The components of the monetary system

 

A monetary system is the set of institutions by which a government provides money in a country's economy. Modern monetary systems usually consist of the national treasury, the mint, the central banks and commercial banks.[1]

A commodity money system is a monetary system in which a commodity such as gold is made the unit of value and physically used as money. The money retains its value because of its physical properties. In some cases, a government may stamp a metal coin with a face, value or mark that indicates its weight or asserts its purity, but the value remains the same even if the coin is melted down.

Commodity-backed money

One step away from commodity money is "commodity-backed money", also known as "representative money". Many currencies have consisted of bank-issued notes which have no inherent physical value, but which may be exchanged for a precious metal, such as gold. (This is known as the gold standard.) The silver standard was widespread after the fall of the Byzantine Empire, and lasted until 1935, when it was abandoned by China and Hong Kong.

Another alternative which was tried in the twentieth Century was bimetallism, also called the "double standard", under which both gold and silver were legal tender.[2]

Fiat money[edit]

The alternative to a commodity money system is fiat money which is defined by a central bank and government law as legal tender even if it has no intrinsic value. Originally fiat money was paper currency or base metal coinage, but in modern economies it mainly exists as data such as bank balances and records of credit or debit card purchases,[3] and the fraction that exists as notes and coins is relatively small.[4] Money is mostly created, contrary to what is written in most textbooks, by banks when they loan to customers. Put simply, banks lending currency to customers creates more deposits and deficit spending.

In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits. Although commercial banks create money through lending, they cannot do so freely without limit. Banks are limited in how much they can lend if they are to remain profitable in a competitive banking system. Prudential regulation also acts as a constraint on banks’ activities in order to maintain the resilience of the financial system. And the households and companies who receive the money created by new lending may take actions that affect the stock of money – they could quickly ‘destroy’ the money or currency by using it to repay their existing debt, for instance.[5]

Central banks control the creation of money by commercial banks, by setting interest rates on reserves. This limits the amount of money the commercial banks are willing to lend, and thus create, as it affects the profitability of lending in a competitive market.[5] This is the opposite of what many people believe about the creation of fiat money. The most common misconception was that central banks print all the money, this is not reflective of what actually happens.

Today's global monetary system is essentially a fiat system because people can use paper bills or bank balances to buy goods.[

 

Money: essence, functions and aggregates

· Whatismoney?

24 November 2015 (updated 20 June 2017)

Euro banknotes and coins are money but so is the balance on a bank account. What actually is money? How is it created and what is the ECB’s role?

The changing essence of money

The nature of money has evolved over time. Early money was usually commodity money – an object made of something that had a market value, such as a gold coin. Later on, representative money consisted of banknotes that could be swapped against a certain amount of gold or silver. Modern economies, including the euro area, are based on fiat money. This is money that is declared legal tender and issued by a central bank but, unlike representative money, cannot be converted into, for example, a fixed weight of gold. It has no intrinsic value – the paper used for banknotes is in principle worthless – yet is still accepted in exchange for goods and services because people trust the central bank to keep the value of money stable over time. If central banks were to fail in this endeavour, fiat money would lose its general acceptability as a medium of exchange and its attractiveness as a store of value.

The nature of money over time

Commodity money

Representative money

 

Fiat money

Present-day currency can also exist independently of a physical representation. Money can exist in a bank account in the form of a computer entry or stored in the form of a savings account. Digital cash, or e-money, is monetary value stored in a pre-paid card or smartphone, for example. And direct debits, internet payments and card transfers are all forms of payment that do not involve cash. (There are even newer decentralised digital currencies or virtual currency schemes like Bitcoin that exist without a central point of control like a central bank. These are not regarded as money from a legal perspective.)

Despite the rapid rise in electronic payments, cash is still very popular. In the euro area, cash is used for a high proportion of all payments under €20. The value of euro cash is guaranteed by the ECB and the national central banks of the euro area countries, which together form the Eurosystem.

The uses of money and how the ECB keeps track of it

Money, whatever its form, has three different functions. It is a medium of exchange – a means of payment with a value that everyone trusts. Money is also a unit of account allowing goods and services to be priced. And it is a store of value. Only a portion of euro cash in circulation actually circulates, i.e. is used for processing payments. For example, many of the circulating €50 notes are hoarded.