Prepared By: Ella Luo Course: FINC 5090 - Finance in the Global Economy Part 2: Money 1. Role of Money Money is broadly use

Prepared By: Ella Luo
Course: FINC 5090 - Finance in the Global Economy

Part 2: Money

1. Role of Money

• Money is broadly used for buying or selling goods and services.
• A pure barter system is inconvenient.

Conditions for Money as a Least-Cost Medium of Exchange:

1. It must be storable.
2. It must have stable purchasing power.
3. It must be easy to handle.

• Money serves as a unit of account (numéraire) when prices are quoted in monetary terms.
• Money can be lent or borrowed, facilitating the transfer of purchasing power over time in a low-risk manner.

2. How Money is Created

Types of Money Creation:

• Standard Commodities
• Official Precious Metals
• Privately Issued Paper Money
• Official Paper Money

Challenges with Early Forms of Money:

• Animals were bulky and difficult to transport.
• Precious metals were advantageous because they were less bulky, did not die or rust, but had high production costs.
• Issues with transportation and integrity of gold and silver coins (e.g., coin flipping, debasement).

Evolution of Money Creation Mechanisms:

• Traders deposited money with international bankers using bills of exchange and promissory notes.
• Receipts and bills were convertible into coins if the issuer was creditworthy.
• Banks issued notes far exceeding their coin reserves, relying on the fact that most notes remained in circulation.
• Banks primarily lend created money to the economy rather than giving it away.
• By refusing to roll over loans, banks can shrink the money supply.

Risks in Money Creation:

• A loss of confidence in bank-issued notes could trigger a run on the bank.
• Governments eventually assigned note production to central banks to avert crises.

Development of Central Banks:

• Initially, official banknotes were convertible into coins issued by mints or treasuries.
• Over time, central bank notes became widely accepted as true money.
• Unlike gold or cattle, modern money has no intrinsic value; its value is based on public trust in its purchasing power.

3. Official Paper Money and Central Banks

Issuing Money: Role of Central Banks

• Central banks do not directly interact with the public; their primary clients are commercial banks, foreign central banks, and governments.
• When a central bank purchases domestic or foreign assets from commercial banks, it does not always pay in banknotes.
• The central bank's liabilities include both banknotes and commercial bank deposits, collectively forming the country's monetary base (!).

Issuing Money: Role of Commercial Banks

• Private banks extend loans beyond their available base money since borrowers often leave funds in savings/checking accounts.
• This creates the potential for bank runs if too many depositors demand physical cash simultaneously.
• To mitigate risks, governments impose reserve requirements and central banks act as lenders of last resort.

Money Multiplier Equation:

M = m × ! = m × (D + G + RFX)

• m: Money multiplier
• !: Money base
• D: Credit to the domestic private sector
• G: Credit to the government
• RFX: Foreign exchange reserves (including gold)

Monetary Policy Tools:

1. Foreign Exchange Market Intervention: Changes in RFX affect the money supply.
2. Open Market Policy: Central banks influence the monetary base by adjusting credit to the government (G) or private sector (D).
3. Reserve Requirements: Adjusting reserve requirements changes the money multiplier, limiting bank lending.
4. Credit Controls: Directly restricts the amount private banks can lend.

4. International Payment Mechanism

Domestic Interbank Transfers: Gross Settlement vs. Periodic Netting

• Netting reduces transaction volume significantly (e.g., from 195 to 25 in a given example).
• Banks require smaller balances in central bank accounts due to netting.
• Large entities may require faster payments.

International Payments

• Domestic banks (S) and foreign banks (R*) are not part of the same clearing system.
• Correspondent Banking System:
  • Uses nostro (ours) and vostro (yours) accounts.
  • Settlement occurs periodically.
  • Slow and expensive, especially for payee-driven payments.

SWIFT - The Modern International Payment Solution:

• SWIFT (Society for Worldwide Interbank Telecommunication) facilitates rapid and secure bank messaging.
• Processes over ten million transactions daily for a small fee.
• Excess revenue is distributed among shareholder banks.
• Enables same-day value payments.
• Provides services such as local check printing and immediate delivery to banks.

5. International Money and Bond Markets

• Banks accept deposits to facilitate international loans.
• The development of international money markets led to the emergence of the international bond market.
• Many investors prefer USD deposits outside the U.S. due to:
  • Fewer regulations
  • Tax advantages from international deposits

This document presents a structured overview of the role of money, how money is created, the function of central banks, international payment mechanisms, and international money markets.