The Origins of Money

We have now established a clear understanding of wealth as a stock of valuable assets and income as a flow of value over time. But the common thread running through both concepts is the medium we use to measure, exchange, and store them: money. It is the lifeblood of a modern economy, yet it is so familiar that we rarely stop to ask a fundamental question: where does it actually come from?

This chapter pulls back the curtain on the origins of money. We will move beyond the simple definition of money as "cash" to explore the miraculous, and often misunderstood, process by which money is created in a modern banking system. Understanding this process is essential to grasping the dynamics of inflation, economic cycles, and the very nature of financial value.

3.1 Money and the Multiplication of Goods and Services

Before we explore where money comes from, we must first understand what it does. Money's primary role is to solve the problem of the double coincidence of wants that plagues a barter system. It acts as a universal medium of exchange, allowing goods and services to be multiplied and traded on a massive scale.

Imagine an economy without money. A baker who wants a pair of shoes must find a cobbler who wants bread. A tailor who needs a house must find a builder who needs a coat. The friction of finding a direct match for every transaction grinds economic activity to a halt.

Money eliminates this friction. The baker sells his bread for money to anyone who wants it. With that money, he can buy shoes from any cobbler. The cobbler, in turn, can use that same money to buy bread from a different baker, or a coat from a tailor, or anything else he desires.

This simple mechanism has a profound effect: it multiplies the possibilities for exchange. Because transactions are now easy, they happen more frequently. Specialization increases—the baker can focus on baking, the cobbler on shoemaking—because they know they can easily exchange their products for everything else they need. This specialization is the very engine of productivity and economic growth. Money, therefore, is not just a passive token; it is an active technology that enables the vast, complex web of exchanges that characterizes a modern economy.

3.2 Cash

The most tangible and familiar form of money is cash—the physical banknotes and coins we carry in our wallets. In economic terms, cash is a liability of the central bank, like the European Central Bank or the Federal Reserve in the United States. It is also known as the monetary base or high-powered money.

Cash serves the three functions of money perfectly for small, face-to-face transactions. It is a medium of exchange (immediately accepted), a unit of account (priced in euros or dollars), and a store of value (it can be saved in a drawer). However, cash has limitations. It is impractical for large transactions, can be lost or stolen, and earns no interest. For these reasons, a more powerful and prevalent form of money has evolved.

3.3 The Miracle of Bank Money

When most people think of their money, they think of the balance in their bank account. This is not cash, at least not in the physical sense. It is bank money, also known as demand deposits or checking account balances. This is money that exists only as digital entries in the ledgers of commercial banks.

This is the "miracle" of modern banking. When you receive your salary and your employer instructs its bank to transfer funds to your bank, the money never physically moves. Your bank's computer system simply increases the number in your account, and your employer's bank decreases a number in theirs. No cash is involved.

Today, the vast majority of the money supply in a modern economy—over 90% in most developed countries—is not physical cash. It is this digital bank money, created through accounting entries. The question, then, is who creates it, and how?

3.4 The Origin of Money Creation by Banks

This leads to one of the most common and persistent myths in economics: that banks are simple intermediaries that gather deposits from savers and then lend them out to borrowers. In this view, the money already exists; the bank just moves it from one pocket to another.

This is incorrect. In reality, commercial banks create new money every time they issue a loan.

Here is how it works:

1. A bank approves a loan of €100,000 for a small business.
2. The bank does not take €100,000 from another customer's savings and hand it over. Instead, it creates a new deposit of €100,000 in the business's bank account. It simply credits the account.
3. At the moment the loan is issued, new money has been created. The business now has a new asset (the €100,000 deposit) that it can spend. The bank has a new asset (the business's promise to repay the loan).

This is the fundamental process of money creation. Loans create deposits. When the business later spends this money by writing checks or transferring funds to suppliers, that new money circulates throughout the economy. The money supply expands.

Conversely, when a loan is repaid, the opposite happens. The borrower uses money from their account to pay the bank. That money effectively disappears from the economy; it is destroyed. The money supply contracts.

The key constraint on this process is not the amount of deposits a bank already holds, but its capital requirements (to protect against losses) and its reserve requirements (the amount of central bank money it must hold). It is also constrained by the demand for credit—if no one wants to borrow, no new money is created.

3.5 How is Money Put into Circulation?

The process described above explains the primary mechanism of money creation. But how does money initially enter the economy? There are several channels:

• Central Bank Lending to Commercial Banks: The central bank can create its own money (reserves) and lend it to commercial banks. This increases the reserves of the banking system, allowing them to create more loans and, therefore, more bank money.
• Government Spending: When a government pays a salary to a civil servant or pays a supplier for goods and services, it credits their bank account. This money is created and injected into the economy.
• Purchasing Assets (Quantitative Easing): A central bank can create money to buy financial assets, such as government bonds, from commercial banks and other financial institutions. This injects newly created money directly into the financial system.
• International Trade: When a country exports more than it imports, it receives payments in foreign currency. To convert this into domestic currency for use in the local economy, new domestic money is often created.

3.6 The Momentum of Money

The amount of money in an economy is only one part of the story. The other is how fast it is moving. This is the concept of the velocity of money.

If the total money supply is €1 billion, but each euro is spent, on average, five times a year on final goods and services, then the total economic activity (GDP) generated is €5 billion.

The momentum, or velocity, of money is not constant. It depends on the confidence of households and businesses, and their willingness to spend.

• In a booming economy, people are confident and spend money quickly. Velocity is high.
• In a recession or depression, fear takes hold. People hoard cash, pay down debt, and delay purchases. The same euro is spent far less frequently. Velocity collapses, and economic activity grinds to a halt, even if the total money supply remains unchanged.

This dynamic is crucial for understanding economic fluctuations. Stimulating the economy is not just about increasing the quantity of money, but also about restoring its momentum.

3.7 The Paradox of Spending Restriction

This leads us to a final, crucial insight: the paradox of spending restriction. What is prudent for an individual can be catastrophic for the economy as a whole.

For an individual or a family, the advice during a financial crisis is sound: cut back on unnecessary spending, save more, and pay down debt. This is a sensible way to protect oneself against uncertainty.

However, when everyone in the economy tries to do this at the same time, a paradox emerges. One person's spending is another person's income. If everyone cuts their spending, everyone's income falls. Businesses see their revenues decline and are forced to lay off workers. Those workers, now with no income, cut their spending even further. The economy spirals downward into a deeper recession. The collective attempt to save more can actually lead to the destruction of wealth and a reduction in the economy's total savings.

This paradox highlights a fundamental tension in economics. What is microeconomically rational (sensible for an individual) can be macroeconomically disastrous (harmful for the whole economy). It is a powerful reminder that the origins of money and its flow through the economy are not just matters of accounting, but are deeply connected to human psychology, collective action, and the delicate balance between prudence and prosperity.

In conclusion, money is far more than just coins and notes. It is a dynamic, ever-changing phenomenon, created primarily through bank lending, whose value and impact depend not only on its quantity but also on its momentum and the collective confidence of those who use it.

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   The Origins of Money /E-cyclopedia Resources by Kateule Sydney is licensed under CC BY-SA 4.0