The functions of money

 

Medium of exchange
for buying things

 

Unit of account
for pricing

 

Store of value
for saving

Central banks usually define and monitor several monetary aggregates. Developments in these aggregates can reveal useful information about money and prices. Several aggregates are needed because many different financial assets are substitutable and the nature and characteristics of financial assets, transactions and means of payment change over time. The Eurosystem has defined a narrow (M1), an “intermediate” (M2) and a broad monetary aggregate (M3) for use in the ECB’s monetary analysis. The ECB looks at developments in these aggregates, together with a lot of other information and analyses, as part of its monetary policy strategy.

How is money created?

The ECB acts as a bank for the commercial banks and this is also how it influences the flow of money and credit in the economy to achieve stable prices. Commercial banks, in turn, can borrow money, i.e. central bank reserves, from the ECB, usually to cover very short-term liquidity needs. The ECB’s main tool for controlling the quantity of “outside” money, and hence the demand for central bank reserves by commercial banks, is setting very short-term interest rates – the “cost of money”.

Money creation in the euro area

 

European Central Bank

 

Commercial banks

 

People & businesses

Commercial banks can also create so-called “inside” money, i.e. bank deposits – this happens every time they issue a new loan. The difference between outside and inside money is that the former is an asset for the economy as a whole, but it is nobody’s liability. Inside money, on the other hand, is named this way because it is backed by private credit: if all the claims held by banks on private debtors were to be settled, the inside money created would be reversed to zero. So, it is one form of currency that is created – and can be reversed – within the private economy.

What about the ECB’s “money-printing” scheme I keep reading about?

In practice, only the national central banks physically issue euro banknotes. “Money-printing” is the colloquial term for the ECB’s asset purchase programme, a form of “quantitative easing”. By purchasing assets in the financial market, the ECB creates additional central bank reserves that can help reduce – through a variety of channels – the interest rates faced by households and firms with a view to supporting the economy and, ultimately, to keep the value of money stable when the room to cut those interest rates directly controlled by the ECB is limited. In this process, the ECB does not actually print banknotes to pay for the assets but creates money electronically, which is credited to the seller or intermediary, e.g. a commercial bank. The seller can then use the additional liquidity to buy other assets or, in case of a commercial bank, extend credit to the real economy. The purchases contribute to improving monetary and financial conditions, making it cheaper for businesses and households to borrow so they can invest and spend more. The ultimate aim is that inflation rates return to levels close to but below 2% in line with the ECB’s price stability mandate.

 

Credit: essence and types

Essence is the property or set of properties that make an entity or substance what it fundamentally is, and which it has by necessity, and without which it loses its identity. Essence is contrasted with accident: a property that the entity or substance has contingently, without which the substance can still retain its identity. The concept originates with Aristotle, who used the Greek expression to tiêneinai, literally meaning "the what it was to be" and corresponding to the scholastic term quiddity or sometimes the shorter phrase to tiesti, literally meaning "the what it is" and corresponding to the scholastic term haecceity for the same idea. This phrase presented such difficulties for its Latin translators that they coined the word essential (English "essence") to represent the whole expression. For Aristotle and his scholastic followers, the notion of essence is closely linked to that of definition.

Bank system and its role in the economy development

Banks accept deposits and make loans and derive a profit from the difference in the interest rates paid and charged to depositors and borrowers respectively. The process performed by banks of taking in funds from a depositor and then lending them out to a borrower is known as financial intermediation.

Through the process of financial intermediation, certain assets are transformed into different assets or liabilities. As such, financial intermediaries channel funds from people who have extra money or surplus savings (savers) to those who do not have enough money to carry out a desired activity (borrowers).

Banking thrive on the financial intermediation abilities of financial institutions that allow them to lend out money and receiving money on deposit. The bank is the most important financial intermediary in the economy as it connects surplus and deficit economic agents.

When you deposit your money in the bank, your money goes into a big pool along with everyone else’s, and your account is credited with the amount of your deposit. The role of the bank is to provide a safe place to keep your money and sometimes the opportunity to earn interest on your deposits.

Services like current and savings accounts provide convenient ways for you to pay your bills without the hustle of using cash. At the same time, when you run short of liquidity, the bank is able to give you some advance to cover up for your shortfall through other depositors funds.