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What actually is money and how is it created?

What actually is money and how is it created? Shaun Richards

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The credit crunch era has not only been hard on the world's economy; it has been hard on concepts of economics, and on economists' ideas too. Past concepts such as wealth, income and money, the subject of this post, have proved to be badly understood. Frankly, many explanations have been of the snake-oil sales(wo)man variety! If we concentrate on the topic of money, what has happened to it has misled many in the post-credit crunch world. Let us mark our cards as to what role it performs and how we can identify it.

The three roles of money:

Store of value — something that is expected to retain its value over time. Precious metals such as gold and silver score strongly at this role due to their physical durability.

Unit of account — here, it performs the role of being a consistent yardstick for prices which in the UK, for example, can be compared in pounds and pence. This does not have to be in the form of currency because, across national boundaries, we often see familiar products such as Mars bars and Big Macs used too.

Medium of exchange — it is held for later use because, apart from its own value, it can be reliably exchanged for the goods and services that we want.

It is plain to see that money works best when it performs all three roles reliably. For example, if it fails to be a store of value it becomes harder for it to be a reliable unit of account or medium of exchange. For example, in some countries, another currency such as the US dollar must be used instead of the home currency due to expected falls in its value.

Fiat money is a type of IOU

The Bank of England pointed this out in its latest Quarterly Bulletin:

"Money in the modern economy is just a special form of IOU, or in the language of economic accounts, a financial asset."

Or if you look at its actual physical notes you will see:

"I promise to pay the bearer on demand the sum of ten pounds (for example)."

It might be amusing to go to its headquarters in Threadneedle Street and ask for it - although the Bank of England may not thank me for provoking such a reaction. Long gone are the days where there was any gilt (gold) in UK gilt-edged securities or currency.

How is money created?

Notes and coins — this is the easiest bit to understand, as the central bank simply instructs the relevant printer or mint to produce more of them as and when required. It has been satirized in the modern era as "printy printy", but in fact this is only a small component of the total amount of money. It is under the direct control of the central bank, though some versions these days have the problem of coins having a raw material value greater than its supposed one.

Bank loans — this is a more awkward and much more widely misunderstood topic, as it is easy to get bogged down on whether you should count bank deposits or bank loans here. Actually, we can consider them for this purpose as one and the same because, when the bank provides a loan, it puts it into the customer's bank account and creates a deposit. So, we see that whilst customers making a new deposit can add to money in this section, so can the bank by making a loan. It is on this road that money supply and money demand as concepts come together, and the claim that either are independent weakens as we see a chicken-and-egg style situation.

Central bank reservesthese have two main purposes. The first is an oil for the system and exchanges between banks (overnight settlement of accounts for example); and the second is a method by which the central bank controls, or in fact more realistically tries to control, the money supply. It used to be a commonly used method, but its usage has declined considerably - and now China is one of the few main examples. Sadly, this has not stopped groups basing theories on its continued existence!


As we peruse the information above, we see that it undermines several economic theories which have become popular in these times. It also reminds us that banks in the western world retain a lot of power over the financial system and, in particular, over the amount of money in it. So, as ever, they are at the heart of things as so much in economic policy starts with the (not so) simple concept of money. Also it provides more food for thought for the implications of quantitative easing but I shall leave those for another post!

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Tags: 2008 financial crisis , bank deposit , bank loan , Bank of England , banking , central bank , central bank reserve , credit crunch , fiat money , gold , income , medium of exchange , monetary reserve , money , Quarterly Bulletin , silver , store of value , unit of account , wealth
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