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Monetary system is the ways that money acts as a medium of exchange between buyers and sellers so that the need for barter is eliminated. Money serves as a medium of exchange (for barter there must be double coincidence of needs), unit of account, standard of deferred payment and a store of value for short periods. Thus money must be acceptable by everyone(i.e. on legal tender), durable, homogeneous, divisible into smaller units, portability (for transporting), it must have a stable value (inflation should be small) and it must be difficult to fake.
Measuring money supply is not easy. There is narrow money (or primary money) (M0 M2) - for medium of exchange function. This includes M0 (monetary base)-notes & coins in circulation + commercial banks cash deposits in the Bank and M2 -- M0 + non interest-bearing (current) accounts + interest bearing retail deposits (readily available) in banks and building societies. It can be either as a commodity money (has value on its own) or token money (nowadays). When token money is used nobody except the Bank should be able to issue that.
Broad money (secondary money) (M4) is for store of value. It includes cash + all deposits + CD + building society shares (except foreign currency deposits). Quasi moneys are postal orders etc. It depends on primary money, their relationship being the money multiplier.
Banks create credit - i.e. they lend out money, receive it back through deposits and lend it out again. When the amount of currency people and banks are holding has reached to minimum compared to the size of their bank accounts and bank lending, i.e. banks have created the maximum amount of credit then the system is fully banked. Then intermediation institutions come into the market that help to rectify a fully banked system. They help to finance the deficit expenditure, serve as a link between ultimate borrowers and ultimate lenders, usually by issuing primary securities.
Banks are financial intermediates. Their money forms part of the money supply, whereas other financial institutions' assets don't. Primary banks deal with the transmission of money, they are the high street banks (commercial banks, clearing banks). Besides credit creation they are dealing with the transmission of money(credit cards, (travellers)cheques, standing orders, direct debit, EFTPOS), advisory services (trusteeship, foreign exchange, brooking, investment management, taxation), other financial products offering (mortgages, insurance).
Discount houses are also primary banks (LDMA), peculiar to UK. They form a cushion between government and commercial banks. They discount bills. Each week Treasury offers bills to sale and their interest determines money supply. LDMA buys them. The Bank is also the lender of the last resource to LDMA.
Secondary banks - dealing with other financial intermediates (bills) and providing services other than money transmission. They include the merchant banks - wholesalers in banking. They operate with a small margin, so need very large sums. They usually specialise in 1 industry only. They accept bills (making them fine (first class) bills by guaranteeing them, these have the lowest discount (interest) rate).
Savings bank(to encourage small savers, insignificant in England, but big in Germany), co-operative banks (France) and credit unions and foreign banks also exist in the money-market. Building societies have special privileges from the state and they assist home-buyers.
Regulation of the banking system is carried out by the Bank of England (the Bank). Because of historical reasons it has the Issue department (notes and coins, £16m balance sheet) and the Banking department (£4.5m).
The Banks functions besides supervision are to be the government's banker, bankers' bank, lender of last resort to LDMA, note issue, operating monetary policy, foreign exchange transactions (Exchange equalisation account), stock sale, advisory services and statistical information and managing the national debt. Supervision is carried out to control that the banks don't operate against the Bank policy (creates inflation) and that they have enough liquidity and not to many bad debts.
The Bank carries out the monetary policy, which was created by Friedeman and is claimed to have the advantage of being non-inflationary. The Bank has now adopted a MTFS(medium term financial strategy) policy to break down the stop and go cycle. Monetary policy is basically the direction of the economy through supply & price of money.
Its main weapon for the policy is interest rate. But investments are non-marginal, Gov. debt increases with increased interest, hot money(short term investment from abroad) flows in, raising rates is politically unpopular and people will borrow despite high rates. The Bank can alter the base rate(Treasury bills, rate it lends to the LDMA). Liquidity ratios were also used for policy. It operates through credit creation, controls investment. Policy is relaxed in recession. But banks have excess liquidity and will use securities as liquid assets.
Control of money supply was also used a while ago, but Ms is hard to determine and velocity of money changes. Open-market operations (issue of 91 day maturity Treasury bills) are now widely used. It creates new money and thus is inflationary, but doesn't increase Nat. debt much. Basically when the Bank sells securities their price will fall, as they have fixed interest rate the rate will rise.
Funding (slae of gilts to general public) is also used to decrease liquidity. It is expensive. The issue of notes and coins, special directives and deposits (damage relationships, effective), moral suasion (only in USA) can in principle also be used, but are not in the UK.
Lately UK has been faced with the EMU directives to meet the convergence criteria. UK is probably not going to join the EMU, but it still should lower its PSBR.
Policy affects first the liquidity of banks, etc. Its intermediate targets are the growth of money stock M06%, credit volume , interest(<4%), stable exchange, steady growth. These will lead to changes in the aggregate demand and ultimately to th overall targets: lower inflation, steady self-sustained economic growth, and low unemployment.
The banking system has been lately regulated by the banking act in 1979. It included the licensing of the banks (LTD - licensed deposit taker), the allowance to call itself a bank and advertise, deposit protection scheme. Monetary control provisions were founded in 1981. The Banking act 1987 set out a stricter supervision (minimum capital to £5m). The Building societies act 1986 was issued to regulated building societies.
There are 2 types of money markets in the UK now. Classical markets include the Bank, LDMA and commercial banks. Government lends to LDMA that lends on to banks. Parallel markets are much newer invention. It includes the local authorities market, finance houses (hire purchase), large Companies, interbank market, CD market and Eurocurrencies market.
Money multiplier is the amount of deposits are created from a given monetary base in cash and accounts in the Bank. It is about 30 in the UK. Banks must hold (because the Bank tells them to) a cash reserve R fraction of their sight deposits D in cash - cb. The private secor wishes to hold a proportion of their sight deposits (mistake in Begg) in cash (cp- actual cash in circulation). Thus monetary base:
H=C+R=(cp+cb)D
Money in circulation is currency + sight deposits, M=C+D. From these M=H and the value of the multiplier is . An increase in c will lead to a contraction of money supply.
Disintermediation is the transfer of flows in tertiary monetary institutions (intermediation institution) to other channels (usuallly less suitable, e.g. banks abroad) followed by a regulation (usually from the government) to limit the intermediation. Funds will also start transferring directly between saver/borrower. Disintermediation decreases the power of authorities to control intermediation institutions.