Institutional units within the monetary sector, which is also called the banking or financial system, are divided into two main groups:
monetary authorities – a central (state, national) bank that issues the national currency, stores state gold and foreign exchange reserves and manages the entire monetary sector of the economy; commercial banks that attract depositors’ funds and issue them at interest to borrowers.
It is assumed that the monetary sphere, as well as the real sector, should be in equilibrium, that is, in accordance with the identity (1.8), its assets should correspond to liabilities.
Assets – the sum of the net foreign assets of the banking system (including net state reserves) valued in national currency and net domestic credit provided by the banking system.
Liabilities are liabilities of the banking system to the private and public sectors, that is, a money supply consisting of cash in circulation, deposits and other monetary instruments.
| M=NFA+NDA, | (1.8) |
| where is the NFA | – net foreign assets; |
| NDA | – net domestic assets; |
| M | – money, liabilities (money). |
The net foreign assets of the money sector consist of net international reserves, which are held in the central bank and controlled by the state, and the net international assets of commercial banks and other financial institutions:
| NFA=NIRc+NIRb, | (1.9) | |
| where NIRc | – net international reserves of the central bank ; | |
| NIRb | – net international reserves commercial bank. |
In most cases, the international reserves of the state (R) are understood only as the foreign exchange reserves of the central bank (NIRc), which can be used by the state at its discretion. However, if the foreign exchange reserves of commercial banks (NIRb) are significant and effectively controlled by the authorities, then they are also included in the concept of international reserves (R), which in this case coincides with the concept of net foreign assets.
Foreign assets of the monetary sector (reserves) are the main source of financing the deficit of the real sector, manifested through the current account deficit. By defining the balance of payments as a whole, the change in net provisions should be equal to the sum of the current account balance of payments and changes in net capital flows:
| ΔR=CAB+ΔFI, | (1.10) |
| where FI | – movement of capital and international investments (foreign investments); |
| Δ | – change in the corresponding indicator per unit of time. |
Equation (1.10) shows that, first, there are only two sources of international financing of the current account deficit, and therefore of covering real sector imbalances: either capital inflows from abroad or the use of international government reserves. Secondly, these sources of funding differ in their mechanism. Net capital inflows from abroad, meaning the change in the net overseas assets of the monetary system not included in official reserves, finance only the current balance and are shown in the capital account, i.e. is in the balance of payments “under the line”. Net foreign state reserves cover the negative balance of the entire balance of payments, are a source of its financing as a whole and are reflected in the general balance, that is, they are carried out “under the line”. Therefore, reserves and capital inflows are on opposite sides of equality.
Substituting equation (1.5) into (1.10), we get:
| ΔR=Y-A+ΔFI | (1.11) |
Equation (1.11) shows that consumption through absorption (A) exceeding income (Y), which is not financed by inflows from abroad (ΔFI), results in a loss of international government reserves (ΔR). Since the size of reserves is limited, the possibilities of financing the deficits of the real sector at the expense of the monetary sector are also limited. This is the main connection between the monetary and external sectors of the economy.