Money (Part II) - Where does it come from?

Where does money come from?

Money, so important to us, does not just appear. It is made like any other product. The government and the Central Bank of a certain country are the authorities held responsible for printing and issuing money to the general public. There are specialized companies to print and mint money. (Eg: Thomas De La Rue) We may think that these companies are so rich since they print money, but the truth is they cannot print money at will. They can only print money when a government places an order to print money, just like producing a normal good upon customer order. Unlike normal businesses, money printing companies cannot keep stocks, obviously, they will mostly operate once and order is placed.

Money Supply

Money Supply (AKA monetary base, base money, money base, reserve money)  is the total money in circulation in an economy at a given point of time. Simply, how much money is within the economy at a certain point of time? Money Supply is a key variable within an economy. It affects the economy and all its activities to a great extent. Money supply affects the price levels, interest rates, investments, production, consumption etc. So how is this money supply measured? It can be measured in 4 ways.

1    1)      M1 – Narrow Money Supply

Narrow Money includes all the cash in hand of the general public and all the demand deposits of the public held in commercial banks.

2    2)     M2 – Broad Money Supply

M2 consists of M1 plus all the Savings deposits of the public held in commercial banks

3    3)     M2b – Consolidated Broad Money Supply

M2b consists of M2 plus all foreign currency deposits of the public in the commercial banks.

4    4)     M4 – Very Broad Money Supply

This consists of m2b plus all the savings and fixed deposits of the public held in financial institutions other than commercial banks.

So that’s a lot of money within an economy and has to be managed effectively. The sole authorities responsible for managing and controlling the money supply in an economy are the government and the Central Bank of the specific country. However the Central bank only engages in the process on behalf of the government.

The main method of influencing the money supply in an economy is through the Repo and Reverse Repo market. These are the two markets that the central bank uses to issue and purchase treasury bills and treasury bonds of the government. (Treasury Bills are short term debt instruments issued by the government to settle their short term cash deficits)

In the Repo market the central bank will issue T. Bill to the general public and people/commercial banks will buy these bills spending the cash balances they have, thus decreasing the money in circulation within the economy. Remember, the above categorization of money supply did not include anything about money held by the government or the central bank. So when the central bank absorbs the cash in the economy it’s like gone or lost.

On the other hand in the Reverse Repo market, the central bank will buy back the T. Bills they issued earlier, of-course at a higher price than what they were sold for. So the person who bought the T. Bill has a capital gain plus an interest component associated with the bill. So when the central bank buys back the bills, it will release the money held with them to the economy thus increasing the money supply.

Intrinsic Value and Extrinsic Value of money

Money basically has two values. Yes! The value mentioned on the face of the note or the coin is known as the extrinsic value of money. It’s the value assigned to the specific note or coin. For example the extrinsic value of a $100 note is simply hundred dollars. And the note can be used to do transactions up to a $100. However, this note is printed on a paper, yeah some special paper, but still a paper. This piece of paper definitely does not worth $100. The real value of the note (paper) is known as the intrinsic value. It might be eve less than $0.50 for the $100 bill.

Features of ‘Good Money’

= General acceptability – money should be accepted by everyone as a medium of exchange

= Scarcity – should be difficult to find and obtain

= Durability – should be durable due to heavy usage

= Divisibility – can be divided in to smaller units (Eg: dollar can be exchanged to two 50 cent coins)

= Portability – should be easy to carry around…

In the next part we will discuss about how money functions in the international market.

Thank You for reading.

Good Luck – NJK Stock Market Guide