In our previous and first part of this series, we discussed how money serves three primary functions – means of exchange, storage of value, unit of account. We also explored how human beings paid for goods and services before metal coins and paper bills were around.
In today’s second part, we will describe how the global banking and financial system started with the establishment of banks in 14th century Italy and what developments eventually led to the creation of central banks in charge of issuing currencies and managing financial and price stability.
How do central banks, monetary policy and inflation go together – and what is their impact on the way we use money today? Read on to find out more…
1. Building Banks
The functions of money intertwine when we consider the factor time. Some people need to buy things now – but don’t have sufficient money to do so. Others have more money than they currently need and want to store that value, investing it. This is how banks originally came about, its center was Northern Italy where Giovanni Medici founded Medici bank, the world’s first bank in 1397.
The business model of (retail) banks can be described as the “lending-and-saving-system”. It basically works as follows: savers bring their assets to banks and store it in their account while earning interest. Mortgage lenders/credit takers can take out a loan to receive money now while having to pay back the principal (in installments) plus additional interest as a service fee and compensation of lost opportunities cost of investment.
Banks eventually became the one-stop-shop for all monetary needs and services people required. Soon, people stored their money in their bank accounts instead of hoarding coins and bills at home. Through the usage of debit and standing orders in the 20th century, electronic payment replaced physical payment. On the order of customers, banks transferred money between bank accounts without money ever being exchanged physically.
Banks charge for their services for account holding fees and transaction fees for each transaction. Trade relations grew, local banks were complemented by regional banks, national banks, and eventually connected in a developing global banking and financial system.
2. Establishment of central banks.
As more and more banks were founded, eventually a network of banks connected to a banking system that was handling the supply of money within certain nations. However, such an uncoordinated system faced various issues. It was especially hard to resolve transactions between banks, in some cases strong inflation of currencies was the result of multiple banks issuing too much money.
To solve these problems, central banks were established, given authority to enforce policies that affect a country’s money supply and credit and to issue the national currency. Central banks also stored a nation’s gold reserves and had to make sure that the issuance of currency was sticking to a determined fixed weight of gold.
Central banks supply a nation with money through the following process: commercial banks deposit a certain amount of money with the central bank which then lends banks a multiple of that amount for these banks to bring into circulation through the issuance of credits to their clients. The goals of central banks are to ensure price stability, a stable economy, and financial stability. Their power comes at a high cost: As they are independent of governments, through intentional manipulation of unintentional actions they could theoretically cause major inflation that would end up breaking the entire banking and financial system.
3. Money and Inflation
In the early 1970s, the world stopped pegging the value of money to gold (= “the gold standard”) – led by US President Richard Nixon doing so for the US-dollar. As a result, world currencies became so-called “fiat currencies”, meaning currencies that are not backed by any commodity. Hence, nowadays the only thing that separates a banknote from any other piece of paper is, basically, trust, and this is very important!
With fiat money, the value of money is only related to its supply. The more money central banks print, the less each unit of currency is worth. Inflation is the creeping constant killer of monetary value. As inflation is ongoing, people need to look for ways to invest their money in order for it not to lose value, ideally even gain some value.
Central banks are the key institution that issues a nation’s currency and is responsible for managing its financial and price stability. Through depositing money with a central bank, conventional banks can bring a multiple of that money into circulation with the issuance of credit loans to business and retail clients.
Over time, banks became the one-stop-shop attending to all their client’s financial needs. With banks, clients can invest, save money or receive money in the form of credit loans or send money to other businesses and individuals.
Since the 1970s, money is no longer backed by gold – we now live in a world of fiat currencies, coined by ongoing inflation as central banks issue more and more money.
In our next and final part 3 of our series, we are going to look at international forex markets and currency exchange. Moreover, we will talk about the consequential global financial crisis of 2008-2009 and its aftereffects still prevalent in our monetary system today. Last but not least, we will talk about digital payments and cryptocurrencies and how they are going to shape the future of money. Be sure to check in!