How money is created?

Last few days I spend few hours of my leisure time (train travel during my work and night time in weekends) to understand how monetary system works in the world. I am not micro economist but last few months I am studying various countries economics and their trade import/exports. Actually this helps me to understand how the global monetary system works and it was interesting for me to learn and explore more on that. I am not sure whether I will be able to convey my learning’s or finding’s in single post and if not able to convey I will continue the same in my next post.

I will list down my questions before getting into the post so that it will be easy for everyone who read this. If it helps someone learning I will be very happy (life is a meaningful journey we have to learn every day and share our knowledge to others).

  • What is money?
  • What is the difference between Currency and Money? Why two terms? Isn’t it confusing?
  • Why dollar(usd) becomes international settlement currency?
  • How Central bank of every country prints currency and release it?

 

What is money?

Money is nothing but a paper printed by the Central bank of the country and it depends on the targeted inflation rate and GDP. Printed money is backed by nothing (please make note here I will explain this later).

  1. What is inflation?
  2. What is GDP?
  3. Why central banks encourage inflation for growth?

I don’t want to discuss more in the terms of economist model here because it will not be easy to understand by normal person with less knowledge in economics. Using this model of modern explanation, economists are confusing the common people and making it difficult to understand the monetary system. Hence I will try to explain in easy understandable form.

When I started to study the monetary system I went through various books and videos. Everywhere one point is clear without understanding banking system it is quite difficult to visualize the system. Because banks are the one who helps to stabilize economy and this is the statement economist says everywhere. Hence I started to dig how banking works and how they make profit. Actually banks were formed when people wanted to store their valuable asset.

In the very beginning of our human race where human started to trade across various parts of the world or colonies, the main problem they faced is that they need something unanimously for settlement of the trades. They followed different methods as below.

 Commodity as money (Barter system):

When people needs something they will seek the opposite seller and swap the commodity for their trade. This is called Barter system.

Barter1

Barter2

However this system fails because it is too hard to carry the commodity along with them and it is very hard to buy in smaller quantity.

It looks funny now. Let’s say if we are in barter system now then our bank balance might looks like below pic

Barter3

Hence people moved to different system as follows.

 

Precious Metal as money:

Because of the failure of Barter system, people wanted to invent a different form of trading. They want a system which should be easily transferrable, accountable, reliable, portable etc. Because of this reason people started to use precious metals like Gold, Silver, Copper, precious stones etc.

After many forms of evolution gold based coin becomes predominantly accepted money (please note I used term money here not currency) for trading across the globe.

Once the gold became money then banking system became necessary in the world. To understand this I read a story about Goldsmith and most economists believes this is the place where banking system was born. Actually this story helps me to understand more about banking system like reserve ratio, reserve currency etc. Let me write the story here so that we can understand how the banking system works.

Goldsmith story:

Moneysmith1

Once gold was accepted universally as a medium of exchange in trade everyone was happy in the world. They worked hard to produce goods and they exchanged gold made coins for their trade. But they felt more unsecured to keep their high valued coins in home because robbery increased at that time because of the greediness. Hence they want a place to keep the coins safely. In the olden days there was goldsmith who already had safety measures like secured wallet storage and security guards for safekeeping the gold, hence people started to seek help from Goldsmith.

Moneysmith2

People: Will you please keep my gold coins safely?

Goldsmith: Dude, sure. Then, what is my profit?

People: I will give you rent for that.

Goldsmith: Pretty good deal. I am in dude!

Goldsmith happily makes money without doing anything. People are happy because risk of robbery becomes zero. But still people feel hard to take their coins during their travel.

Just assume X need to give 10,000 coins for the trade did with Y. X needs to carry 10,000 coins in the hand and needs to travel along with that and it is still unsafe, so they want something different and it should be easily transferrable. After discussion with goldsmith and people they invented new system called bearer note or I.O.U (I owe you) or paper money (note the term paper is money and not currency).

What it means?

Goldsmith started to issue paper money against the amount of gold which investors are holding in the wallet. Each paper money is backed by gold in the goldsmith wallet and people can easily carry their paper money in their own pocket and carry their trade. If anyone wants gold back they can simply go to Goldsmith and submit their bearer note or I.O.U or paper money and demand gold back. Goldsmith started to lend his own money and profits (rent which people are paying) at higher interest rate to people. Up to this stage everyone was happy including people and goldsmith (he is lending his own money and making profit even though people is giving rent promptly).

Does it sound like banking system?

Yes, you are right!

Moneysmith3

Things started to becomes messy once Goldsmith becomes greedier because the borrowers pay more interest than rent. Goldsmith realized not many people returned to his office for asking gold by swapping the I.O.U or bearer notes or paper money. Hence he started to print more currency (note currency here not money) without backed by gold (just printing in paper) and started to lend and he became super rich.

Depositors became so suspicious of goldsmith how he became so rich in short time frame. They wanted to visit the banks wallet and confirm whether the gold was there or not. All gold was there. They told sorry to Goldsmith and happily left the place. This gave more confidence to Goldsmith and he started to print more currency and start lending. Goldsmith became extra ordinary rich and again suspicion increased among the people and this time they not only visited bank and all the people together asked their gold back. Now goldsmith was in deep trouble and he is not able to return the gold back, Entire system becomes collapsed (doomed).

Now just relax and come out of the story!

Replace the greedy Goldsmith with banks and thinks of the whole system then you can understand the current banking system and all the flaws in Goldsmith story are corrected in this modern banking system. Not all commercial banks can print currency only the central bank of the country can print currency and it acts as bank to bankers. Central bank defines reserve ratio for lending i.e.) the amount of depositors money can be loaned. Every deposit we are making in the bank has been lending it to someone and banks are making profit from that. Local reserve currency is nothing but every commercial bank needs to deposits their reserve in central bank of the country.

Now the greedy goldsmith is replaced by modern banks (still greedy exists which we can see later) and money printing is taken care by central banks based on targeted GDP & inflation not backed by gold like Goldsmith. Banks are happily lending the hardly earned depositors money like the greedy goldsmith without much effort and making the money from debt (interest paid by borrowers).

What is the difference between Currency and Money? Why two terms? Isn’t it confusing?

In my post, I marked in bold to differentiate money and currency. Let me reiterate here as below

Banks and governments create currency from nothing (just printing in paper and in digitized world they are just typing the number in computer). Currency is a medium of exchange.

Money is a medium of exchange and a store of value backed by something like gold or some precious metals as in olden days.

Both are medium of exchange but differs lot. Earlier every paper money printed in this world is backed by gold but suddenly this system vanishes from practices. To understand this we need to slightly understand monetary history which was never revealed in our text books during school or college days.

After World War II all the countries in the world decided to increase the global trade and should promote transparent trading model which needs globally accepted banking system. Hence as part of this IMF (International Monetary Fund) was formed which has been later called as World Bank. World Bank invites members of all the countries to discuss on the fully negotiated monetary system in Bretton Wood (New Hampshire, USA). Their most important goal was to prevent each country from pursuing selfish policies, such as competitive devaluation, protectionism and forming trade blocks, which damaged the world economy in the 1930s.

The chief features of the Bretton Woods system was an obligation for each country to adopt a monetary policy that maintained the exchange rate by tying its currency to gold and the ability of the IMF to bridge temporary imbalances of payments. Basically the agenda is tying all the currencies in the world are tied to gold and all the countries can do trade peacefully without any war by swapping currencies for the trade. Actually the way of tying gold will provide fixed exchange rates as well (not like today free floating exchange rate based on demand and supply). But the agreement was made differently and this history is not recorded in many places.

What is Bretton Woods system?

All the currencies of the world should be tied to gold and central bank of the country will be authorized party of printing currency (objective is to have fixed exchange rate system to avoid another world war). But at the end of World War II there is no enough gold in many countries, hence it was difficult to print currency against gold then US came out with different idea because they had huge amount of gold after the World War II (read the history of World War II to know how they got huge gold). US mentioned I will link US dollar to gold at the rate of $35 per ounce of gold and other countries can print their currency using USD as reserve money instead of gold (US valued their currency equals to gold). Most of the countries agreed and few opposed but somehow this system was implemented.

Brentwoods

This is the place where USD becomes so precious currency in the world but other countries needs US Dollars to print currency rite hence US started to give loans for them. USD becomes governing currency of the world because it is backed by gold (trustable) and all went well until it is backed by gold.

How many of us know this story?

Until 1971 if you provide USD in US central bank they will give you gold in return. Just look at the old USD and latest one.

OLD USD

Just look at the above image (bottom). “Ten Dollars in gold coins payable to bearer on Demand”.

Look at the new USD notes there is no word like that and even in any of the currencies in today’s world there is no word like that.

New USD

Look at the replaced world “This note is legal tender for all DEBTS, PUBLIC and PRIVATE

All went fine up to the time it is backed by gold until 1971 (Nixon’s shock). All countries worked very hard tried to decrease trade deficit especially Japanese, Germans and French but US was engaged in war with Vietnam hence their trade deficit widened and they also needed more money for wars. Gold backed by money started to recede (after US president Nixon ordered to abandon the system) and they started to print money backed by nothing. Whole Bretton wood system collapsed and every country currency adapted to floating rate exchange system (today monetary policy) instead of fixed rate exchange system like the Bretton Wood system,

More info about end of Bretton wood system in World Bank site is below

https://www.imf.org/external/about/histend.htm

By now you can clearly understand “Currency is a medium of exchange backed by nothing and money is a medium of exchange backed by valuable asset

Why dollar(usd) becomes international settlement currency?

I think now we are clear how USD became predominant currency in the world and why every currency quoted against USD in forex market and everywhere. Before 1971 itself all the countries mostly becomes debt to US and then every country started to do their export using USD hence most of the international trades are settled using USD because they need to settle their debt. Debt becomes part of our life and you can see most of the countries in the world are in huge debt.

How Central bank of every country prints currency and release?

This is the place where I started to study about this whole monetary system and tempted me to learn this. In my childhood days I asked my parents by showing the currency paper notes and asked the following notes.

Who is printing this?

Answer is all we know, central bank of the country.

Can we print this paper currency (because it is backed by nothing)?

Answer is no because as per the law of any country it is illegal.

If Central banks print currency how they release it to public?

This one I have not got answer for many days from many people including my parents, teachers and the peopleI met. I got this answer after I went through the below publication.

http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q102.pdf

This article clearly explains how the modern banking system works and how the money creation is happening in the economy. Very big thanks to them because it clearly explains the debt economy which we are living today and the way they explains states clearly the following

  1. 1. Money is nothing but debt.
  2. If every citizen of the country is having too much savings in the bank. Do you think country is in prosperous and wealthy mode? Answer is no and they are in recession (modern economics will call this as inflation or hyperinflation). Too much of money in the economy is called inflation because money alone won’t buy anything there should be production in the country not only the money. If money (buying power) alone means every country can print more currency and make their citizens as more happy.
  3. If there is debt in the economy then there is money. Please note too much of debt also bad for the economy. Modern economy transferred to this shocking debt state from Goldsmith story and the money takes different form as debt.
  4. If there is more savings then also recession and if there is more debt then also recession. Then how the economy is driven in the country? Because of this reason every Central bank of the country targets GDP and inflation which we can see in detailed manner of this post.
  5. Only few portion of physical money is created by Central bank of the country and the rest is created by the commercial banks using the process of lending. Physical money (cash or fiat currency) is very less in the economy and debt money in the economy is huge.
  6. Commercial banks are creating money like anything by each and every penny/cents/paisa of the citizen’s hard work in a fraction of second through a process called lending and a policy called fractional reserve ratio and money supply is controlled by interest rates of the central bank.

Before getting into details of how commercial banks are creating money. First we see how Central bank of the country creates/prints money. Now we clearly know there is no gold backing system hence Central bank can prints as much as money they want. But if they print more means that leads to inflation hence they target minimal inflation and maximum GDP. Based on the required GDP and inflation they print paper currency. Now the question comes, currencies are printed by Central bank and now how they release to public. This is where more trick arrives and we need to understand this clearly to get full picture how the economy of the country drives.

Let us take US because they are considered as giant of the world. How they print and release the currency in the country?

To understand this we need to understand two important organisations.

FED (Federal Reserve System) – Central bank of US

US Treasury

What is FED?

As you know, central bank of the country is having rights to issue (but FED won’t print) currency and decide interest rates, lend money to commercial banks, increase/decrease money supply etc. Basically they will manage monetary policy of the country.

For more info on FED, please refer the education document from FED site

http://www.bostonfed.org/education/pubs/banking2.pdf

What is treasury?

Treasury is financial agent for US government and its main responsibility is to fund the government. Basically they will manage fiscal policy of the country.

How treasury get funds?

By collecting tax from people and getting funds from government projects like Railways, coal mining etc.

What is deficit spending?

If government spends too much money compared to the revenue (tax money and other government incomes) then it is called deficit spending. Then in that case, government is having two options either increase tax of the people or issuing debt securities which is nothing called bonds. If government increases taxes then money supply will be reduced in the economy and also people will lose trust in the government (basically in next election they won’t be back to power) hence government try to issue bonds for managing government debts.

To manage deficit spending (which is every citizen debt) government easy option is releasing bonds by ordering US Treasury. Please note here money creation actually starts by debt (not yet created but money creation reason is debt).

US treasury will conduct auction and in this place all the big banks in a race buys those debt bonds.

Bond

Is it confusing? Why banks buys debt bonds?

In olden days banks wallets are filled with gold and in this modern world it is filled with debt bonds (this will act as precious collateral for banks). US treasury has got required money from banks through auction. As of now no new money is created in the economy only treasury got required for their government deficit.

Banks along with collateral (bond they bought) will visit FED then swap bonds with currency. YES, NEW MONEY IS CREATED in the economy. New money is created when the Federal Reserve buys a treasury bond from a bank. But where did the money that the Federal Reserve used to buy the bond with really come from? The simple answer is: “Out of thin air”.

New money is created only if there is debt which is more contrary from the olden days of banking system. Now you can understand why debt everywhere!

Do you think new physical currency is printed whenever FED swaps bond with banks?

Answer is pretty simple: NO

In this digital world, FED will simply update the accounts of the bank with numbers. Only few amount of physical currency exists in this world and the rest is simple digital number. In US there is only 1.2 trillion dollar that exists physically and the rest is only digital currency. Refer the FED website

http://www.newyorkfed.org/aboutthefed/fedpoint/fed01.html

As of now we saw how new currency is created and only few exists in physical form. Rest of the money in the economy is created by the commercial banks through the process of lending. Once banks got money in their account then only real game starts in this world.

Money’s origin is debt and this debt will spread across every country through the process of lending by commercial banks. Every loan we are making with the bank is creating new money in the country. If you look closely in this modern economy only few portion of the money is created by central bank and rest of the money is created by commercial banks through the process of lending. Because of this reason only interest rates becomes so important to the economy.

Now just look at an example how commercial banks creates money in the economy through the process of lending.

Let us assume in the country there are only two banks. Let us assume central bank states 10% as reserve ratio

What is reserve ratio?

Reserve ratio means amount of money that commercial bank can hold of it depositors money without lending the whole deposited amount. Lets us look below example for better understanding.

Just assume there are only two banks in the country (Bank A and B) with reserve ratio as 10% and having deposit as 10,000.

Step 1: Both banks have below amount

Deposit      Loans they can give

A Bank     10,000       9000

B Bank     10,000       9000

Total money in the country: 20,000

Step 2: Customer X deposits 1000 in Bank A

Deposit      Loans they can give

A Bank     11,000       9900

B Bank     10,000       9000

Total money in the country: 21,000

Step 3: Customer Y gets a loan of 900 from A bank and made some transaction and transacted amount got deposited into B bank

Deposit      Loans they can give

A Bank     11,000       9000 (Note: only loan amount reduced not the deposit amount)

B Bank     10,900       9810

Total money in the country: 21,900

Only 1000 got deposited in the bank A but in turn total money in the country got increased by 1900. 1900 virtual money got created in the economy. By this way vast amount of virtual money is getting created in the country by the commercial banks without getting printing physically by the Central Bank. Now just think 1 million deposit it will make huge impact in the economy.

By the above example you can easily understand how the money is created in the country depends on the deposit and lending. If lending stops then there is no money creation/circulation in the country and this is biggest impact to human race itself. Most of the money in this modern world are created through the process of lending and this lending process will have serious impact to all the countries economy. Current Greece crisis itself is one of the best examples for this system. Too much lending in Greece caused a big havoc and the entire country is in big debt.

Now you can understand the below without much explanation.

  1. Why banks are issuing credit cards so cheaper? (because in every transaction we are creating new money in the economy)
  2. Why banks insists digital transaction for huge amounts? (because they don’t have physical money)

What it means if banks are showing more profit?

I think now any one can say and the answer is more people in the country are in debt. If there is no debt then banks cannot make profit. By measuring the banks growth you can measure the countries growth easily.

From this you can easily conclude that current monetary system is operated based on debt of the each and every person in this world. This is the primary reason why more people in this modern world are in debt compared to our ancestors. Even they earned less they lived happily but now we earn more money but it is not enough, hence today’s world has to be called as debt world.

Debt spreads across every countries not only Greece but still the world is driven by debt based money. How? If money is invested in productive manner then it will makes the economy of the country into a good shape.

Just assume if 10 persons gets loans from bank (each 1 million) and invested in real estate. Consider 10 more persons (each 1 million) gets loan from bank and started a business like electronic gadgets, medicines R&D. First 10 (real estate) will only speculate the market and their value won’t appreciate much and the rest invested in start-up having high chances of becoming billionaire if they worked wisely. That’s why you can see China, Korea and all who is becoming fast growing nation through their productive economy. Hence production should drive the economy not the speculation based.

I think I covered only few aspects of money creation and I will continue write about this in my future post. Thanks very much~!

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3 Responses to How money is created?

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