intermediaries cannot create money.
Financial Assets
A financial asset is any way to keep wealth. This can be maintained across two asset classes:
- Real assets: Jewelry, land, etc.
- Financial assets: Deposits, mutual funds, treasury bills, stocks, etc.
A good or asset is anything that yields a return to the person who possesses it.
Characteristics of financial assets:
- Liquidity: The ability to recover the money quickly. The more liquid an asset is, the lower the interest it will pay. Liquidity is related to the recovery period.
- Risk: Uncertainty generated by the asset. The higher the risk, the higher the return.
- Profitability: The return that the financial asset gives us.
Financial Markets
There are several markets as a function of the financial assets that are traded. Financial markets allow the purchase and sale of financial assets since they connect buyers and sellers through financial intermediaries.
Types of markets:
- Credit market: Formed by banks and other financial entities. These entities capture savings and other resources from savers and sell them as loans or credits.
- Stock market: Formed by entities that capture resources through the issuance of securities that are traded on the stock exchange.
- Primary market: Newly created assets are traded. For example, shares are issued for the first time.
- Secondary market: When the shares are bought and sold after the first issuance.
- Money market: Money and financial assets with a maturity of less than one year are traded.
- Capital market: Financial assets with a maturity of more than one year are traded.