How does money work?

Question

Who works out how much money each country can print? Do you have to have an equivalent amount of gold for the output of currency?

Answer 1

You don't have to have an equivalent amount of gold. We aren't on a gold standard.

In our country, the money supply is controlled by the Federal Reserve. As to "who works out how much money" each country can print, typically that is determined by currency markets. Countries that print money like it is going out of style suffer badly with inflation and real exchange rates.

Answer 2

Each country's federal reserve bank (or national bank) is independent - with the exception of the European Currency (Euro), there of course only the Europen Central Bank is free to make decisions.

The coverage of currencies in Gold or foreign money (in other currencies) varies throughout the world.The Swiss Franc is covered more than 100% while some currencies depend on pure trust.

Usually the responsible national bank has to consider the exchange rates, the domestic interest rates as well as the economical situation in the country to make decisions on the development of the money amount. It's not that easy...

Read more in the link suggested.

Answer 3

It works becuase it is an accepted form of exchange by the people using it.

A country can print as much as they want, but there are dire consequences doing this (uncontrolled spending, inflation, etc)

Currencies don't have to be tied to gold. The U.S. wne tof the Gold Standard in ~1971.

Answer 4

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Answer 5

No one does that.

you and me decide how much money is printed when it all boils down.

it usually also depends on how many natural and renewable resources a country has.

how much food is available.

and how educated the people are.

thats my personal opinion.

Aaron

Answer 6

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2. M.R. Would you mind repeating your answer, I didn't quite get the gist the first time round.

Answer 7

Introduction

The origin of the word “MONEY” comes from the Latin word “Moneta”,
which comes from the temple of Juno (Hera), wherein was the Roman mint,
in the early days of Rome.
Money is an important media that is widely used throughout the world to
gain access to other or scarce commodities.
Economics offer various definitions of money, though it is now commonly
defined by the functions attached to any good or token that functions in trade
as a medium of exchange, store of value, and unit of account. Money maybe
seen as a required standard of payment.

In common usage, money refers more specifically to currency, particularly
the many circulating currencies with legal tender status conferred by a
national state; deposit accounts denominated in such currencies are also
considered part of the money supply, although these characteristics are
historically comparatively recent. Other functions money may posses are a
means of rationing access to scarce resources and a means of accumulating
power of command over others.

Since the introduction of money, it is used as an alternative to barter, which
is considered in a modern complex economy to be inefficient because it
requires a coincidence of wants between traders, and an agreement that these
needs are of equal value, before a transaction can occur. The efficiency
gains through the use of money are thought to encourage trade and the
division of labour in turn increasing productivity and wealth.

Early interventions shows that a number of commodity money systems were
amongst the earliest forms of money to emerge, for example:

(a)The shekel referred o a specific volume of barley in ancient Babylon.

(b)Iron sticks were used in Argos before Pheidon’s reforms.

(c)Cowries were used as money in ancient China and throughout the south pacific.

(d)Salt was used as a currency in pre-coinage societies in Europe.

(e)Ox-Shaped ingots of copper seem to have functioned as a currency in the “Bronze Age” eastern Mediterranean.

(f)State certified weights of gold and silver have function as currency since the reign of Croesus of Lydia, if not before.

(g)Rum-Currency operated in the early European settlement of Sidney cove in Australia.

Under a commodity system, the objects used as money have intrinsic value
i.e. they have value beyond their use as money. For example, gold coins
retain value because of gold’s useful physical properties besides its value
due to monetary usage, whereas paper notes are only worth as much as the
monetary value assigned to them. Commodity money is usually adapted to
simplify transactions in a barter economy and so it functions first as a
medium of exchange. It quickly begins functioning as a store of value,
since holders of perishable goods can easily convert them into durable
money.

HISTORY OF MONEY

The history of money is a story spanning thousands of years. Related to this numismatic is the scientific study of money and its history in all its varied
form. Money itself must be a scarce good; many items have been used as money, from naturally scarce precious metals and conch shells through cigarettes to entirely artificial money such as banknotes. Modern money (and most ancient money too) is essentially a token – in other words, an abstraction. Paper currency is perhaps the most common type of physical money today. However, goods such as gold and silver retain many of money’s essential properties.

The use of proto-money may date back to at least 100,000 B.C. Trading in red ochre is attested in Swaziland, from about that date, and ochre seems to have functioned as a proto-money in Aboriginal Australia. Shell jewellery in the form of strung beads would have served as good with the basic attributes needed of early money. In cultures where metal working was unknown, shell or ivory jewellery were the most divisible, easily storable and transportable, scarce, and hard to counterfeit objects that could be made. It is highly unlike that there were formal markets in 100,0000 B.C. nevertheless, proto-money would have been useful in reducing the costs of less frequent transaction that were crucial to hunter-gatherer cultures, especially bride purchase, splitting property upon death, tribute, and intertribal trade in hunting ground rights (“starvation insurance”) and implements. In the absence of a medium of exchange, all of these transactions suffer from the basic problem of barter- they require an improbable coincidence of wants or events. Jewellery has often been used for currency and wealth storage in some historical and contemporary societies, especially those in which modern forms of money are scarce, in addition to being used for decoration and display of status and wealth.

In cultures, of any era, that lack money, bartering and some system of its kind “credit” or “gift exchange” would be the only ways to exchange goods.
Bartering has several problems, most notably the coincidence of wants problem. If one wishes to trade fruit for wheat, it can only be done when the fruits and wheat are both available at the same time and place, which may be for a very brief time, or may be never. With an intermediate commodity (whether it be shells, rum, gold etc.) fruit can be sold when it is ripe in exchange for the intermediate commodity. This intermediate commodity can then be used to buy wheat when the wheat harvest comes in. Thus the use of money makes all commodities become more liquid.

Where trade is common, barter systems usually lead quite rapidly to several key goods being imbued with monetary properties. In the early British colony of New South Wales in Australia, rum emerges quite soon after settlement as the most monetary of goods. When a nation is without a fiat currency system it is quite common for the fiat currency of a neighbouring nation to emerge as the dominant monetary good. In some prisons where conventional money is prohibited, it is quite common for goods such cigarettes to take on a monetary quality. Gold has emerged naturally from the world of barter again and again to take on a monetary function. It should be noted that the emergence of monetary goods is not dependent on central authority of government. It is a quite natural market phenomenon.
Many early instances of money were objects which were useful for their intrinsic value as well as their monetary properties. This has been called “commodity money”, historical examples include iron nails (in Scotland), pigs, and rare seashells, whale’s teeth, and (often) cattle. In medieval Iraq, bread was used as an early form of currency.

The use of shells or ivory was nearly universal before humans discovered how work with precious metals; in China, Africa, and many other areas, used of cowrie shells was common. In China the use of cowrie shells was superseded by mental representations of the shells, as well as representations of metal tools. These imitations may have been the precursors of coinage.

Salt and spices have been used as money. From 550 B.C. accepting salt from a person was synonymous with receiving a salary, taking pay, or being in that person’s service. Definite indications are available that both black and white pepper have been used as commodity money for hundreds of years before Christ, and several centuries thereafter. Being a valuable commodity, pepper has naturally been used as payment.

Even in the modern world, in the absence of other types of money, people have occasionally used commodities such as tobacco as money. This happened on a wide scale after World War II.
Once a commodity becomes used as money, it takes on a value that is often different from its intrinsic worth or usefulness. Having the property of money adds an extra use to the commodity, and so increases its value. This extra use is a convention of society, and the scope of its use as money within the society affects the value of the monetary commodity. So, although commodity money is real, it should not be seen as having a fixed value in absolute terms. To a large extent its value is still socially determined. A prime example is gold, which has been valued differently by many different societies, but perhaps valued most by those who used it as money. Fluctuations in the value of commodity money can be strongly influenced by supply and demand, whether current or predicted (if a local gold mine is about to run out of ore, the relative market value of gold may go up in anticipation of a shortage).

Money can be anything which the trading parties agreed, has a transferable value, but the usability of a particular sort of money varies widely. Desirable features of a good basis for money include being able to be stored for long periods of time, dense so it can be carried about easily, and difficult to find on its own, so it is actually worth something.

The system of commodity money in many instances evolved into a system of “representative money”. This occurred because banks would issue a paper receipt to their depositors, indicating that the receipt was redeemable for whatever precious goods were being stored. It didn’t take long before the receipts were traded as money, because everyone knew they were “as good as gold”. Representative paper money made possible the practice of fractional reserve banking, I which banker would print receipts above and beyond the amount of actual precious metal on deposit.

So in this system, paper currency and non-precious coinage had very little intrinsic value, but achieved significant market value by being backed by a promised to redeem it for a given weight of precious metal, such as silver. This is the origin of the term “British Pound” for instance; it was a unit of money backed by a Tower pound of sterling silver, hence the currency Pound Sterling. For much of the nineteenth and twentieth centuries, many currencies were based on representative money through use of the gold standard.

Fiat money refers to money that is not backed by reserves of another commodity. The money itself is given value by government fiat (Latin for “let it be done”) or decree, enforcing legal tender laws, previously known as “forced tenders”, whereby debtors are legally relieved of the debt if they (offer to) pay it off in the governments money. By law the refusal of “legal tender” money in favour of some other form of payment is illegal, and has at times in history (Rome under Diocletian, and post-revolutionary France during the collapse of the Assignats) invoked the death penalty.

Governments through history have often switched to forms of fiat money in times of need such as wars, sometimes by suspending the service they provided of exchanging their money for gold, and other times by simply printing the money that they needed. When government produces money more rapidly than economic growth, the money supply overtakes economic value. Therefore, the excess money eventually dilutes the market value of all money issued. This is called inflation

In 1971 the United States finally switched to fiat money indefinitely. At this point in time many of the economically developed countries’ currencies were fixed to the United States dollar and so this single step meant that much of the western world’s currencies became fiat money based.

Following the first Gulf War then president of Iraq Saddam Hussein repealed the existing Iraqi fiat currency and replaced it with a new currency. Despite having no backing by a commodity and with no central authority mandating its use or defending its value, the old currency continued to circulate within the politically isolated Kurdish regions of Iraq. It became known as the Swiss Dinar. This currency remained relatively strong and stable for over a decade. It was formally replaced following the second Gulf War.

Credit money often exists in conjunction with other money such as fiat money or commodity money, and from the user’s point of view is indistinguishable from it. Most of the western world’s money is credit money derived from national fiat money currencies.
In a modern economy, a bank will lend all but a small portion of its deposits to borrowers; this is known as fractional reserve banking. In doing so, it increases the total money supply above that of the total amount of the fiat money in existence (also known as M0). While a bank will not have access to sufficient cash (fiat money) to meet all the obligations it has to depositors if they wish to withdraw the balance of their cheque accounts (credit money), the majority of transaction will occur using the credit money (cheque and electronic transfers).

Strictly speaking a debt is not money, primarily because debt can not act as a unit of account. All debts are denominated in units of something external to the debt. However, credit money certainly acts as a substitute for money when it is used in other functions of money (medium of exchange and store of value).

MONETARY POLICY

Monetary policy is the government or central bank process of managing money supply to achieve specific goals, such as constraining inflation, maintaining an exchange rate, achieving full employment or economic growth. Monetary policy can involve changing certain interest rates, either directly or indirectly through open market operations, setting reserve requirements, or trading in foreign exchange markets.

Monetary policy is generally referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy has the goal of raising interest rates to combat inflation.

Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to central banks, the monetary authority has the ability to alter the interest rate and the money supply in order to achieve policy goals. The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard.

A policy is referred to as contractionary if it reduces the size of the money supply or raised the interest rate. An expansionary policy increases the size of the money supply, or decrease the interest rate. Further monetary policies are described as a accommodative if the interest set by the central monetary authority is intended to spur economic growth, neutral if it is intended to neither spur growth or combat inflation, or tight if intended to reduce inflation or “cool” an economy.

There are several monetary policy tools available to achieve these ends. Increasing interest rates by fiat, reducing the monetary base or increasing reserve requirements all have the effect of contracting the money supply, and, if reversed, expand the money supply. Since the 1970s, monetary policy has generally been formed separately from fiscal policy. And even prior to the 1970s, the Bretton Woods system will ensure that most nations would form the two policies separately.

History of Monetary Policy

Monetary policy is associated with currency and credit. For many centuries there were only two forms of monetary policy: decisions about coinage, and the decision o print paper money to create credit. Interest rtes, while now thought of as part of monetary authority, were not generally coordinated with the other forms of monetary policy. Monetary policy was seen as an executive decision, and was generally in the hands of the authority with senior age, or the power to coin. With the advent of larger trading networks came the ability to set the price between gold and silver and the price of the local currency to foreign currencies. This official price could be enforced by law, even if it varied from the market price.

With the creation of the bank of England in 1694, which acquired the responsibility to print notes and back them with gold, the idea of monetary policy as independent of executive action began to be established. The goal of monetary policy was to maintain the value of the coinage, print notes which would trade at par to specie, and prevent coins from leaving circulation. The establishment of central banks by industrializing nations was associated then with the desire to maintain the nation’s peg to the gold standard, and to trade in a narrow band with other gold back currencies. To accomplish this end, central banks as part of the gold standard began setting the interest rates that they charged both their own borrowers, and other banks required liquidity. The maintenance of a gold standard required almost monthly adjustments of interest rates.


The advancement of monetary policy as an engineering discipline has been quite rapid in the last 150 years, and it has increased especially rapidly in the last 50 years. Monetary policy has grown from simply increasing the monetary supply enough to keep up with both population growth and economic activity. It must now take into account such diverse factors as:
Short term interest rates;
Long term interest rates;
Velocity of money through the economy;
Exchange rate;
Credit quality;
Binds and equities (corporate ownership and debt);
Government versus private sector spending/savings;
International capital flows of money on large scales;
Financial derivatives such as options, swaps, future contracts, etc.

Types of Monetary Policy

In practice all types of monetary policy involve modifying the amount of base currency (M0) in circulation. This process of changing the liquidity of base currency is called open market operations.

Constant market transactions by the monetary authority modify the liquidity of currency and this impacts other market variables such as short term interest rates, the exchange rate and the domestic price of spot market commodities such as gold. Open market operations are undertaken with the objective of stabilizing one of these market variables.

The distinction between the various types of monetary policy lies primarily with the market variable that open market operations are used to target.
Targeting being the process of achieving relative stability in the target variable.

The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregate implies floating exchange rate unless the management of the relevant foreign currencies is tracking the exact same variables (such as harmonized consumer price index).


Monetary Policy:Target Market Variable:Long Term Objective:
Inflation TargetingInterest rate on overnight debtA given rate of change in the CPI
Price Level TargetingInterest rate on overnight debtA specific CPI number
Monetary AggregatesThe growth in money supplyA given rate of change in the CPI
Fixed Exchange RateThe spot price of the currencyThe spot price of the currency
Gold StandardThe spot price of goldLow inflation as measured by the gold price
Mixed PolicyUsually interest ratesUsually unemployment + CPI change



Inflation Targeting

Under this policy approach to the target is to keep inflation under a particular definition such as Consumer Price Index, at a particular level. The inflation target is achieved through periodic adjustments to the Central Bank interest rate target.

The interest rate used is generally the inter bank rate at which banks lend to each other over night for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar.

The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee.

Changes to the interest rate target are done in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined target.


Price Level Targeting

Price level targeting is similar to inflation targeting except that the CPI growth in one year is offset in subsequent years that overtime the price level on aggregate does not move.

Monetary Aggregates

In the 1980s several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan.

This approach is also sometimes called monetarism. Whilst most monetary policy focuses on a price signal of one form or another this approach is focused on monetary quantities.


Fixed Exchange Rate

This policy is based on maintaining a fixed exchange rate with foreign currency. Currency is bought and sold by the central bank on a daily basis to achieve the target exchange rate. This policy somewhat abdicates responsibility for monetary policy to a foreign government.

This type of policy was used by China. The Chinese yen was managed such that its exchange rate with the United States dollar fixed.

Gold Standard

The gold standard is a system in which the price of the national currency as measured in units of gold is kept constant by the daily buying and selling of base currency. This process is called open market operations.

The gold standard might be regarded as a special case of the “Fixed Exchange Rate” policy. And the gold price might be regarded as a special type of “Commodity Price Index”.


Mixed Policy

In practice a mixed policy approach is most like “inflation targeting”.
However some consideration is also given to other goals such as economic growth, unemployment and asset bubbles. This type of policy was used by the Federal Reserve in 1998.

MONETARY DEMAND
The demand for money represents the desire of house holds and businesses to hold assets in a form that can be easily exchange for goods and services. Spend ability or liquidity is the key aspect of money that distinguishes it from other types of assets. For this reason, the demand for money is sometimes called the “demand for liquid”.
The demand for money is often broken into three (03) distinct categories: the transactions demand, speculative demand and precautionary demand.

The “Transaction Demand” is the primary reason people hold money because they expect to use it to buy something sometime soon. In other words people expect to make transaction for goods or services. How much money a person holds onto should probably depend upon the value of the transaction that is anticipated. Thus a person on vacation might demand more money than on a typical day.

Wealthier people might also demand more money because their average daily expenditures are higher that the average person.
An in-depth analysis shows that an individual’s demand for money is what determines the aggregate and economy-wide demand for money.

Extrapolating from the individual to the group, we could conclude that the total value of all transaction in the economy during a period of time would influence the aggregate value of all transaction since all GDP produced will be purchased by someone during the year.
The “Speculative Demand” for money is the second type of money which arises by considering the opportunity cost of holding money. People hold money to reduce the risk of their overall portfolio of assets, “according to John Maynard Keynes who introduces the speculative demand for money (The General Theory of Employment, interest and money, chapter 15, 1936). Keynes observed that the transaction and precautionary motives are mainly influenced by income and changes in the expected return on other financial assets have little effect. It is through the speculative motive that monetary authorities (e.g. the Federal Reserve) can “in normal circumstances” influence the economy”.

Thirdly the “Precautionary Demand” for money shows that people hold money as to meet unexpected expenses. The benefit of holding money under the precautionary motives is being able to maximize utility by making all the transactions you can afford and are willing to make.
Money shortages result in the lost opportunity to spend. It may be taxi fare in a heavy rain or a one time sale. One may still be able to cover an unexpected large expense such as a car accident or medical emergency by withdrawing illiquid non-money investments. However, the conversion of an investment to money entails expense such as the penalty for cashing in a certificate of deposit before it matures.

The cost of holding money for precautionary purposes is the same as under the transaction motive. By holding money you are prevented from earning interests on other investments.
The precautionary motive has traditionally been ascribed to the demand for M1 money only. But precautionary funds are also held in M2 money such as savings, money market accounts and certificates of deposits. Moreover, increasing real in come and consumer credit may reduce the cost of liquidating non-money assets.

MONEY SUPPLY
Money supply is a macro economic concept; it is the quantity of money available within the economy to purchase goods, services and securities.
Money supply is the total number of bank notes and coins in an economy, e.g. in the United States of America, coins are minted by the United States mint, part of the department of Treasury outside of the Federal Reserve. Bank notes are printed by the Bureau of Engraving and printing on behalf of the Federal Reserve as symbolic tokens of electronic credit based money that has already credited or more precisely issued by private banks through fractional reserve banking.

In this aspect, all bank notes in existence are systematically linked to the expansion of the electronic credit based money supply. However coinage can be increase or decreased outside this system by legal mandate or legislative acts. At present bank issue of electronic credit-based money. The common practice is to include printed and minted money supply in the same metric M0.
The more accurate starting point for the concept of the concept of money supply is the total of all electronic credit based deposit balances in bank (and other financial) accounts plus all the minted coins and printed paper. The M1 money supply is M0, plus the total of (non-paper or coin) deposit balances without any withdrawal restrictions.

ROLE OF THE CENTRAL AND COMMERCIAL BANKS.

A bank is a business that provides banking services for profit. Traditional banking services include receiving deposits of money, lending money, and processing transaction. Some banks issued bank notes as legal tenders.

Central Banks are the entity that is responsible for overseeing the monetary system for a nation (or group of nations). Central Banks have a wide range of responsibilities, from overseeing monetary policy to implementing specific goals such as currency stability, low inflation and full employment.
Central Banks also generally issue currency, functions as the bank of the government, regulate the credit system, oversee Commercial Banks, manage exchange reserves and act as a lender of last resort. The Central Bank system in the United States is known as the “Federal Reserve System” which is comprises of twelve (12) regional “Federal Reserve Banks” located in major cities throughout the country.

Commercial Banks are the term used for a normal bank to distinguish it from an investment bank. After the great depression, the United States congress required that banks only engage in banking activities, whereas investment banks were limited to capital market activities. Therefore Commercial Banks are referred to as a bank or a division of a bank that mostly deals with deposits and loans from corporations or large businesses.


Money Multiplier

The most common mechanism used to generate money is typically called the money multiplier. It measures the amount by which the commercial banking system increases the money supply. To control the amount of money created by the system, central banks place reserve ratios on the commercial banks which set the proportion of primary deposits that the banks may no lend out.

In the USA this ratio is ten percent (10%) and in other countries there is no reserve ratio. The reserve ratio is to prevent banks from:
1.Having a shortage in money when a large demand of deposits is withdrawn.
2.Limit the amount of money that will be generated.

The money multiplier measures the change in money (checkable deposits and currency) resulting from a given change in bank reserves. The term “multiplier” indicates that the change in money is inevitably a “multiple” of the initial change in bank reserves. The core of this multiplier is the reserve requirement ratio and money creation activities of fractional reserve banking.
However the money multiplier differs from the simple deposit expansion multiplier (which is the inverse of reverse requirement ratio) because banks are prone to keep some excess reserves and borrowers are inclined to transfer checkable deposits into savings deposits and currencies.