Central Banks and Money: Economic Foundations
Central Banks: Roles in Financial Stability
The main functions of central banks are to ensure financial stability and control inflation.
Price Stability as a Core Objective
Price stability is one of the primary objectives of central banks, such as the European Central Bank (ECB). To accomplish this goal, they set a time horizon of two or three years, during which inflation must remain below a certain level.
Controlling the Money Supply
The central bank controls the money supply because it is the sole issuer of money, a key tool to manage inflation. To achieve this objective, official interest rates are set to lend money to financial institutions in periodic auctions.
Credibility in Monetary Policy
An important element for the success of monetary policy in achieving price stability is credibility. To promote credibility, the central bank seeks to ensure its independence from political influence.
The Eurosystem and Monetary Policy
Monetary policy affecting Spain takes place within the Eurosystem, which comprises the national central banks of the Euro area and the European Central Bank (ECB).
Diversity in Central Bank Design
The design of a central bank is not homogeneous across countries. Some central banks prioritize greater transparency, others do not have inflation as their primary objective, and they also differ in their communication methods.
Understanding Money and Financial Systems
Money facilitates the exchange of goods and services, serving as any good that society accepts as payment. Money must fulfill several key functions:
- Medium of exchange
- Unit of account
- Store of value
- Standard of deferred payment
History of Money
To facilitate transactions, the first coins emerged in the 7th century BC. Later, bankers began issuing convertible paper money and documents that secured the deposit of specific amounts of gold or silver in bank vaults. Currently, this paper money is no longer convertible and is known as fiat money.
The Value of Money
The value of money is what can be bought with it. Money is devalued by high inflation, as it loses confidence in its role as a store of value.
The Money Supply
The money supply is the sum of currency in circulation plus bank deposits. The money supply is a multiple of the monetary base, which represents the initial liquidity in the system from which financial institutions create money.
Reserve Ratio and Financial Intermediaries
Financial institutions hold only a portion of the deposits they receive, determining the reserve ratio. With excess reserves, they create money by granting loans. Financial intermediaries are institutions that mediate between economic units (savers) who want to invest funds for profitability, and those economic units that need financing. Banks, as key financial intermediaries, play a crucial role in money creation.