Bitcoin and Money. How does money work?

In Part One, we learnt that money is any item that is generally accepted as payment for goods and services and repayment of debts. The main functions of money are that it serves as a medium of exchange, a unit of account and a store of value.

We also learned that fiat money is not backed by anything, except the full faith and credit of the government.

However, money takes on more than the coins and paper we discussed thus far. In today’s modern terms, money can also include any verifiable electronic record (an electronic fund transfer for example) that will be accepted as a payment for goods or services. You can take this further and include the balances in your bank account or credit card facility as money because it can be transferred to a merchant or supplier without ever being converted into cash.

In fact, the total amount of money in circulation in an economy, usually referred to as ‘money supply‘, extends even further. It can also include other types of bank money such as savings deposits and money market accounts, as well as money in mutual funds and collective investment schemes. Money supply can, therefore, be measured in narrow or broader terms, depending on the context. Bank money, which consists only of electronic records, forms by far the largest part of broad money in developed countries.

In this section, we will explore the mechanics of how central banks influence the money supply and interest rates in economies. We will:

• Briefly touch on the concept of ‘Money Supply‘.
• Then explore fractional reserve banking and its impact on an economy’s money supply.
• Thereafter we will dispel the misconceptions that crypto-enthusiasts perpetuate about the endless ‘printing’ of fiat money so that we can have a more balanced, fact-based argument for why Bitcoin is a good alternative to fiat money.
• Lastly, we’ll briefly cover quantitative easing programmes. In the next section, we will show why it does not always lead to hyperinflation the way many crypto-enthusiasts proclaim it will, when they attempt to discredit traditional money in favour of their crypto ambitions.

In the next section, we’ll bring it all together to show the lesser-known consequences of wealth redistribution.

The term “money supply” commonly denotes the total, safe, financial assets that households and businesses can use to make payments or to hold as short-term investments. The money supply is measured using the so-called “monetary aggregates“, defined in accordance with their respective level of liquidity. The exact definitions of monetary measures depend on the country.

In the United States, for example, M0, also called ‘base money’, represents currency in circulation; M1 is M0 plus transaction deposits at depository institutions, such as drawing accounts at banks; M2 represents M1 plus savings deposits, small-denomination time deposits, and retail money-market mutual fund shares.

The European Central Bank considers all monetary aggregates from M2 upwards to be part of broad money. Typically, “broad money” refers to M2, M3, and/or M4.

The term “narrow money” typically covers the most liquid forms of money, i.e. currency (banknotes and coins) as well as bank-account balances that can immediately be converted into currency or used for cashless payments (overnight deposits, checking accounts, etc). It is typically denoted as M1. Narrow money is a subset of broad money.

Deposits in foreign currency are excluded from all monetary aggregates by most countries, or they are included only in broad money, with some exceptions. For the purposes, of these posts, it is not important to know the details of the exceptions. Simply the concept that money is ‘broader’ than our ‘narrow’ experience of it.

Changes in the money supply are closely watched because of the relationship between money supply and macroeconomic variables such as inflation. Central banks analyze the money supply and execute monetary policies in response to it by controlling interest rates and increasing or decreasing the amount of money flowing in the economy. Even though relationships do exist between an economy’s money supply and inflation, there are many more variables at play that can affect price levels.

Fractional-reserve banking is the practice whereby a bank accepts deposits, makes loans or investments, but is required by its central bank to hold reserves equal to only a fraction of its deposit liabilities. Reserves are held as currency in the bank, or as balances in the bank’s accounts at the central bank. Remember that the central bank is the banker for the government and other commercial banks in a country.

Banks try to lend as much as possible to maximise their profits. If they could, they would lend out all of it. But central banks require member banks to keep a small percentage of their deposits in reserve when they close each night, so that they have enough cash on hand for the following day’s transactions. This is known as the reserve requirement.

Having only a small portion of deposits as reserves allows banks to use the remaining deposits to act as financial intermediaries between borrowers and savers, and to provide longer-term loans to borrowers while providing immediate liquidity to depositors. However, a bank can experience a bank run if depositors wish to withdraw more funds than the reserves that are held by the bank. To mitigate the risks of bank runs and systemic crises (when problems are extreme and widespread), central banks of most countries regulate and oversee commercial banks and act as lenders of last resort to commercial banks.

Because banks hold reserves in amounts that are less than the amounts of their deposit liabilities (from the bank’s perspective, customer deposits in bank accounts are regarded as liabilities to account holders), fractional-reserve banking permits the money supply to grow beyond the amount of the underlying base money originally created by the central bank. A bank customer simply has to pay for something using a loan in order for additional money to enter circulation.

In most countries, the central bank regulates bank credit creation and impose reserve requirements and capital adequacy ratios. This can slow down the process of money creation that occurs in the overall banking system. It also helps to ensure that banks remain solvent and have enough funds to meet their customers’ demand for withdrawals. However, rather than directly controlling the money supply by adjusting their banks’ reserve requirements, central banks more often than not, pursue an interest rate target to adjust the rate of inflation and bank issuance of credit. See Open Market Operations below for more on this.

Central Banks

The authority through which a country’s monetary policy is conducted is the central bank. It is through the execution of the central bank’s monetary policy that a country’s money supply is influenced. The mandate of a central bank typically includes some combination of the following objectives: Price stability, i.e. inflation-targeting; the facilitation of maximum employment in the economy; the assurance of moderate, long term, interest rates.

Central banks operate in practically every nation in the world, with few exceptions. There are some groups of countries, for which, through agreement, a single entity acts as their central bank, or monetary unions, such as the Eurozone, whereby nations retain their respective central bank yet submit to the policies of the central entity, the ECB. Central banks are the bankers to governments and other commercial banks domiciled in its jurisdiction.

Central banking institutions are generally supposed to be independent of the government executive. However, in recent times, it has become quite clear that central banks have become unduly influenced by political leaders and their agendas.

‘Printing money’ – the basics

Some cryptocurrency evangelists liberally talk about governments “printing money” or “creating money out of thin air“. These types of remarks range from inaccurate to incorrect. It is not usually a government that prints money, but some institution under the auspices of the central bank, that will design and mint coins and banknotes. And it is the central bank that will typically regulate the issuing and quality of coins and banknotes in circulation.

To understand how central banks “print money,” remember that most of the money in use today is not cash. The money that is created takes the form of credit that is added to banks’ accounts with the central bank. It’s similar to the kind of credit you receive when your employer deposits your salary directly into your bank account. So when people say that the central bank “prints money,” what they really mean is that it is adding credit to its member banks’ deposits.

Printing money is generally associated with an expansive monetary policy. By adding credit to member-banks’ deposit accounts, central banks increase the money supply that is available to spend or invest. The availability of that supply is loosely referred to as liquidity. “Printing money” is one of the central bank’s solutions to spur borrowing, investing and economic growth.

The reserve requirement is the amount of funds that a bank must have on hand each night. It is a per cent of the bank’s deposit liabilities that is set by the central bank. The higher the reserve requirement, the less profitable it is for a bank. This is because it reduces the amount of money available to the bank that it can lend out to retail and business clients at a higher rate of interest (if any) than what it will get from its deposits at the central bank.

If a bank doesn’t have enough on hand to meet its reserve requirement, it borrows the shortfall from other banks. It may also borrow from the central bank, usually at a higher rate. The interest that banks charge each other to borrow funds is some form of overnight interbank interest rate that can be influenced by the central bank’s interventions, which we will cover in this section.

How the central bank influences interest rates

The most visible and obvious power of many modern central banks is to influence market interest rates. Contrary to popular belief, they rarely “set” rates to a fixed number. Instead, central banks us a mechanism based on its ability to create as much fiat money as required. The mechanism to move the market towards a ‘target rate’ is generally for a central bank to participate in the open money market with its member banks. A combination of approaches can be followed.

One approach is for central banks to intervene in the money market to influence the supply of or demand for bank reserves. Central banks can lend money to or borrow money from (taking deposits from) banks until the targeted market rate is sufficiently close to the target. When the actual interbank rate between banks is higher than the target, the central bank can increase the money supply via a repurchase agreement (or repo), through which it “lends” money to commercial banks. When the actual rate is less than the target, it can decrease the money supply via a reverse repo, in which the banks purchase securities from it.

Central banks could, for example, set a target overnight rate, and a band of plus or minus 0.25%. Banks borrow from each other within this band to maintain their reserve requirements, but never above or below. This is because the central bank will always lend to them at the top of the band, and take deposits at the bottom of the band.

Another very common approach is for central banks to create a shortage of bank reserves (more on this below) and then refinancing this shortage by lending funds to banks at the desired rate.

The target rates are generally short-term rates. For example, a central bank might set a target rate for overnight lending of 4.5%, but rates for (equivalent risk) five-year bonds might be 5%, 4.75%, or, in cases of inverted yield curves, even below the short-term rate.

Open Market Operations

Open market operations refer to the ways a central bank engages with its member banks when buying and selling securities from or to them, in order to influence the money supply and/or interest rates. More specifically, these operations include the daily, weekly or even monthly refinancing operations that are usually conducted via auctioning systems:

• Auctions for government securities,
• Repo auctions,
• End-of-day square-off processes,
• Estimating the daily liquidity requirements, and so forth.

When the central bank buys government securities from a bank, it adds credit to the bank’s reserves. Although it is not actual cash, it is in effect the creation of money. This gives the bank more money to lend to consumers. This is what people mean when they say that a central bank is printing money.

When the central bank increases a bank’s credit by buying up its securities, it generates a surplus over and above the minimum reserve requirement. This pushes down the overnight interbank lending rates between banks, as each bank tries to unload this surplus. This is an example of how the central bank open market interventions can reduce short-term interest rates. Banks charge each other a bit more for longer-term loans. Libor rates are well-known rates used between banks. They are used as the basis for most variable rate loans, including car loans, adjustable-rate mortgages, and credit card interest rates. They are also used to set the prime rate, which is what banks charge their best customers.

In order to ensure that the interbank interest rate is close to the target level or within the target band, a central bank may at times have to intervene during the day to influence the supply of and demand for bank reserves. Such a system, among other things, requires a well-functioning, liquid and competitive interbank market.

Central banks also create and maintain a shortage of bank reserves in the money market through levying a cash reserve requirement and draining liquidity through open-market operations. It can then refinance the shortage by lending funds to banks at its policy interest rate. If central banks are not able to maintain an adequate shortage, its refinancing operations can become less effective and it runs the risk of not being able to effectively execute on its monetary policies.

Creating and refinancing liquidity shortages

Creating liquidity shortages in the market, and refinancing those shortages are essential to the way central banks implement their monetary policies. Through its refinancing system, central banks provide liquidity to commercial banks that enable them to meet their daily liquidity requirements. ‘Liquidity’ in this context refers to the commercial banks’ balances at the central bank that are available to settle their transactions with one another, over and above the minimum statutory level of reserves that they have to hold. Central banks create a liquidity requirement (or shortage) in the money market, which it then refinances at the repurchase (repo) rate; a fixed interest rate determined by a monetary policy committee.

Banks have to hold relatively low-yielding securities to use as collateral in the Bank’s refinancing operations. Funding that is locked into acquiring these assets also restricts the banks’ ability to extend credit.

To ensure that its repo rate remains effective, a central bank compels commercial banks to borrow a substantial amount (i.e. the liquidity requirement) from it. The central bank, therefore, has to transact regularly in the money market to create and monitor such a shortage. That is, it has to drain excess liquidity from the money market. In addition to levying a cash reserve requirement on commercial banks, central banks also use various types of open-market instruments, such as debentures, reverse repos and foreign-exchange swaps to drain excess liquidity.

Let’s take the issuance (auction) of central bank debentures as an example. Market participants will tender for the amounts and interest rates on debentures, which are then allocated in ascending order of the interest rates bid until the amount on tender is fully allotted. The debentures could have different maturities of say 7, 14 or more days. They could be auctioned weekly. In the process, bank reserves are used up and a liquidity shortage is created. At maturity, the central bank pays each participant the nominal amount plus interest.

Quantitative easing (QE) is an unconventional form of monetary policy, that is usually used when inflation is very low or negative, and standard expansionary monetary policy has become ineffective. QE is unconventional because it is a central bank policy that involves the purchases of unconventional assets with unconventional objectives. The goal of quantitative easing is to lower the interest rates on long-term assets, rather than to lower short-term interest rates as is the case with conventional expansionary policy.

A central bank implements quantitative easing by buying financial assets from commercial banks and other financial institutions, thereby raising the prices of those financial assets, lowering their yield and simultaneously increasing the money supply. This differs from the more usual policy of buying or selling short-term government bonds and other short-dated securities to keep interbank interest rates at a specified target value.

Expansionary monetary policy to stimulate the economy typically involves the central bank buying short-term government bonds and other securities to lower short-term market interest rates. However, when short-term interest rates reach or approach zero, this method can no longer work. In such circumstances, central banks may then use quantitative easing to further stimulate the economy, by buying financial assets without reference to interest rates, and by buying longer-maturity assets (other than short-term government bonds), thereby lowering interest rates further out on the yield curve.