Monetary system

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Commodity money system[edit]

A commodity money system is a monetary system such as the gold standard in which a commodity such as gold is made the unit of value and physically used as money, any other money, such as paper notes, being theoretically convertible to it on demand. A historical alternative which was rejected in the Twentieth Century was bimetallism, also called the "double standard", under which both gold and silver were legal tender.[1]

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. Typically fiat money is paper currency or base metal coinage, but can also be simply data such as bank balances and records of credit or debit card purchases.[2] In the modern economy most money is held as deposits in banks, and the fraction that exists as currency (notes and coins) is relatively small.[3] Money is mostly created, contrary to what is written in most textbooks, by banks when they loan to customers. Put simply, bank lending create deposits. 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’ money by using it to repay their existing debt, for instance.[4]

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 we can use paper bills or bank balances to buy goods.[6]

See also[edit]

References[edit]

  1. ^ Velde, Francois R., Following the Yellow Brick Road: How the United States Adopted the Gold Standard. Economic Perspectives, 4th Quarter, 2002. Available at SSRN: http://ssrn.com/abstract=377760 or doi:10.2139/ssrn.377760
  2. ^ http://www.investopedia.com/terms/f/fiatmoney.asp
  3. ^ "Money creation in the modern economy: an introduction". Bank of England. 
  4. ^ "Money creation in the modern economy". Bank of England. 
  5. ^ "Money creation in the modern economy". Bank of England. 
  6. ^ http://www.dummies.com/how-to/content/how-the-fiat-system-works.html

External links[edit]