Brief Guide to Economics - Money & Banks

This was the question posed by reikidreamer:

Accurately describe to me how money is created in this Country, the U.S.A. (or other countries) and how the banks. Do banks work the way you think they work? Is money created the way you think money is created? If you can explain the correct theory to me you will be a Financial winner in life. You must understand money before you can create it.

I have a small problem where one thought leads to another and I don't always answer the question, but here is my attempt.

I started by trying a brief reply:

Short version is that new money is printed to replace notes which are already in circulation. The old ones are removed from circulation and replaced with new ones. That happens in 95% of the case. The problem with printing additional money would be that it would cause inflation, so that rarely happens. These new notes are then issued to the Federal Reserve Banks. The central bank, Federal Reserve in the USA, is the one that controls the supply of money. Just printing it out though is not the way to go. What they do is to increase money supply is to buy fixed-income securities from the government, thus increasing the amount of money in circulation. In the same way, they sell fixed-income securities to decrease the money in circulation. Fixed -income securities are basically government bonds, which are government debt securities...

But then there was the problem about terminology. How could I explain it to someone who does not have an Economics and Finance background?

So as I was saying, fixed-income securities here are government bonds when it comes to the creation of monies. A government bond is a risk-free bond which is issued by the central bank of a country and when bought by the public, it is basically decreasing money in circulation because the public is investing. So should you or I buy government bonds, we have less money to spend on shoes, handbags, cars, flat screen TVs. When the term expires on those bonds or the government wants more money in circulation, it can also buy those bonds back early from the public. Sometimes they are bought at the original price from the public.  A buyback can also save the government millions in interest, which is another reason for buybacks, especially when national debt is high.

Now this might get a bit more complicated as money is not just money in your pocket or in the bank. There are four categories of money which when added together, create the money supply of a country.

M0 – this is the physical currency circulating in the economy. It is any liquid or cash asset held within a central bank. It is the most liquid measure of the money supply. Liquid means that cash or assets that can be quickly converted into currency – cash in hand. Your current account is liquid. If you go into your bank today and ask for money, they’ll give it to you. Your house, on the other hand, isn’t very liquid as it can take forever for you to sell it and see that money in your hand.

M1 – similar to the above, but this is the physical money, the coins and notes in your hands. This is the measure used to quantify the amount of money in circulation. This category is also very liquid.

M2 – M1 + all time-related deposits, savings deposits and non-institutional money-market funds.  Also money that can de readily transferred into cash. Economists look at this category when not only trying to quantify the money in circulation, but also trying to explain different monetary conditions. This is because when looking at the money market and the value of a currency against another, you can start having an idea of current economic conditions.

M3 – M2 + time deposits, institutional money-market funds, short-term repurchase agreements (Repo) and other liquid assts. It is the broadest of all categories and is used to estimate the entire supply of money within an economy.

Given all these categories it can get confusing, but that was just a little taste.

Now banks want to hold onto your money for as long as possible. Why? Basically because all deals are done with other people’s money. The money I have in the bank is being used to pay for someone else’s interest, someone else’s mortgage, loan and so on and so forth. So you can imagine what would happen if one day every single person decided to go to bank X and wanted to withdraw their money. Impossible because the bank does not have the cash there physically. They cannot give it to everyone because the money is tied in loads of different investments. It happened in Brazil once where a bank was rumoured to be having financial difficulties and everyone who had an account with them rushed to get the money out. Basically, based on that rumour, the bank did indeed crash. It closed its doors and defaulted on its debt. Lots of people never got to see their money ever again. Why? Because money is virtual! There isn’t enough physical money in the world to cover the amount generated by banks in the form of interest. So there you go. Money is created by computers and is just numbers in a computer.

To control all this sort of thing, there is something called “Basel II” which improved on the way capital was measured and established various rules and guidelines as to how banks operate.  These are merely recommendations, but countries can’t really not follow them. These regulations are a safeguard against the types of financial and operational risk banks face.  I am not going much into this as I feel I am digressing. What I wanted to say here, which I find important is that banks are rated by companies such as Fitch Ratings, Standard & Poors, and Moody’s based on various criteria, for example, credit risk, market risk, operational risk, amongst others.

Banks have their risk, there is no denying it. They take on a lot of risk so that they cannot only safeguard your money, but make millions out of it.

Now, who wants a lesson in economics, GDP and all that fun stuff?



Resources:

www.investopedia.com
www.wikipedia.com