Q82. What is a bank and how does it create money?
A bank is a deposit-taking business that makes money from borrowing and lending.
A loan is a specified amount of money given to a person or a business for a given period of time at a specified rate of interest. For example, my local bank lends me €10,000 at 8% interest for one year. Loans can be secured - backed property or other assets, which get taken by the bank in the event of a default on the loan - or they can be unsecured.
Banks make money, literally, through fractional reserve banking, where only a small portion of deposits given to the bank by its customers are kept in the bank as reserves in the form of cash and other highly liquid assets, which customers can withdraw. The bank lends out the rest of the deposited funds, up to a maximum allowed it by the central bank, while still allowing all deposits to be withdrawn upon demand. The bank can do this because, at any given moment, most people do not attempt to access 100% of their deposits. The rest is loaned out, and when that loan is repaid, the bank gets its principal back, plus interest.
Through fractional reserve banking, banks can create money, adding to the money supply. For example, private commercial banks take deposits from the public. Some of this money they keep, as a reserve to cover withdrawals. Normally, this reserve requirement is set as part of the monetary policy of the central bank of the country. The rest of the money deposited by customers is lent or invested by the bank, to make a profit. The bank thus 'creates' money each time it lends to other businesses and to other banks.
For example, imagine the reserve ratio is 10%, meaning 10% of all a bank's assets must be held to cover withdrawals, and that there are three banks in the world. The first bank receives €100 million worth of money from the public. After setting aside 10% (€10 million) to meet its reserve requirement, Bank 1 lends the remaining 90% (€90 million) to Bank 2, which keeps €9 million on reserve and then lends out the balance of €81 million to Bank 3. Bank 3 again sets aside 10% and then lends on 90% (€72.9 million). In each case, as shown in the table, the bank's assets have been balanced by the level of its liabilities, but there is now more money in the system than when it started. A lot more. In total, with only three banks, there is now €271 million in the system, all brought into being by deposit creation. The process continues for as many banks as there are in the system. Thus, the banking process 'creates' money, literally.
The fractional reserve system literally 'makes' money by deposit creation.
Q83. How does a government create money?
A government raises funds by three means:
• Printing money.
First, the government can levy taxes on income, on property, on consumption of different goods and services (for example, gasoline and cigarettes, two relatively demand-inelastic products), as well as import and customs duties levied on foreign goods and services, and on sales of capital goods, inheritances, and tariffs.
Taxes can be lump sum - for example, everyone pays €100, regardless of their income - or taxes can be progressive, meaning that tax receipts rise with income, or regressive, meaning taxes fall as income rises. Governments generally raises taxes to fund social expenditures on schools, hospitals, and roads, as well as altering the distribution of income (and hence income inequality) in society. Governments also use taxes to form part of a fiscal policy to stimulate or dampen down the level of total spending.
In addition to taxes, governments can pay for their spending by borrowing from other governments by issuing government-backed bonds. When a government is in fiscal deficit, it must do this to pay for current expenditure.
Finally, governments can raise money by printing money. Money, as we know it today, is fiat money -the government simply decides a particular piece of paper is worth €10, the governor of the central bank signs the note, and that piece of paper, which a few seconds ago was practically worthless, is now worth €10. Thus, the government has made a profit by creating money. Government revenue from printing money is called seignior age.
Governments that print too much money run the risk of reducing the purchasing power of each additional note and so, when considering adding to the money supply, they must take inflation, and perhaps the danger of hyperinflation, as well as the economy's position in the business cycle, into account.
Q84. Can the government ever really manage the economy?
In any country, aggregate demand is the sum of consumption expenditure, investment, government spending, and net exports.
During phases of the business cycle when individual households and businesses are cutting back their spending, because of fears about the future, current employment problems, or something else, consumption, investment and / or purchases of imports and exports can fall. This fall in aggregate demand can lead to a vicious cycle, where the economy becomes further depressed because it is depressed. The only agent in the system capable of increasing aggregate demand is the government -by employing workers, beginning large public works programmes, moving or retraining workers, stimulating the economy by changing interest rates to make borrowing cheaper, and even by changing the exchange rate to increase the competitiveness of the country's exports.
Demand management attenuates peaks and troughs in business cycles.
During phases of the business cycle when the economy is doing very well, the government can change interest rates and government expenditure to decrease aggregate demand, and so attenuate the worst boom and bust moments of the business cycle, achieving a smoothing of the peaks and troughs of the business cycle, as shown in the graph. With active demand management, the peaks are lower, but so are the troughs.
Q85. What is a poverty trap and how can people get out of one?
A poverty trap occurs when the income a person or household might earn from taking a job is less than the combined unemployment benefits they receive while unemployed.
The poverty trap is self-reinforcing because, in the presence of a poverty trap, the longer someone is unemployed, the longer they will remain unemployed.
Poverty traps are serious problems in developing countries, because they can cause economic growth and development to stagnate, and, in countries with large welfare systems, because they damage labour mobility.
There are many ways to reduce poverty traps, including gradation of benefits - reducing benefits the longer a person remains unemployed - or reduction of benefits all together.
Changing tax thresholds for income classes, changing minimum wages, as well as creating tax-credit systems, also can help to alleviate the existence of a poverty trap.