The value of money is an idea instilled within everyone from a young age. We are taught that we should get a good education and work hard so that we can earn enough money to live our lives how we choose.
But often we don’t question why this is important.
Why do these pieces of paper (or plastic these days!) have value?
And who determines their value?
The answer to these questions comes from understanding where money comes from and the different types of money.
Types of Money
There are two types of money and they come from three different sources.
The first type of money is physical currency, the notes and coins that many of us use every day. This money is issued by the government through a mint and then put into circulation. Governments earn something called seigniorage from the production of money as there is clearly a difference in the cost of producing money and the value of that physical currency itself.
In the modern day, seigniorage is really the difference between the cost of producing money and the interest rate on treasury bonds that central banks buy with their newly created physical currency.
Today, physical currency only makes up around 3% of all money in circulation in the UK. Although we see cash everyday, that is a very small portion of the money supply.
To truly understand money, we need to understand where the other 97% comes from.
The role of Banks
Banks are typically explained as intermediaries that store deposits and use them to make loans. This is fundamentally incorrect as loans instead create deposits not the other way round. Instead banks create money electronically, and they create a huge amount of it!
Our financial and banking system is built on debt and changing your perspective can help you understand it. Let’s consider the relationship between savings and loans with an example.
Tom goes to the bank after inheriting £10,000 and deposits it. Now the bank is happy for Tom to do this but, to make a profit, they need to lend this money out.
Banks are often subject to a reserve requirement either internally or as a government regulation. This is the fraction of money that must be held by the bank at any time so that if you come back for your money, there’s something for you to get. Let’s set the reserve requirement at 10% in this example. Therefore, the bank has to keep £1,000 in reserve and can loan out the other £9,000.
Tess then goes to the bank and applies for a £9,000 loan. She is approved by the bank for the loan and it is credited to her account.
The bank now has created £9,000. The bank still has a liability to Tom for the original £10,000 if he wants it back. It now has a liability to Tess as well as she now has £9,000 in her account that she can withdraw if she wishes. This has increased the money supply. The bank keeps 10% of Tess’s money in line with the reserve requirement and now has £8,100 to loan out.
Tim now goes to the bank and applies for a £8,100 loan. He is approved by the bank for the loan and it is credited to his account.
The bank has created another £8,100. It still has a liability to Tom for his original £10,000 and the liability to Tess for the £9,000 in her account and now it has a new liability to Tim for the £8,100 in his account.
This process goes on and on and the money supply continues to grow. We can work out how much money we end up with by calculating the money multiplier.
Money multiplier = 1reserve requirement
In this scenario, the money multiplier is 10 so Tom’s original £10,000 becomes £100,000 thus creating £90,000 worth of new money. Only £90,000 of new money is created because the original £10,000 was already part of the money supply.
The crucial element of this whole process regards how Tom received his inheritance. If it is £10,000 in cash stored in a vault then the money multiplier process occurs. If it is simply a cheque from somebody else for £10,000 then the money multiplier process does not occur. This is because money is simply moving from one account to another and the bank would not change its reserves meaning that the lending process does not occur. The person that Tom received his money from has already had the loan process occur when that money first entered their account, therefore it won’t happen again.
The role of Central Banks
We are now led to the crucial player in the control of the money supply, the central bank. Central banks can quite literally create money out of thin air with the click of a button. Although banks can create money through the system explained earlier, central banks simply type numbers into the computer. Since the 2008 financial crisis, central banks have used a tool known as quantitative easing to increase the money supply.
Central banks such as the Bank of England purchase government bonds (known as gilts in the UK) with money created on the magic computer. This increases the number of reserves that banks have and can increase their ability to make loans. Typically when more loans are made, economic activity rises as people have loaned money to spend. Between 2009 and 2021, the Bank of England created £895 billion in new money to bolster the economy.
The question you are probably asking is why isn’t this inflationary? Creating money equals inflation as far as many are concerned. Firstly, it’s far more complicated than that. The economic growth rate, changing reserve ratios, velocity of money and status of the economy can all affect how inflationary the money supply can be. Firstly, money created by commercial banks is destroyed when loans are repaid. The increase in the money supply stemming from Tom’s £10,000 deposit is slowly destroyed as those subsequent loans are repaid.
However, increases in the money supply caused by the central bank quantitative easing can be inflationary. Arguably, the huge amount of quantitative easing that occurred during the pandemic has played a part in the current global surge in inflation. It cannot be held solely to blame given supply chain issues and geopolitical problems but the increase in the money supply likely has had some role in the current situation.
In addition to the factors mentioned above, the changing money multiplier has a significant effect on the money supply. Just because banks are held to a reserve requirement, it doesn’t mean they can’t hold more reserves. In fact, they often do hold more reserves, particularly in times of economic stress. Changing circumstances change the money multiplier and it is by no means a fixed number.
This post has aimed to give a basic explanation of a highly complex topic.
For a more technical explanation, please read the following 2014 article from the Bank of England: Money Creation in the Modern Economy