Money, Monetary Aggregates, and Banks

Money, monetary aggregates, and banks

Monetary system: fundamentals of monetary analysis
Money plays a central role in the functioning of the modern economy, providing exchange, valuation, and preservation of purchasing power. Understanding the nature of money, monetary aggregates, and the banking system is essential for analyzing monetary policy and its impact on financial markets.

Functions of money
Money performs three classic functions.

Medium of exchange: money eliminates the necessity of a double coincidence of wants characteristic of barter, and significantly reduces transaction costs.

Measure of value: money serves as a unit of price measurement, simplifying comparison of the value of various goods.

Store of value: money allows purchasing power to be transferred over time.

In the modern economy, both cash (banknotes and coins) and non-cash money (bank deposits) fulfill the functions of money. The majority of the money supply in developed economies exists in non-cash form.

Monetary aggregates
Monetary aggregates are indicators of the money supply, differing in the degree of liquidity of included assets. Narrow aggregates contain the most liquid forms of money, while broad aggregates include less liquid assets.

M0 (monetary base, monetary base) includes cash in circulation and reserves of commercial banks in the central bank. These are funds directly created by the central bank.

M1 includes cash in circulation and demand deposits (current accounts). These are funds directly used for settlements.

M2 adds to M1 time and savings deposits as well as retail money market funds. This is a broader indicator, including less liquid forms of money.

Definitions of aggregates differ between countries. Central banks publish data on monetary aggregates and use them for monitoring monetary conditions.

The banking system and money creation
Commercial banks play a key role in the creation of money. When a bank issues a loan, it creates a deposit of an equal amount in the borrower’s account. This deposit is money (part of M1 or M2).

Thus, bank lending increases the money supply.

The deposit multiplier shows how much the money supply increases when the monetary base expands. If $r$ is the required reserve ratio, the theoretical multiplier equals $1/r$. With a reserve ratio of 10%, an increase of the monetary base by $1$ dollar may lead to an increase in deposits by $10$ dollars.

In practice, the multiplier is lower than the theoretical value. Banks may hold excess reserves above the required level. Some money leaks into cash. The demand for credit may be insufficient.

Reserve requirements
The central bank sets the required reserve ratio — the portion of deposits that banks must hold in reserves (either in cash or in accounts at the central bank). Reserve requirements constrain banks’ ability to create money and serve as a tool of monetary policy.

Over recent decades, the role of reserve requirements has diminished. Many central banks use zero or minimal reserve requirements, relying on other instruments for controlling the money supply.

Application for investors
The dynamics of monetary aggregates are informative for assessing monetary conditions. Rapid growth of the money supply may indicate easy monetary policy and create prerequisites for future inflation. The contraction of the money supply may signal tightening conditions.

Bank credit activity is connected to the economic cycle. Growth in lending stimulates demand and supports economic activity. Credit contraction worsens recessions.

The health of the banking system is critical for financial stability. Problems in the banking sector can lead to a credit crisis with severe consequences for the economy and markets.