What is money?

24 November 2015

Euro banknotes and coins are money but so is the balance on a bank account. What actually is money? How is it created and what is the ECB’s role?

The changing essence of money

The nature of money has evolved over time. Early money was usually commodity money – an object made of something that had a market value, such as a gold coin. Later on, representative money consisted of banknotes that could be swapped against a certain amount of gold or silver. Modern economies, including the euro area, are based on fiat money. This is money that is declared legal tender and issued by a central bank but, unlike representative money, cannot be converted into, for example, a fixed weight of gold. It has no intrinsic value – the paper used for banknotes is in principle worthless – yet is still accepted in exchange for goods and services because people trust the central bank to keep the value of money stable over time. If central banks were to fail in this endeavour, fiat money would lose its general acceptability as a medium of exchange and its attractiveness as a store of value.

Present-day currency can also exist independently of a physical representation. Money can exist in a bank account in the form of a computer entry or stored in the form of a savings account. Digital cash, or e-money, is monetary value stored in a pre-paid card or smartphone, for example. And direct debits, internet payments and card transfers are all forms of payment that do not involve cash. (There are even newer decentralised digital currencies or virtual currency schemes like Bitcoin that exist without a central point of control like a central bank. These are not regarded as money from a legal perspective.)

Despite the rapid rise in electronic payments, cash is still very popular. In the euro area, cash is used for a high proportion of all payments under €20. The value of euro cash is guaranteed by the ECB and the national central banks of the euro area countries, which together form the Eurosystem.

The uses of money and how the ECB keeps track of it

Money, whatever its form, has three different functions. It is a medium of exchange – a means of payment with a value that everyone trusts. Money is also a unit of account allowing goods and services to be priced. And it is a store of value. Only a portion of euro cash in circulation actually circulates, i.e. is used for processing payments. For example, many of the circulating €50 notes are hoarded.

Central banks usually define and monitor several monetary aggregates. Developments in these aggregates can reveal useful information about money and prices. Several aggregates are needed because many different financial assets are substitutable and the nature and characteristics of financial assets, transactions and means of payment change over time. The Eurosystem has defined a narrow (M1), an “intermediate” (M2) and a broad monetary aggregate (M3) for use in the ECB’s monetary analysis. The ECB looks at developments in these aggregates, together with a lot of other information and analyses, as part of its monetary policy strategy.

How is money created?

The ECB acts as a bank for the commercial banks and this is also how it influences the flow of money and credit in the economy to achieve stable prices. Commercial banks, in turn, can borrow money, i.e. central bank reserves, from the ECB, usually to cover very short-term liquidity needs. The ECB’s main tool for controlling the quantity of “outside” money, and hence the demand for central bank reserves by commercial banks, is setting very short-term interest rates – the “cost of money”.

Commercial banks can also create so-called “inside” money, i.e. bank deposits – this happens every time they issue a new loan. The difference between outside and inside money is that the former is an asset for the economy as a whole, but it is nobody’s liability. Inside money, on the other hand, is named this way because it is backed by private credit: if all the claims held by banks on private debtors were to be settled, the inside money created would be reversed to zero. So, it is one form of currency that is created – and can be reversed – within the private economy.

What about the ECB’s “money-printing” scheme I keep reading about?

In practice, only the national central banks physically issue euro banknotes. “Money-printing” is the colloquial term for the ECB’s asset purchase programme, a form of “quantitative easing”. By purchasing assets in the financial market, the ECB creates additional central bank reserves that can help reduce – through a variety of channels – the interest rates faced by households and firms with a view to supporting the economy and, ultimately, to keep the value of money stable when the room to cut those interest rates directly controlled by the ECB is limited. In this process, the ECB does not actually print banknotes to pay for the assets but creates money electronically, which is credited to the seller or intermediary, e.g. a commercial bank. The seller can then use the additional liquidity to buy other assets or, in case of a commercial bank, extend credit to the real economy. The purchases contribute to improving monetary and financial conditions, making it cheaper for businesses and households to borrow so they can invest and spend more. The ultimate aim is that inflation rates return to levels close to but below 2% in line with the ECB’s price stability mandate.