What is money really? The question is more complex to answer than many expect. Here, we break down the essence of money, and the role central and commercial banks play in the money creation process. This knowledge will help you to understand how the economy and markets operate at a deeper level.
We have also rolled up the history of money in another article, where the evolution of money from stones and seashells to modern bank notes is discussed in detail.
The Three Functions of Money
Let’s start with a key consideration: What is money used for?
In general, the three functions of money are:
- A store of value with which to transfer ‘purchasing power’ (the ability to buy goods and services) from today to some future date
- A medium of exchange with which to make payments
- A unit of account with which to measure the value of any particular item that is for sale
In some scenarios, we may see certain assets act as a store of value but not medium of exchange nor unit of account (e.g. Gold, arguably bitcoin). Or as a medium of exchange but not a unit of account (e.g. buying altcoins with USDT where the direct trading pair does not exist, using BTC as the interim trading pairs).
The functions of money may be considered to operate in a hierarchy, as depicted in figure below:
There are many assets that people view as stores of value — houses, for instance — that are not used as mediums of exchange. By comparison, an asset can only act as a medium of exchange if at least two people (as parties to a transaction) are prepared to treat it as a store of value, at least temporarily.
Finally, for an asset to be considered a unit of account, it must be able — in principle, at least — to be used as a medium of exchange across a variety of transactions between several people. As such, it represents a form of coordination in society. For this reason, some economists consider the operation as a unit of account to be the most important characteristic of money. Indeed, it is commonly argued that a defining feature of monetary policy lies in central banks’ control of the unit of account.1
Most money circulating today was created as banks lend out customer deposits, in a system known as the fractional reserve banking system.2
When you deposit $100 into a bank, the bank will typically lend out this money in order to earn interest. However, it may not lend out the entire $100, since a certain amount needs to be held on hand in case you request a withdrawal. On the other hand, it does not need to hold the entire amount, otherwise it cannot lend out any.
In general, monetary authorities impose reserve requirements on banks: for every dollar of deposits at a bank, a certain percentage must be kept as reserves. The percentage is called the required reserve ratio, which varies greatly among countries. Now we try to go through the journey of money creation.
To keep it simple, we assume that the required reserve ratio is 10% and the bank does not hold any excess reserves. Thus, for the $100 deposit, the bank keeps $10 in reserves and loans out $90. This $90 makes its way through the economy, eventually being deposited in another bank. Of this $90, $9 is kept in reserves with $81 loaned out. The process repeats again and again, until there is no more to be loaned out.
The process of money creation step-by-step
At first, only the $100 owned by you exists in this economy. Then, the first loan creates an additional $90, and the second loan creates an additional $81. As the process repeats, eventually $90 + $81 + $72.9 + … = $90/0.1 = $900 is created.
Thus, $1,000 in assets now exists in this economy, of which $100 is originally cash but $900 is created from debt. Equivalently, a total of $1000 deposits are now in the banking system. This is why most existing money comes from lending via fractional reserve banking.
Here is the whole process step by step:
This process can be viewed with a multiplier concept. If x is the required reserve ratio, 1/x is the simple deposit multiplier. It refers to the maximum deposits resulting from $1 of deposit received by the banking sector. In our case, this multiplier is 1/10%=10. And the injection of $100 into the banking sector leads to a total of $100 * 10 = $1,000 deposits. It is basically a simplified version of the money multiplier, which gauges the multiplier effect by incorporating more factors such as currency in circulation and the existence of excess reserves.
Why are we ‘creating’ money through loans and debt?
This money creation process is vital to the economy. When banks are willing to lend during times of prosperity, we see credit expansion and money injection into the economy. During a recession, banks look to lend less to protect themselves from defaults, causing a credit contraction and a reduction in the money supply.
Influencing banks’ willingness to lend is how central banks and governments around the world can counteract this natural credit expansion and contraction cycle, using countercyclical monetary and fiscal policies. During periods of excess growth, central banks will aim to contract the money supply by raising interest rates and required reserve ratios, reducing the aggregate reserves; and vice versa when there is a recession.
Nevertheless, we should note that the required reserve ratio has been less important in controlling the effect of money creation. Since the global financial crisis in 2008, the Federal Reserve System, the central bank of the US, has started paying interests on reserves held by banks as part of its strategy of manipulating the interest rates. Banks in the US have accumulated huge amounts of excess reserves since then.3 Also, banks tend to be constrained by other banking regulations that require them to hold certain amounts of capital when making loans, so they normally hold reserves more than the reserve requirements.
In March 2020, the Federal Reserve even removed the required reserve ratio for banks, which means it is possible for banks to hold no money in reserve when making loans. Applying the concept of the multiplier, you can see that the maximum amount of money created theoretically goes to infinity as the ratio approaches zero.4 In practice, however, this never happens. In other words, the money creation process is limited by other monetary initiatives, capital requirements, and the banking system’s risk tolerance.
The money hierarchy is a concept introduced by Perry Mehrling, professor of economics at Boston University.5
First of all, one must distinguish between money and credit. Money is a means of final settlement, while credit is a promise to pay money, or means of delaying final settlement.
When you deposit money into the bank, it is a credit. The bank deposit only exists as a balance on the bank’s ledger, where the bank promises it will pay you back upon redemption. It is an ‘I-owe-you’ (IOU) from the bank.
From the money creation process above, we know that–except the original money deposit ($100) which is not a credit–all money created is a chain of IOU created by the debt owners and their associated banks.
Different forms of money are inherently hierarchical, with physical banknotes at the top and other forms of deposits successively lower depending on how liquid and risky they are.
The risks of depositing your money with a bank
When you put deposits into a bank, you bear the liquidity risk and credit risk of the bank. If the bank defaults, it is possible for you to lose everything. Although bank deposits are normally covered by deposit insurance (e.g. FDIC in the US or FSCS in the UK), they are still one level below physical banknotes due to the difference in liquidity and risk.
Further down the hierarchy are other forms of deposits. For example, money held in a brokerage account is of lower quality since they usually also hold money in banks, adding more layers between you and physical access to your deposit.
As we move down the hierarchy, more intermediaries are involved, affecting the quality (liquidity and credit riskiness) of the money.
So, it seems physical banknotes are the safest form of money.
Why people aren’t holding only physical banknotes
There are a few reasons why people choose bank deposits over keeping banknotes under the pillow:
- Add-on services: Banks provide other services like savings interest, credit & debit cards, FX conversion, and securities exchange services which are difficult to access via physical cash
- Convenience: Many economic activities nowadays are conducted online and through electronic means instead of face-to-face
- Cost and Safety: Transfer and storage of large sums of physical cash is costly and risky
A combination of these reasons above may explain why people choose to hold their money as bank deposits instead of physical cash.
More Insights on the Essence of Money
And now you know how money is created, regulated, and multiplied in the market! If you want to learn more about the basics of macroeconomy, also check out our articles on the history of money, how banks influence the money supply and decentralised finance as an alternative financial system.
1. Ali, Robleh. The Economics of Digital Currencies. Bank of England, Sept. 2014, www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/quarterly-bulletin-2014-q3.pdf
2. Kagan, Julia. “Fractional Reserve Banking.” Investopedia, Investopedia, 29 Jan. 2020, www.investopedia.com/terms/f/fractionalreservebanking.asp
3. Keister, Todd and James J. McAndrews. “Why Are Banks Holding So Many Excess Reserves?” Dec 2009. https://www.newyorkfed.org/medialibrary/media/research/current_issues/ci15-8.pdf
4. Board of Governors of the Federal Reserve System, Mar. 2020, www.federalreserve.gov/monetarypolicy/reservereq.htm.
5. Mehrling, Perry. The Inherent Hierarchy of Money. 25 Jan. 2012, ieor.columbia.edu/files/seasdepts/industrial-engineering-operations-research/pdf-files/Mehrling_P_FESeminar_Sp12-02.pdf
6. “Money Supply.” Wikipedia, Wikimedia Foundation, 24 Mar. 2020, en.wikipedia.org/wiki/Money_supply
7. “Monetary Aggregates.” Trading Pedia, www.tradingpedia.com/forex-academy/monetary-aggregates/
8. Hopper, Laura. “What Are Open Market Operations? Monetary Policy Tools, Explained.” 21 Aug. 2019.