Forex: A Nation's Money Supply

As long as nations have their own currencies, trying to analyze international payments adjustment and exchange rates without looking at national money supplies is like the proverbial playing of Hamlet without the Prince. On the whole, the surplus or deficit on the balance of payments is in fact a net flow of money between nations, usually tending to make the money supplies in each nation match the national ratio between national moneys. Understanding how international payments adjustment and exchange rates work is to understand how they relate to money supplies as well as to prices and incomes.

A surplus in a nation's balance of payments represents a way in which the nation adds to its money stock, and a shortage is a way in which its money stock is depleted. This generalization is broadly correct, though the implications of a payments surplus as the net increase in a nation's holdings of money claims against the nation's bank deposits, currency, and the like).

In the beginning, money was the same thing as the international reserve asset. This was true for major countries before the late 19th century. Gold was the international reserve asset, and the domestic assert backing up paper money, and even a prime form of circulating money itself. This was especially true before the emergence of fractional-reserve banking across the 18th century.

When banks stayed close to the cloakroom function of issuing bank notes that could all be fully redeemed in gold when the depositor wished to turn them in gold was both money and reserves. Something similar held for many colonial economies before their independence. The colonizing country's currency circulated as its money supply--- either raised or otherwise, depending on whether the country was in payments, be it surplus or deficit.

Today, most countries' monetary institutions are more complicated than this. The money supply is no longer confined to an amount equaling the nation's monetary reserves, either domestic or international reserve assets. Gold has long since been retired from private monetary circulation, though it is still an industrial and consumer good of raising value.

A nation's international reserve assets are held largely by its private banks, as part, but only part of it--- backing up for the nation's money supply. Most of modern money consists of demand deposits in banks backed up by only fractional reserves held by the banking system. All foreign currency is held by this banking sector, that all money liabilities to foreigners are owed by it, and that the national money consists solely of bank demand deposits, ignoring currency in circulation.


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