Money, Banking, and International Finance

Economists use liquidity to define money. Liquidity is people can easily convert an asset into cash with little transaction costs. For example, if you take all your assets and list them in terms of liquidity, then liquidity forms a scale as shown in Figure 1. Cash is the most liquid asset because a person already has money and does not need to convert it to money. Subsequently, a savings account is almost as good as cash because customers can arrive at a bank or ATM and convert their deposits into cash quickly with little transaction costs.

Nevertheless, cars and houses are the least liquid assets because owners require time and high transaction costs to convert these assets into cash. Economists define the money or the money supply as anything that people pay for goods and services or repay debts. In developing countries, people use cash as money. In countries with sophisticated financial markets like the United States and Europe, the definition of money becomes complicated because money includes liquid assets, such as cash, checking accounts, and savings accounts. People can convert these assets into cash with little transaction costs. Consequently, economists include highly liquid assets in the definitions of money. However, economists never include assets such as houses in the definition of money.

Unfortunately, homeowners need time and have high-transaction costs to convert a house into cash. Many homeowners will not sell their homes quickly by selling it for a lower value than the home’s market value. Every country uses money. Therefore, every country has a government institution that measures and influences the money supply.

This institution is the central bank. For example, the central bank for the United States is the Federal Reserve System, or commonly referred to as the “Fed.” The Federal Reserve regulates banks, grants emergency loans to banks, and influences the money supply. Since the money supply and the financial markets are intertwined, the Fed can influence financial markets indirectly, when it affects the money supply.

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Therefore, the Fed can indirectly affect the interest rates, exchange rates, inflation, and the output growth rate of the U.S. economy. When the Fed manages the money supply to influence the economy, economists call this monetary policy. Consequently, this whole book explains how a central bank can influence the economy and its financial markets. Furthermore, readers can extend this analysis to any central bank in the world.

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