Do we really need physical money

November 24, 2015 (updated June 20, 2017)

Euro banknotes and coins are money, but a balance at the bank is also money. What is money anyway? How is it created and what role does the ECB play in it?

Background: what is a central bank?

Money through the ages

The appearance of money has changed over the course of history. In the past, money was mostly commodity money, i. H. an item made of a material with a certain market value. Gold coins are an example of commodity money. Later, so-called representative money came up in the form of banknotes that could be exchanged for a certain amount of gold or silver. Modern economies, including the euro area, are based on fiat money. This is money that is officially legal tender and is issued by a central bank. Unlike representative money, however, it cannot be used against e.g. B. a certain amount of gold can be exchanged. Modern money in itself has no value; banknote paper is basically worthless. Nevertheless, fiat money is accepted as a means of payment for goods and services because people trust that the responsible central bank will keep the value of money stable over time. If the central banks failed in this task, fiat money would lose its general acceptance as a medium of exchange and would no longer be attractive as a store of value.

Manifestations of money over time

Our money today does not necessarily have to be in physical form, i.e. it has to be tangible. It can also be “invisible” and exist as a computer entry in a bank account or as a balance in a savings account. Digital money, also known as e-money, is a monetary value that z. B. is stored on a prepaid card or a smartphone. Direct debits as well as internet and card payments are all cashless forms of payment. (There are even newer, decentralized digital currencies or virtual currency schemes such as Bitcoin. They are not subject to any central control authority such as a central bank. However, legally these digital currencies are not considered money.)

Although more and more payments are being made electronically, cash is still very popular. In the euro area, amounts under € 20 are mostly paid in cash. The value of euro cash is guaranteed by the ECB and the national central banks of the countries in the euro area - the Eurosystem.

What is the purpose of money and how does the ECB monitor it?

Regardless of its form, money has three functions: It is a medium of exchange - a means of payment with a value that everyone trusts. Money is also a unit of account that can be used to determine the price of goods and services. It's also a store of value. Only part of the euro cash issued actually circulates, i.e. it is used for payments. For example, many of the € 50 banknotes issued by the central bank are hoarded.

Functions of money

Central banks usually define various monetary aggregates and monitor their development. This way they can gain useful information about money and prizes. Why are multiple monetary aggregates used? This is because many different financial stocks are interchangeable, and the nature and characteristics of financial stocks, transactions, and means of payment change over time. The Eurosystem has defined three monetary aggregates - a narrow (M1), a medium (M2) and a broad (M3). The ECB uses all three in its monetary analysis. As part of its monetary policy strategy, the ECB takes into account numerous other information and analyzes as well as how the three monetary aggregates have developed.

How is money created?

The ECB is the bank of the commercial banks. Through this function, it influences the flow of money and credit in the economy in order to ensure stable prices. Commercial banks can borrow money from the ECB, i. H. they are given central bank balances. As a rule, they cover their very short-term liquidity needs with these funds. The most important instrument of the ECB for controlling the amount of "external money" and thus the demand for central bank balances on the part of the commercial banks is the setting of very short-term interest rates, i. H. the "cost of money".

How is money created in the euro area?

Commercial banks can also create "internal money", i. H. Bank deposits - this happens every time a new loan is granted. The difference between outside and inside money is that outside money is an asset for the economy as a whole, but there is no liability for anyone. The term “internal money”, on the other hand, is due to the fact that it is offset by loans to private debtors: If the private debtors were to settle all of the bank's claims, the internal money created would be reduced to zero again. In other words: internal money is a form of money that is created in the private sector and can be dissolved again.

What is the ECB's “money printing policy” about which so much is being written?

In fact, only the national central banks of the euro area issue euro banknotes. Colloquially, the ECB's asset purchase program is sometimes referred to as a “money printing policy”. The asset purchase program is a form of quantitative easing. By purchasing assets on the financial market, the ECB creates additional central bank balances. These can help to lower the interest rates for households and companies through various channels. The aim is to prop up the economy and ultimately keep the value of money stable when the ECB has limited room for maneuver to lower these interest rates directly. The ECB does not actually print banknotes to pay for the assets, but creates electronic money that is credited to the seller or the intermediary (e.g. a commercial bank). The seller can use the additional liquidity to buy other assets or, in the case of a commercial bank, to provide loans to the real economy. The purchases help improve monetary and financial conditions. This reduces borrowing costs for companies and households, so that they can invest or spend more. The ultimate goal is for inflation rates to return to levels below but close to 2%, in line with the ECB's price stability mandate.

Background: What is the enhanced asset purchase program?