Introduction
When we talk about money and how it’s created, we must take into account that there are two types of money in circulation today; central bank-issued currency and credit money. Central bank-issued currency is only created by central banks and credit money is created through the actions of commercial banks, giving rise to the banking system we know today. But how exactly do they create this credit money? In short, they do so by making loans, but not all loans are created equal, so let’s take a closer look at the different types of loans.
What Is
Credit Money And Where Does It Come From?
You've
probably heard of credit, but do you really know what it is? Credit is simply
money that has been loaned to you. It's like when you go to the bank and take
out a loan. The bank doesn't just hand over cash; they give you the money you
need, plus interest. That's how credit works.
When you
take out a loan, the bank doesn't just hand over cash. Instead, they create new
money by crediting your account. This process is called fractional reserve
banking, and it's how most of the money in our economy is created. Here's how
it works
The
multiplier effect
When a
commercial bank makes a loan, it simply credits the borrower's deposit account
with a larger amount of money. The actual physical cash doesn't change hands.
So where does the new money come from? It comes into existence as credit – that
is, as a new liability on the bank's balance sheet. In this way, banks create
most of the nation's money supply. Banks create new money by making loans and adding to their
customers' deposit balances. This process is called
fractional reserve banking.
What Is
Credit Money And Where Does It Come From?
Most people
think of money as currency, like coins and paper bills. But did you know that
less than 10% of the world's money exists as physical cash? The rest is what's
called credit money. So, what is credit money and where does it come from?
Credit money comes into existence when a bank extends a loan to someone. The
loan is given in the form of a deposit, which is credited to the account of the
borrower in addition to funds he or she already has on deposit with the bank.
The bank
then charges interest on the amount borrowed, creating even more credit money.
As an example, say Sara takes out a $500 loan at an annual interest rate of 6%.
She pays back her $500 plus $6 for the interest over one year
($516). In that year, Sara will have made $5 (6% of her original balance) from
just sitting there doing nothing!
What Is
Money Creation By Commercial Banks?
In the
modern economy, most money takes the form of bank deposits. But how do
commercial banks create deposits? The answer might seem simple: They accept
deposits from customers and make loans to borrowers. However, it's not quite
that simple. When a bank makes a loan, for example, it simultaneously creates a
matching deposit in the borrower's account. So any time a bank issues a loan,
it actually creates new money! It has been estimated that about 90% of all the
money in our economy today has been created by banks making loans.
What Is
Money Creation By The Fed?
The Federal
Reserve System--the central bank of the United States--plays a unique and
vital role in our nation's economy. When the Fed creates money, it does so
primarily by buying securities--usually U.S. Treasury bonds--from banks, which
in turn credits the accounts of those banks at the Fed. The result is an
increase in the reserves held by those banks and a corresponding increase in
their ability to make loans and support economic activity. In this way, the Fed
increases the overall supply of credit in the economy, which can help spur
economic growth.
What Is
Money Destruction, Or Deflation?
Money
destruction, or deflation, happens when the price level of goods and services
decreases. This can be caused by a decrease in the money supply, an increase in
taxes, or a decrease in government spending. When this happens, people have
less money to spend, and businesses make less profit. As a result, the economy
slows down and can even enter a recession.
It becomes
much harder for people to buy things because they don't have enough money.
Businesses also struggle because they are not making as much profit, so they
end up laying off workers. That makes unemployment higher, which has a ripple
effect on other aspects of the economy such as consumption and investment.
Eventually, it affects prices again because if companies can't charge more than
their cost of production then they will go out of business. That's why we must pay attention to what's happening with our money!
How is
credit money created?
Credit money
is created when a bank extends a loan to a borrower. The loan makes new
deposits, which are then used to fund the borrower's purchase. The process of
creating credit money is sometimes called fractional reserve banking. When a
bank makes a loan, it only keeps a fraction of the total value of the loan in
its reserves. The rest of the money is lent out to other borrowers, who then
spend it and help create new economic activity. In theory, banks do not need to
keep any cash on hand at all because they can always use what they owe their
depositors as backing for loans. If all depositors came forward at once
demanding their money, the bank would be unable to pay them because there would
not be enough cash on hand.
How can
banks create credit?
Banks can
create credit because they are allowed to lend money that doesn't exist. That's
right, the bank doesn't have to have the money on hand to lend it out.
When a bank makes a loan, it simply creates the money out of thin air and
credits it to the borrower's account. The borrower then spends this new money,
which increases the amount of money in circulation. In this way, banks can
effectively create new money whenever they make loans.
To increase
the amount of money in circulation, even more, most loans don't get paid back
right away. Instead, payments are deferred and made gradually over time. For
example, if you buy a car with a $25,000 two-year loan at a 10% interest rate per
year, your payments will be about $525 per month for 24 months (2 years). After
2 years, you'll have paid back about $27750 including interest but you still
own the car!
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