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.
From stones and seashells to modern banknotes, read about the evolution of money in The History of Money: From Barter to Currency.
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 for sale.
In some scenarios, certain assets act as a store of value, but not as a medium of exchange or unit of account (e.g., gold; Bitcoin, as seen by some); 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 — and using BTC as the interim trading pair).
The functions of money may be considered to operate in a hierarchy, as depicted in the 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’s control of the unit of account.
Money Creation
Most money circulating today was created as banks lent out customer deposits in a system known as the fractional reserve banking system. As an example: When someone deposits $100 into a bank, the bank typically lends 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 of a withdrawal request. On the other hand, it does not need to hold the entire amount; otherwise, it cannot lend any out.
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 amongst countries.
Now, let’s journey through 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 and is eventually 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 step-by-step process of money creation.
At first, only the original $100 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 + $72.90 + … = $90/0.1 = $900 is created.
Thus, $1,000 in assets now exists in this economy, of which $100 is originally cash, and $900 is created from debt. Equivalently, a total of $1,000 in deposits is now in the banking system. This is why most existing money comes from lending via fractional reserve banking.
Here is the entire step-by-step process:
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 deposits received by the banking sector. In our case, this multiplier is 1/10% = 10. The injection of $100 into the banking sector leads to a total of $100 * 10 = $1,000 in 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 in order to protect themselves from defaults, which causes a credit contraction and reduction in the money supply.
Influencing banks’s willingness to lend is the countercyclical monetary and fiscal policies used by central banks and governments around the world to counteract this natural credit expansion and contraction cycle. During periods of excess growth, central banks aim to contract the money supply by raising interest rates and required reserve ratios (and vice versa when there is a recession).
Nevertheless, it should be noted 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 interest 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. Additionally, 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 more reserves than the reserve requirements.
In March 2020, the Federal Reserve removed the required reserve ratio for banks, meaning that it is possible for banks to hold no reserve money when making loans. Applying the concept of the multiplier, the maximum amount of money created, theoretically, goes to infinity as the ratio approaches zero. In practise, 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.
Money Hierarchy
The money hierarchy is a concept introduced by Perry Mehrling, Professor of Economics at Boston University.
First, 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 one deposits money into a 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 the depositor back upon redemption. It is an ‘I owe you’ (IOU) from the bank.
From the money-creation process above, we know that — except for the original money deposit ($100), which is not a credit — all money created is a chain of IOUs from 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 one deposits into a bank, they bear the liquidity and credit risks of the bank. If the bank defaults, it is possible 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 the brokerage usually also holds money in banks, adding more layers between the customer and physical access to their deposit. As we move down the hierarchy, more intermediaries get involved, affecting the quality (liquidity and credit riskiness) of the money. With that, some may view physical banknotes as the safest form of money.
The hierarchy expands and contracts. In expansion mode (e.g., when the economy is doing well), credit becomes available to even marginal borrowers and the quality of risky credit is perceived to be higher. Whereas in contraction mode, only the best borrowers (less risky) can access credit.
Why people aren’t holding only physical banknotes.
There are a few reasons why some choose bank deposits over keeping banknotes under their pillow:
- Add-on Services: Banks provide other services like savings interest, credit and debit cards, FX conversion, and securities exchange services, which are difficult to access via physical cash.
- Convenience: Many current economic activities are conducted online and through electronic means instead of face-to-face.
- Cost and Safety: Transfer and storage of large sums of physical cash are costly and risky.
A combination of these reasons above may explain why some choose to hold their money as bank deposits instead of physical cash.
More Insights on the Essence of Money
To learn more about the basics of macroeconomy, check out our articles on the History of Money and decentralised finance as an alternative financial system.
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