Understanding Money: Types, Features, and Monetary Policy

Posted on Mar 23, 2025 in Economy

The Essence of Money

Money: A medium of exchange generally accepted. Key characteristics include:

  • Desirability and acceptance
  • Divisibility
  • Durability
  • Easy to transport
  • Difficult to counterfeit

Types of Money

  • Commodity Money: Used as money because it has intrinsic value.
  • Representative Money: A document acknowledging a debt or serving as a means of payment.
  • Fiat Money: Money with value based on confidence in the issuing entity, not intrinsic value. Examples include existing notes and coins, and bank payments.

Features of Money

  • Medium of Exchange: Facilitates the buying and selling of goods and services.
  • Store of Value: Allows saving and delaying consumption.
  • Unit of Account: Enables comparison of the value of goods and services.

Price of Money: Interest Rates

The interest rate is the charge for a loan. Factors influencing interest rates:

  • Risk: Higher risk leads to higher interest rates, and vice versa.
  • Liquidity: Ease of converting back to money; higher liquidity results in lower interest rates, and vice versa.
  • Duration: The time to recover the investment; longer duration means greater interest, and vice versa.

Classes of Fiat Money

  1. Legal Tender: Money issued by a country’s monetary authority; notes and coins are legal tender (e.g., € in a wallet).

Money, Banking, and Deposit Creation

Mechanisms set by financial institutions to facilitate transactions (cards, checks, notes, etc.) with banks and building societies.

Fractional Reserves

Banks take deposits and lend money. They don’t pay out 100% of collected money but keep a percentage as reserves. The monetary authority sets the required reserve ratios.

The legal ratio of cash reserves is set by the ECB for commercial banks.

Monetary Multiplier

Measures the increase in the quantity of money in circulation through the financial system.

Monetary Policy: European Central Bank (ECB)

The ECB is the independent monetary authority for countries using the €. Its primary objective is to maintain annual inflation around 2%. Achieving this helps with other objectives.

ECB Features

  • Decides monetary policy for the Eurozone.
  • Manages interest rates, reserves, foreign exchange, and precious metals.
  • Promotes efficient payment systems and financial stability.
  • Issues Euro banknotes.
  • Oversees banks and the financial system.

Definition: Monetary Policy: Actions taken by a country’s monetary authorities to achieve macroeconomic objectives, using various instruments and intermediate targets.

Instruments of Monetary Policy

  • Reserve Requirements: Percentage of deposits commercial banks must hold.
  • Open Market Operations: Monetary authorities buy or sell bonds. Buying injects money into the market; selling withdraws money.

Intermediate Objectives

These help achieve the ultimate objectives:

  • Money Supply: Reducing reserve requirements, repurchasing bonds, or increasing deposit facilities increases money supply and lowers interest rates, and vice versa.
  • Interest Rates: The official cash interest rate is set by the ECB and can be adjusted through buying and selling bonds.
  • Credit Conditions: The monetary authority regulates the financial system and can set conditions to facilitate or hinder loans.

Types of Monetary Policy

  • Expansionary Monetary Policy: Used to stimulate economic activity.
  • Contractionary Monetary Policy: Used to cool down the economy.