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Monetary System

Updated on April 26, 2024
Article byKhalid Ahmed
Edited byShreeya Jain
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Monetary System?

A monetary system refers to a governance framework and policy to create, circulate, and regulate money in an economy. Its primary purpose is to lay the foundation of all economic activities and determine a nation’s economic health.

Monetary System Definition

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It also helps in economic development, stability, and growth. Currently, governments use it to maintain the value of a domestic currency in foreign markets through interest rates, spending policies, and tax measures. Governments use it to control inflation and deflation, leading to a stable economy. Hence, it also allows businesses to operate & grow balanced by facilitating the provision of appropriate resources.

Key Takeaways

  • A monetary system is the means and methods to create and regulate money in an economy by the government. 
  • It plays a vital role in inflation and deflation control and forms the basis of all economic activities, allowing balanced business growth. 
  • They can be classified into three types: Commodity money, Commodity-based money, and Fiat money, the most widely used form of money like the U.S. dollar.
  • The monetary system derived from the barter system allows easy trade between two people even without the dual want of needs and at any place and time, which was impossible in a barter system.

How Does The Monetary System Work?

The monetary system refers to those sets of frameworks and policies with the help of which the government can create enough money for circulation and usage in the economy. The monetary system must be controlled and maintained strategically as it is directly connected to the stability of an economy. Now let us understand how the international monetary system works:

  • Money Creation: A central authority creates money. The central bank of the U.S. is the Federal Reserve System, often referred to as the Fed. This creation process can take various forms:
  • Currency Issuance: The central bank typically issues these based on its monetary policy objectives and the economy’s needs. The U.S. Department of the Treasury also plays a role in minting coins and issuing new currency.
  • Commercial Banks: Commercial banks are the primary intermediaries in the U.S. monetary system. They accept deposits, make loans, and offer various financial services to individuals and businesses.
  • Payment Systems: Payment systems in the U.S. include a wide range of options, including physical checks, debit and credit cards, and automated clearinghouse (ACH) transfers. Hence, these systems facilitate the transfer of funds between individuals and businesses.
  • Financial Markets: Moreover, the U.S. has a well-developed financial market system. Therefore, these markets provide platforms for trading financial assets, which impact the allocation of capital in the economy.
  • Regulation and Oversight: Governments and regulatory agencies oversee and regulate the financial and banking sectors to ensure the stability and integrity of the monetary system.
  • Monetary Policy: Central banks use monetary policy tools to influence the money supply, interest rates, and overall economic conditions. These tools include open market operations (buying or selling government securities), changes in interest rates, and reserve requirements for banks.

However, with the increasing adoption of digital payment methods and cryptocurrencies, there can be a dual monetary system where digital currencies and physical cash coexist. Therefore, this is common in many advanced economies today.

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Types

There are three types of monetary systems –

#1 – Commodity Money

It comprises commodities having intrinsic values or precious metals and minerals. Here, these commodities serve as currency in physical form. Hence, commodity money tends to retain its monetary value even if someone melts it down, as with gold and silver. People have used gold and silver as money for trade because of their enduring monetary value.

#2 – Commodity-Based Money

Under this comes money whose value is derived from certain commodities that do not require to be handled daily, like currency notes. Currency notes may not have tangible value but can be exchanged with the commodity that backs it. For instance, the currency of the United States, called the dollar, derived its value from gold, which became known as the gold standard.

#3 – Fiat Money

Under this monetary system, the government promises to guarantee the currency value through a legal decree without being backed by any valuable commodity. Furthermore, fiat money cannot be exchanged with gold or silver, but one can easily exchange products, services, or other commodities. Currently, all the currencies in the world come under fiat money because people everywhere use them to purchase goods. Thus, it generally comprises paper currency and coins of a metal base.

Therefore, this fiat money is a country’s legal currency that no one can refuse for the exchange of goods or services without being punished under the law. Moreover, all fiat money can be transformed into bank balances, credit cards, or debit card purchases.

Examples

Let us understand the concept using examples.

Example # 1

In the fictional state of Dreamland, the monetary system forms the backbone of their economy. Hence, this system is crucial in driving economic activities, with banks managing government deposits and credit. It supports modernization, funds essential infrastructure projects, and encourages sustainable corporate growth. Dreamland’s monetary system includes different forms of money like commodities, commodity-based assets, and fiat money, making trade smoother.

Moreover, Dreamland and Galaxy Nation also engage in well-regulated international trade, boosting both nations’ growth. This system maintains economic stability, controls inflation, and promotes responsible spending, much like in the real world. In this fictional scenario, this system mirrors reality, serving as a vital element for economic health and advancement.

Example # 2

The Bank for International Settlements (BIS) recently unveiled a plan for the world’s monetary system that uses programmable central bank money.

The blueprint, which is a component of the BIS Annual Economic Report 2023, heralds the start of a brand-new era that offers potential for the advancement of monetary and economic systems. The novel system pushes the limits of traditional transactions by integrating tokenized versions of central bank digital currency (CBDC) with commercial bank deposits and other tokenized assets.

Furthermore, global central banks are eager to investigate the opportunities this new monetary system offers, together with other public bodies and the business sector. They want to expand monetary system boundaries and boost cross-border integration. BIS will continue to support these initiatives as an international center for central bank collaboration and innovation. The upcoming full BIS Annual Economic Report and the BIS Annual Report, both of which will be published on June 25, 2023, will provide further information about the blueprint.

Difference Between The Monetary System And The Barter System

Let us use the table below to understand the difference between the monetary system and the barter system:

Monetary systemBarter system
Fiat money is used to exchange goods or services.Here, goods are used to exchange for other goods.
Moreover, fiat money helps anyone buy or sell goods or services.In a barter system, both parties must agree upon the conditions and quantity of goods exchanged.
Money needs to be paid first for any exchange of goods or services.If parties do not agree, then the goods cannot be exchanged..
It may or may not require a double coincidence of wants.Hence, it happens only when a double coincidence of wants is present in the transaction.
These are available in all situations.This system is only feasible in some situations.
A monetary system is possible if two people have money quite easily.Furthermore, it is challenging to trade if two people have different valued goods.
Both local and international monetary system trade is possible.Only local trade is possible.
Hence, it helps people to borrow from each other and banks.There is no option for borrowing.
One can quickly transfer money from one person to another from faraway places.Over here, it is not possible to transfer goods from a distance.

Frequently Asked Questions (FAQs)

1. What is the international monetary system?

A collection of globally agreed-upon laws, norms, and supporting institutions is known as an international monetary system enabling international commerce, a cross-border incentive to invest, and the redeployment of money between countries with different currencies.

2. Who created the monetary system?

Mesopotamians devised the fort form of money in the form of shekels around five thousand years ago. Later on, these were replaced by gold and silver coins in the sixth century. Furthermore, these metal coins were later used as a mode of payment to armies.

3. How do cryptocurrencies fit into the monetary system? 

Cryptocurrencies are digital or virtual currencies that use cryptography for security. They operate on decentralized technology called blockchain. While they are not part of traditional monetary systems, they have gained popularity as alternative forms of money and investments.

This has been a guide to what is Monetary System. Here, we explain its types, differences with barter system, and examples. You can learn more about it from the following articles –

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