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

Jamez

28 Mar 2025 • 3 min read

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:

It must be storable.
It must have stable purchasing power.
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:

Foreign Exchange Market Intervention: Changes in RFX affect the money supply.
Open Market Policy: Central banks influence the monetary base by adjusting credit to the government (G) or private sector (D).
Reserve Requirements: Adjusting reserve requirements changes the money multiplier, limiting bank lending.
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.