Introduction and early history

Table of Contents:

Learning outcomes

After studying this text the learner should / should be able to:

1. Describe the relationship between money and economic growth.

2. Elucidate the relationship between money and inflation.

3. Discuss the technical aspects of money.

4. Describe the concept of money creation.

5. Appreciate the history of primitive and later forms of money.

6. Describe the forms of money creation in the precious metal coin money age.


Have you ever sat back and thought about what money really is, and what "backs it up", if anything? Have you wondered what causes the amount of money circulating in the economy to increase every year? Instinctively you will know that it does because prices generally increase every year - slightly in some and more-than-slightly in others1 - and know instinctively that the cause is an increase in the amount of money in circulation. The maxim that inflation is caused by too much money chasing too few goods has probably floated through your consciousness a few times.

Have you considered the role that you play in money creation? Whenever you utilize a bank credit facility such as a home loan or an overdraft facility, you and your bank create new money.

Have you pondered the role of the central bank in money creation? You will have heard, seen or read about the central bank's role in setting the repo rate / bank rate / base rate / official rate / discount rate (it's named differently in different countries). What happens after the central bank reduces or increases it and what gives rise to such central bank action? Have you speculated on what actually happens when a central bank says it injected so and so many billions into the economy and felt a little irritated because they (or the media reporter) did not elucidate this action?

You will have experienced share (also called equity and stock) market booms and the inevitable busts that follow. One of the main underlying causes is money creation, and yet this significant cause is rarely put forward, let alone how it contributes. The story is actually surprisingly simple: banks create money (= bank deposits) by extending loans. Bank loans are obviously extended if there is a demand for loans, and the bank considers the consumer creditworthy / project viable. Underlying the demand for new loans is additional economic activity being financed - consumption (C) or investment (I), and these are the two components of the domestic demand for goods and services, called gross domestic expenditure (GDE). It drives economic (called gross domestic product - GDP) growth, and impacts on company profits and therefore on share prices, and so on. To complete the "big picture" (the macroeconomy) we need to add net external / foreign demand: exports (X = foreign demand for domestic goods) less imports (M = domestic demand for foreign goods) which make up the trade account balance (TAB). Therefore the big picture is:

GDP & M3

Figure 1: GDP & M3

A simple time series chart (see Figure 1) will reveal the close relationship between nominal GDP and M3 (a broad measure of money). This is for a particular country for a period of 50 years. Note that the growth rates have never been negative over the period.

The story of money creation is so astonishing (in that it is truly simple) and the system so fine (caveat: if responsibly managed) that it has to be told in an uncomplicated manner. This text is an endeavour to achieve this ideal. One of the thrusts of these texts is that new bank lending does not begin with a new bank deposit. In fact, the exact reverse applies: a new bank deposit (= money) is the consequence of new bank lending, and this is so because we all accept bank deposits as the main means of payments (= the definition of money). In the genesis of banking days the bankers, the goldsmiths, who transmuted into bankers, certainly had to take in deposits of precious metal coins before they could lend. However, they soon learned that they could lend money without taking deposits.

The second thrust of these texts is to refute the notion that money creation revolves around the so-called reserve requirement (RR) of banks (also called the cash reserve requirement). The perceived dominance of the RR in money creation also has its genesis in the past: in the convertibility of bank notes into gold. However, this "standard" (of money creation management) left the world economic stage in the first half of the twentieth century. It was followed by the requirement that banks hold reserves with the central bank equal to a prescribed percentage of their deposits (the RR ratio). You will understand that this standard imposes a quantitative relationship between banks' reserves with the central bank and bank deposits, and therefore constitutes a powerful money creation management tool.

This tool meant that the central bank had total control over money creation - just by managing the amount of bank reserves with itself (and it has the monopoly to do this). This standard did not last for long because with a quantitative control tool the price of money (= the interest rate) had to be left to its own volition. The consequences in terms of interest rate volatility were quite profound.

This standard gave way to one where interest rates are targeted, i.e. are not left to find their own level, and where the RR became a derivative of the system and not the driving force. Thus, instead of the RR being the kernel of the money creation process, in reality it is only one of many factors that affect bank liquidity. And bank liquidity is completely under the control of the central bank; because of this the central bank is able to manipulate bank lending rates to whatever level it deems propitious in terms of the desired growth rate in bank lending / money creation. Remember: the level of bank lending rates influences the demand for bank loans, and underlying this is GDE growth.

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