The Money System and the Role of Central Banks

The markets in August were tense as investors gauged the impact of the Delta variant on economies around the world and the timing of the Federal Reserve’s (Fed) start of tapering (reduction of monetary stimulus). On the sidelines, a topic of discussion was the prospect of rate hikes by developed countries, with New Zealand’s post-pandemic environment being a notable early possibility. As a result, hikes were postponed this time, but are expected to take place next October.

Market participants are also nervously watching the future path of monetary normalization and rate-hike timing for Europe and the United States. Monetary tightening by central banks has a major impact on currencies and financial assets.

Therefore, in this article, from a portion of the new employee training at Invast Securities, “The Mechanism of Money,” we will explainWhy central banks raise rates.

Origins of Paper Money

The money we use consists of banknotes and coins, and the banknotes originate from“deposit receipts”issued by banks. These receipts referred to deposits of gold at the time in medieval periods.“gold coins”were the actual backing.

Long ago, the amount of money depended on how much gold, silver, and copper were discovered. Coins with a stable weight and purity served as a standard of exchange value, minted by a king with authority and trust, who distributed them to the people. People paid with coins in their transactions.
Among them, the most valuable were gold coins. The wealthy stored gold coins with skilled goldsmiths who kept splendid vaults to protect them from theft or burglary.

Let's call the goldsmith who held the vault G. G would hand over a deposit receipt in exchange for gold coins and charge a storage fee. When a wealthy person A bought something, they would give the receipt to G and pay with the gold coins they withdrew. The recipient B, who received the payment, also stored their gold with G to avoid theft and received a receipt in return.

If so, why would A need to withdraw gold coins from G and give them directly to B? The result would be the same. Over time, people realized that paying with receipts was more convenient and safer than paying with actual gold coins, and these receipts began to function as currency. This becamepaper money.

The Beginning of Banking

As people began transacting with paper money, the gold coins in G’s vault lay idle. Here, G thought, “If depositors don’t come to withdraw, could I issue banknotes backed by this gold?” Clever G started lending more money by issuing notes beyond the deposited gold and receiving interest as profit.

Thus, modern banking began. From this point, money is created (increases) when banks lend it.

In hindsight, the coins in G’s vault were not his property, and he used them to lend out to earn profits, which was fraudulent. Yet the method was kept secret and not criticized. By the time people realized it, banking had become an indispensable part of the state.

However, occasional problems arose. When a large number of deposit receipts were brought by customers and they demanded the return of many gold coins, banks could not meet such requests because they had issued more notes than gold. In such cases, banks cooperated with other banks to lend gold coins for a short period.

The gold coins temporarily away from a bank would eventually come full circle back to the bank, so there is no need to worry.The current call market (interbank short-term lending)already had a network of such interbank trades in place at this time.

Inflation and Central Banks

With this, banks could create money as much as needed. By lending to those who needed money, productivity rose and economic growth accelerated.

What banks must be careful about isthat issuing too much money reduces the value of money itself.The relationship of supply and demand. When there is excess supply, money loses value. It ceases to be valuable. This is called inflation.

If inflation progresses too far, what eventually occurs is barter. In the film Grave of the Fireflies, there is a scene where people exchange kimonos for rice during wartime, illustrating a situation where money has no value.
At that point, banking ceases to be viable, so preserving the value of money becomes the most important taskto stop inflation.

Thus, since issuing banknotes by multiple banks would make it hard to control the money supply and if banks failed, the currency would become worthless, the issuance authority was placed under a single bank and under government control. This is today’s central banking system.

In this way, the central bank’s primary job is to stop inflation, and deflation, where money gains value, is not a central concern.
However, as the economy is heavily influenced by national activity, the central bank increasingly takes on responsibilities toward the economy and employment, and under recession may increase the money supply to support economic activity,a role in sustaining economic activity.

Currently, countries such as Japan and the United States target inflation around2% per year. This level is considered neither too high nor too low, and is believed to be a comfortable rate to foster economic growth. If inflation exceeds this level, central banks have a reason to raise rates.

Now, as countries pursue post-pandemic monetary normalization, please pay close attention to inflation and central bank actions.

※The content of this article reflects the author's views and is not intended to provide definitive investment judgments or to solicit the buying or selling of any type of product. It is provided for informational purposes only.