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**To understand the financial crises that the world has been going through, you need to understand what money is.**

**Money, Currencies, Exchange Rates**

Money is denoted in currencies which are controlled by their governments. In the US, it is the dollar; in the eurozone of 17 governments, it is the euro; in China, it is the rimini; in the UK, it is the pound. The euro is an anomaly since it is not controlled by a single government (more about that later).

Within a country (or zone in the case of the euro), there is a knowable amount of money in circulation. The amount depends on the definition of money that is used. ‘M0’ is the narrowest of the several definitions: it is the total amount of the particular currency in notes and coins that is owned by all persons and entities, whether in their wallets or in their safes, including, in the UK, the safes of banks. Other definitions include forms of money such as deposits in bank current accounts, deposits in savings accounts with banks or other institutions, and term deposits, only repayable on a specified date.

Money in a particular currency is a commodity (like copper, wheat, oil, gold) which can be bought or sold with another currency at a rate determined by the market. As with any commodity, the price is higher if you are buying than if you are selling. Thus a bank might quote an exchange rate of 1.6 US$/GBPound for buying dollars with pounds and 1.5 US$/GBPound for selling dollars in return for pounds.

**Lending, Borrowing, Commercial Banks**

Once money is accepted as payment for goods and services, individuals start to accumulate bank notes and coins. They need a bank to keep it safe until they are ready to make use of it. Some owners of money have more money than they need while others have less. So it becomes useful for pairs of individuals to agree that one should lend money to the other. Just as money lubricates the exchange of goods and services between buyers and sellers, so banks lubricate the use of money, bringing together lenders and borrowers. The lender usually requires the borrower to pay back a greater sum than they have borrowed, the extra being the ‘interest’.

**Commercial banks offer safe keeping to holders of money.**

The Bank opens a ‘current account’ for the owner of the money and agrees to repay it on demand. It also offers the account holder facilities for making and receiving payments to and from third parties by such means as cheques, standing orders, direct debits, and internet transactions. As the Bank gathers more depositors and the total sum of the deposits increases, the Bank finds itself in possession of large quantities of money sitting in its vaults doing nothing. This money does not belong to the Bank and, in principle, it is repayable to the depositors instantly on demand. In practice, the daily demand for repayment is a small fraction of the total. The Bank is providing a service to depositors for which it is not being paid unless it finds ways of making a profit from this service. There are several such ways:

– Charge depositors for running their current accounts
– Offer depositors temporary loans (overdrafts) on which the bank charges interest
– Lend some of the idle money of its depositors to third parties and charge interest

But there is another important way for banks to make a profit by lubricating the use of money:

– First borrow money from other parties for an agreed period for which the Bank will pay the lender interest; for example, through deposit and term deposit accounts
– Then use the money that they have borrowed by offering loans to others at a higher rate of interest than that which they are paying to the parties from whom they have borrowed.

**Bonds**

When governments, banks, and companies need extra money for the conduct of their business, they get it by selling bonds. The bond unit has a name, like ‘Treasury $100 5% 2018’. The seller of the bond will pay interest of 5% on the face value of $100 and will buy back the bond at its face value on a specified maturity date in 2018. Such bonds are negotiable: units of the bond may be bought and sold in the money market until its maturity date. The interest rate at the time of issue depends upon the credit-worthiness of the borrower. The re-sale value of the bond on the bond-market varies with market conditions. If interest rates go up to 5.5%, the price of this particular bond might fall to $88. If interest rates go down to 4.5%, the price might rise to $115. But near its maturity date in 2018, the price will converge on its face value of $100.

**Credit-rating Agencies are commercial companies who rate the credit-worthiness of organizations, including governments.**

**Central Bank, Bank rate, Foreign Exchange Reserves**

Each national currency has an associated Central Bank. In the UK, the central bank is the Bank of England. Central Banks have the legal right to create money with which to buy bonds from their governments and others at an interest rate or Bank Rate of their choosing. They sometimes try to stimulate the economy by keeping interest rates very low and by buying up bonds in the open market. Some call this ‘quantitative easing’ while others call it ‘printing money’. But the Central Bank only supplies notes (printed money) when asked to do so. Usually, the money is created by transfers from the Bank’s own account to the receiver’s current account in return for the seller’s bonds. The Central Bank cannot go bankrupt since it is allowed to issue any required amount of new money to meet all demands.

Central Banks hold reserves of money. Gold was once paramount, but today foreign currencies, especially the US dollar, are more important. Additionally, countries possess ‘drawing rights’ on the International Monetary Fund (IMF). Such reserves give a Central Bank a means for controlling the exchange rate for its currency. If, for example, the rate for its currency is rising, the Bank may sell its own currency and buy foreign currencies on the market, so keeping its exchange rate down and the prices of its exports low.

**Government Income, Expenditure, Deficit and Debt**

Governments spend money on many things: education, defense, social services, transport, and so on. The amount that they spend exceeds their income. This is called a budget deficit. They make up the difference by borrowing money from the population and foreigners by selling bonds. The accumulation of all past deficits and surpluses is called a Debt. Governments do not usually wish to keep a Debt going forever, so it is the policy of many governments to run a ‘balanced budget’ in the long term. If Income equals Expenditure, there is no deficit and therefore no Debt. However, circumstances may force the government to run a deficit which may push the Debt higher.
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Ihab Salloum