A monetary system is a system by which a government provides money in a country's economy. Modern monetary systems usually consist of the national treasury, the mint, the central banks and commercial banks.[1]
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Main article: Commodity money |
A commodity money system is a type of monetary system in which a commodity such as gold or seashells is made the unit of value and physically used as money. The money retains its value because of its physical properties. In some cases, a government may stamp a metal coin with a face, value or mark that indicates its weight or asserts its purity, but the value remains the same even if the coin is melted down.
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Main article: Representative money |
One step away from commodity money is "commodity-backed money", also known as "representative money". Many currencies have consisted of bank-issued notes which have no inherent physical value, but which may be exchanged for a precious metal, such as gold. (This is known as the gold standard.) The silver standard was widespread after the fall of the Byzantine Empire, and lasted until 1935, when it was abandoned by China and Hong Kong.
A 20th-century variation was bimetallism, also called the "double standard", under which both gold and silver were legal tender.[2]
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See also: Bullion |
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Main article: Fiat money |
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. Originally fiat money was paper currency or base metal coinage, but in modern economies it mainly exists as data such as bank balances and records of credit or debit card purchases,[3] and the fraction that exists as notes and coins is relatively small.[4] Money is mostly created by banks when they loan to customers. Put simply, banks lending currency to customers, subject to each bank's regulatory limit, is the principal mode of new deposit creation.[5]
The central bank does not directly fix the amount of currency in circulation, nor is central bank money. Although commercial banks create circulating money via lending, they cannot do so freely without limit. Banks are limited in how much they can lend both by regulatory limits and by good management practice, in order to remain profitable and solvent. 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' the money or currency by using it to repay their existing debt, for instance.[6] When the principal of the loan is being repaid by the borrower that money is erased/destroyed and the bank only keeps the interest as income.
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.[6] 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 people can use paper bills or bank balances to buy goods.[7]
A debt based monetary system is when money creation is issued as debt from commercial banks (primarily). It is essentially leveraged margin that they created themselves, so there is no interest that needs to paid on the margin. Large banks are required to have a 10% reserve requirement,[8] so they can only leverage up to 10 times their deposits / liabilities. Smaller commercial banks such as community banks and credit unions have zero reserve requirement.[9] The Federal Reserve can only create new money as debt as well, during quantitative easing they buy U.S. Treasuries and mortgage-backed securities.[10][11] When the principal is being paid back to the bank that money is erased/destroyed, the bank only keeps the interest from the loan as income.
