The Money and money creation


Money in today's world is pretty confusing. It is not gold. It is not even a right to you receive gold. It is simply "buying power". Whether it is a paper-currency or a point in your bank account, what it represents is your purchasing power.

Why central banks are so obsessed by inflation. Its primary mission has become to get that the money in circulation remains reasonably its purchasing power. If there is high inflation, then the purchasing power of our money decreases rapidly and the money ceases to have value; and everyone is looking for an alternative, other currency, property, gold, whatever that were not loosing "purchasing power" in the market.

Central banks then fighting inflation regulate interest rates. If those are up, people borrow less and the consumption is down causing a fall in prices of consumer goods.

But how is money created?

We usually think in a machine for manufacturing banknotes, but a 90 % the money that exists are mere notes accounting in a bank. When we take notes from a bank that annotation decreases in the bank and the bank gives you a piece of paper which replaces this annotation. The banknote is this bank annotation transferred to a paper, nothing more and nothing less. And central banks make these papers to sell it to the banks through another account note (in the bank account the balance decreases and at the central bank the balance increases ) and that they can give us them when we decided to have got in a peace of interchangeable paper, our note of purchasing power we had deposited in the Bank.

And the point is that our money or purchase power is in banks deposited, we have given it to the bank to keep and he, the bank, invests it and lends it to other people.

Suppose I give you a massage and you do not pay me with money but you sign to me a promissory note, a peace of paper that has your debt. Now suppose that I pay later with the promissory note to another person for its services or products. Being accepted this promissory note as currency means that its creation is equivalent to money creation. At the end the old banknotes were promisory notes; in them was put in writing: "The Bank of Spain (or England) will pay to the bearer 100 "pesetas" (or pound) and the peseta (or pound), at least in old times, It had its counterpart in grams of gold. The banknote was a promissory note.

Consider now the case of a loan from bank in order to buy my neighbor's House. The bank lends me from money having in deposit (for now has not been created any money) but with the money I pay to my neighbor for his house and he deposited it back in the bank, so the Bank still has the same money available to lend again. Money was not technically created, but the reality is that before, the Bank had X money in deposit, nor I nor my neighbor had money, and now the Bank has the same amount on deposit, my neighbour has Y thousands of euros and I have a debt of Y thousands of euros. My neighbor has increased their purchasing power so that for practical purposes has been created money out from nothing. My debt signed by me has become ready to be spent money.

But what happens if my neighbor deposit money I gave him in another bank? Then my Bank has a problem, he has no money to lend to other people. But this has easy solution, he requests it to another bank for an interest rate lower than that he charged to me and already he has money to lend. This interest rate is the interbank rate, the famous euribor in European banking. The final effect in the case I have proposed is the same as in the case of a single bank.

As money moves into the European banking system or even 'Western' countries everything is fine, but the reality is that part of that money comes out of this system. We Import oil from Arab countries, buy products from China, and these and many other countries are dedicated to accumulate currency reserves, in euros and dollars primarily. This, among other things, time ago do that there are certain imbalance in the interbank market and that some banks don't find who lend them to resume lending. Then they turn to the Central Bank, the ECB for the euro area and the FED in USA, and asked money borrowing.

Comes into play then this bottomless pit which is the central bank. The central bank lends money to these banks making a mere accounting point, no need to create banknotes. Money comes out "his account" and enters in the bank account that requests. It is obviously a loan with interest. Just come into play the interest rate that makes the Central Bank. These central bank loans are a true creation of money, because they come out of nowhere, of the bottomless pit which is the Central Bank account.

Central Bank takes care for not to create lots of money, not give too many of these loans, therefore the widespread growth of money supply causes a runaway consumption and thus an increase in inflation from excess demand. This increase in inflation reduces the purchasing power of the currency, and the Central Bank's mission is to maintain the purchasing power of money. This is a reason to limit such loans.

But we must not forget that this created money is nothing more than "debt". The money in circulation is growing in the form of debt and thanks to debt that individuals and companies are accumulating. It is not created not otherwise in the Western world. But the ability to borrow has a limit. If this limit is reached the amount of money in circulation stagnates, trade doesn't increase, GDP stagnates and inflation tends to zero. If inflation gets too low then the Central Bank lowers interest rates, making borrowing capacity rises again, returning to expand lending. And so until interest rates are near zero and indebtedness is maximum reaching total stagnation. But if an external factor of inflation comes in, as rising oil prices, rates may not lower in spite of being required to maintain a healthy growth of trading.

Another factor is the increase of population. If the population increases, then there are more people able to borrow and if they do then is increased the amount of money in circulation. If the population stagnated, the ability to borrow stalls.
Do you remember Japan? Japan seems to me an interesting case of maximum borrowing rates near zero and a maximum debt also been. And what we see is stagnation for decades and whose only hope is to increase its exports in order to increase their wealth.

Of course there are more factors to consider. The increasing wealth and hence the ability to borrow is a significant one. If you increase the wealth then increases the borrowing capacity and this allows the creation of money in the form of debt. Bubbles represent an increase of wealth and an increase in borrowing capacity, and puncture of bubbles is a wealth destruction.

(Via: el dinero y su creación at