Money: technical issues

Money has a name: dollar, pound, rupee, franc, rand and so on. One of these or another name is the name of your country's currency or, more formally, the monetary unit6 of your country; this will be set down in some statute7 of your country. The unit (say one dollar) will most likely be made up of sub-units or parts (say 100 cents). This enables prices in your country to be in multiples of one cent8.

A glance at a bank note will reveal that it is issued by your central bank; so it is a liability of the central bank9. If you are in the UK and you have a fifty pound note it will say: I promise to pay to the bearer on demand the sum of fifty pounds (see Box 2). In some cases the note will state: This note is legal tender for the payment of the amount stated thereon or This note is legal tender for all debts, public and private (USD notes). Your note may even state both these phrases.

Box 2: GBP

GBP

What do these lofty phrases mean? The first one means nothing more than the central bank will exchange your weather-beaten bank note for a crispy new one. In days past it meant something more significant; we will discuss this issue in more detail later.

The legal tender covenant means that a creditor (think: a creditor provides credit and is therefore owed an amount of money) is legally obliged to accept payment from a debtor (think: a debtor makes a debt and therefore owes money)10 in the form of bank notes (and coins - although not stated on the coins11) to the value specified on the note. If the payment of legal tender money is refused the debt is extinguished12.

The question arises: does a country only have one currency that is designated legal tender by statute? The answer is yes (usually). This means that only the currency of a country may be used to pay for goods and services in that country (and from abroad after exchanging the local currency for a foreign one). However, in extreme circumstances (as in hyper-inflationary times) in a few countries, other currencies have been declared legal tender. For example, in Zimbabwe in 2009, the Zimbabwe dollar lost all its money attributes / roles (see below) and the South African rand (ZAR) and the US dollar (USD) were declared legal tender. The Zimbabwe dollar went into hibernation for its severe financial winter.

Money's primary role is to serve as a means of payment / medium of exchange. The other roles of money will be obvious: unit of account (also known as standard of value) and store of value13.

Unit of account means that records (accounting records in the modern age) can be kept of assets and liabilities in one standard, and that comparisons can be made between the assets and liabilities of different entities and at different times.

Store of value means that the medium of exchange maintains its purchasing value, that is, you can keep the money tucked away (under mattresses in the olden days and in the bank today) and spend it later when it will at least buy the same amount of goods and services as when you received the money.

The simplicity of money creation

Money is literally created by entries in the accounts of commercial banks, and this takes place when a bank loan / credit14 is applied for and accommodated by a bank. Thus, when the bank (let's assume for the moment there is only one bank) provides you with a loan facility, such as an overdraft, and you utilize the facility, that is you pay the furniture store for the new LCD TV, the furniture store deposits the money. So, the bank credit granted to you created the new bank deposit (= new money). These are entries in the accounts of the bank: the loan to you is an asset (= it owns) and the deposit is a liability (= it owes).

Sound incredulous? It is, and even more unbelievable is that we homo sapiens are responsible for this because we all generally accept bank deposits as money, that is, as a means of payment / medium of exchange. In other words we pay for the majority of goods and services we buy by the transfer of bank deposits, which makes it money. Notes and coins, the other component of money, are also used to make payments, but bank deposits are overwhelmingly used in this modern age. A new bank deposit is new money created, and it springs from bank credit / loan extension.

Figure 2

So, now we know that money (M) is comprised of bank deposits (BD) which are immediately available15 or available soon16 and bank notes and coins (let's call these N&C):

Another example may be useful: Company A (Co A) which produces goods and wants to sell them, and Company B (Co B) which wants to trade in the goods produced by Co A. Co B does not have the money to do so and approaches Bank A (let's assume that it is the only bank) for a loan of LCC 100 million. It is in the business of lending money and grants17 the loan in the form of a credit to Co B's bank account in its books. Co B's balance sheet changes as indicated in Figure 2.

Bank A's balance sheet is the converse of Co B's balance sheet as indicated in Figure 2. It will be noted that the deposits of Co B, a member of the non-bank private sector (NBPS) of the economy, have increased, that is, the amount of money (M) in circulation has increased, by LCC 100 million. The increase in M has a balance sheet cause of change (BSCoC): the credit extended to the NBPS. The actual cause is the approach by Co B to the bank and the bank accommodating it, i.e. the demand for loans / credit.

Figure 3

Let us take the transaction a little further. Co B clearly borrowed the money in order to buy goods from Co A. In addition there is a strong financial reason: the interest rate on his new deposit is lower that the bank's lending rate (reflecting the bank's margin). Co B will do an EFT payment to Co A via the internet, show Co A the proof of payment (pop), and take delivery of LCC 100 million worth of goods. The final balance sheet changes are as indicated in Figure 3. (Note that the changes in all the balance sheets balance.)

An alternative to the above is that Co B obtains an overdraft facility of LCC 100 million from the bank. This is more likely in real life, but the outcome is the same. In terms of the money-component identity, M = BD + N&C, we have:

It should be apparent that we also have an identity from Bank A's balance sheet: AM = Accredit to NBPS:

Money was created by accounting entries by a bank. This shatters the notion that a bank must receive a deposit before it can provide credit; the path of causation is: a bank creates new deposits by providing new credit. The belief system that money creation rests on something tangible, like silver or gold, should now lie in ruins. This also indicates that banking is a good business; it is, and it is so because we, the general public, generally accept bank deposits as a means of payment. This simple reality makes it money.

A significant question now arises: does this not mean that the banks are able to create loans and its counterpart, money, ad infinitum? The answer is a yes, but it is a qualified yes. Because of the phenomenon of banks being able to create money by accounting entries, a policy on money, that is, a monetary policy, is required. Also required is exacting bank regulation and robust supervision because, inter alia, the phenomenon of money creation makes banks inherently unstable.

You will have heard of the central bank of your country. You will have read or heard about your central bank's key interest rate (KIR - called by different names such as repo rate, discount rate, bank rate, base rate, but we call it by this generic name from here on). Central banks "control" money creation by the banks through its KIR, and in many cases are responsible for the supervision of banks.

In conclusion: money is bank notes and coins plus the short-term bank deposits of the private sector. Banks create money by accounting entries, that is, virtually "out of thin air". In order to cement the understanding of this barely credible reality, and how monetary policy developed and is now implemented, we need to delve back into history to see how it all came about.

 
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