What Is Money? Understanding Money In The Modern Economy

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Whether you want to save money, make money or spend money it’s important to understand what money actually is. For many people it probably means the value of the banknotes and coins that you might have in your wallet or the numbers that you see when you log into your online or mobile banking.

But what do those numbers mean? Where do they come from? How is money created? How does money move around the financial system, and why do some people have a lot more of it than others? You may have heard of concepts such as “fractional reserve banking”, “debt money” and “compound interest”. This article will answer these questions and shed some light on what it all means.

In particular, if you’re a millennial (like me) or part of Generation Z it has never been as important to understand money as it is now. With student debt spiralling, real wages virtually stagnant for over a decade and taxes higher than at any point since WW2, you are a part of a different kind of generation: Generation Money.

Note: the technical aspects of this article are based on papers published by the Bank of England. Links to these are at the end of the article.

What Is Money?

So, let’s start with a definition of money. It’s probably fair to say that most people have a good idea of why money is useful, even if you never consciously think about it.

When you want to buy food, you hand over an amount of money in exchange for it. When you take on a new job, you expect to be given some money to compensate you for your work.

So, it’s clear that money is something that we all value and that we expect to be able to swap for some other goods or services that we would like.

Today that most often means either exchanging physical money (coins and banknotes) or electronically transferring money from one bank account to someone else’s.

Generally, it is thought by academics that the following three criteria should be met for something to count as money:

  1. Store of value: whatever is being used as money must have some value that lasts over time. This rules out perishable goods such as food as they would go bad, but clearly items like gold bars would retain their value over many years, even if its value fluctuates over that time.
  2. Unit of account: essentially this means that money should have an easily translatable pricing mechanism which for modern nations means currency, such a £10 note or a £1 coin. In the past this could also mean ounces of gold, barrels of oil or some other measure of a unit that allows people to put a price on things.
  3. Medium of exchange: money should be something that people are willing to swap for other goods or services, rather than hold on to for long periods of time. Houses, for example, might be a good store of value and are even a unit of account, but they’re not practical to use as a medium of exchange because it takes so long to transfer ownership rights and not everyone would be willing to accept payment in houses

If we put together the above three requirements, we can see why gold was often used as money throughout history. It has many uses beyond simply being used to pay for goods – for example, it is used in jewellery and in manufacturing – which means it could be relied upon to keep at least some of its value in the future.

Gold coins as money

Gold is a soft metal and can be easily minted into coins

As a soft metal, gold is also relatively easy to divide it into units based on weight, such as ounces or grams. This means it was a good unit of account – “I’ll give you 5 ounces of gold for that cow”. In part because of this, it was also a good medium of exchange as people could carry pouches of gold coins around ready to exchange them for other items that they wanted.

People were willing to exchange a certain amount of gold for other goods, such as food, rather than holding onto gold as long as they could.

Because people know that there is always demand for gold, they know that they can always exchange gold again in the future when they need to. This made it a good medium of exchange.

Today, gold is obviously no longer used as money. Without diving into the history of how we ended up dropping gold as money, and then gold-backed currency as money, today we generally see money as being coins, banknotes and digits in our bank accounts.

So, what are coins and banknotes? If you have a look at, say, a £20 note you will see the following written on it:

“I promise to pay the bearer on demand the sum of twenty pounds”

This, in effect, summarises what banknotes actually are: an I Owe You (IOU), or a ‘promise to pay’. Therefore, unlike gold, they have no intrinsic value other than as money.

Banknotes and coins in the modern economy, then, are a form of IOU but they’re a special form of IOU. This is because they’re backed by the Bank of England (or in other countries, their own version of the central bank) and are trusted by everyone in the economy.

In effect, they are an IOU from the central bank to you (consumers).

If you visit the Bank of England at Threadneedle Street in London and present them with a £20 note, they are obligated to exchange it for the sum of twenty pounds, i.e. they will give you a new £20 note.

Four IOUs for the sum of £20 each

This is particularly important to see how banknotes are both a store of value (in the short to medium term at least) and a medium of exchange due to public confidence. We rely on everyone else in the economy valuing banknotes and coins and accepting them as payment.

We’ve talked about physical currency (banknotes and coins) but what about bank deposits – the numbers you see in your bank account? Well, this is where things get a bit less intuitive.

Bank deposits are also an IOU, but a specific IOU from commercial banks to consumers. When you log into your mobile banking app and look at your bank balance, assuming it’s positive then that amount is effectively what your bank owes you in pounds.

If your bank balance is negative – you are overdrawn – then you owe your bank that amount.

Assuming your bank balance is positive, you have the right to demand that your bank exchanges that digital balance for physical currency: banknotes and coins. And we already know from above that these banknotes and coins are another type of IOU that’s ‘guaranteed’ by the Bank of England.

Ultimately, when you withdraw cash from your bank account you are exchanging a digital IOU from your bank for a physical IOU from the Bank of England.

Note: prior to the invention of computing, the numbers in your bank account would simply have been physical ledger entries, i.e. numbers recorded on paper.

So, money in the modern economy is a special kind of IOU from the commercial banks to consumers in the case of bank deposits, and from the central bank to everyone else in the economy in the case of banknotes and coins.

Note: there is a third type of money called ‘central bank reserves’ which we will ignore in this article, but I will be writing an overview of what this is and how its used by the Bank of England and commercial banks in the economy.

How Is Money Created?

The above discussion of how money in the modern economy is essentially a special form of IOU has hopefully given you a clue as to how money is actually created.

First, let’s think about what would happen if no new money was created – or had ever been created. We would have a set amount of total money (the money supply) in the economy which must be used to fulfil all of the demands within the economy.

These demands include the payment of taxes, consumers purchasing goods and businesses paying wages to their workers and investing in machinery and equipment.

But other factors in the economy will change over time, one of the most obvious factors being the number of people active within it.

Over the past few centuries, the population of the UK has consistently increased – at various points dramatically so in a relatively short space of time.

If the money supply didn’t increase at the same time, or at least reasonably soon after population increases, then scarcity of money would become a potential issue.

This means more people in an economy whose demands must be met with a smaller pool of money to go around. In practical terms, people’s incomes would decrease.

This is because it would, in theory, create a deflationary period meaning prices would be forced to come down so that people can buy at least the same amount of goods as they could before, given no increase in the money supply.

As prices fall, businesses would pass this reduction in their revenue on to their employees – otherwise they would potentially lose money. This means they would lay off workers or reduce pay.

We can see it’s reasonably clear then that we need a dynamic money supply that can vary in response to other changes, or expected changes, in the economy.

In modern economies, banks create new money at the point at which they make a new loan and increase a customer’s bank deposit by the same amount. When you take out a loan, the money that is given to you and appears in your bank account is newly created money.

This applies to almost all of bank lending: mortgages, loans, overdrafts and credit cards.

Let’s look at the example of buying a house. Let’s say that you want to buy a house valued at £100,000. You have saved up £20,000 (20%) for a deposit and you apply to a bank for a mortgage for the remaining amount of £80,000.

Once approved, the bank is ready to lend you £80,000 for your home purchase. For now, let’s ignore interest charged on top of the loan and let’s assume that you agree to repay the mortgage over 25 years.

When you are ready to exchange contracts with the seller of the house, the bank will release the £80,000 to you (in reality it will be released to your solicitor). That £80,000 appears as a new bank deposit in the solicitor’s bank account.

This is newly created money. That money did not exist before your mortgage was approved.

Bought with savings + newly created money

This £80,000 will be passed on to the seller of the home and it goes into their bank account. Often, they will then use this money to purchase another home for themselves, but sometimes they won’t need to and will simply have £80,000 of newly created money in their bank account.

If so, they can then use this money to purchase goods or services, or they can invest it or save it.

For more on how money flows through the economy, I’ll be writing about the velocity of money soon.

Over the next 25 years you will make repayments to your bank on the outstanding mortgage balance (plus interest). Each time you make a payment to your bank, you are destroying money. Once the £80,000 mortgage is fully paid off, the process of creating and then destroying money will be complete.

There is a common misconception that when a bank makes a loan, it is ‘lending out’ the deposits it holds. In fact, this is what I was taught in economics at university. However, it is not true in reality.

The theory goes that banks would take deposits from customers and store their cash for them. Over time they realised that most customers do not withdraw the full amount of their deposits.

Therefore, banks could ‘lend out’ a portion of customer’s deposits to new customers, who in turn would deposit most of this loaned money into another bank account. That process would then repeat and sometimes this is referred to as the money multiplier effect.

In reality though, bank loans create new deposits – they do not come from existing deposits.

Money In The Economy

To avoid deflationary cycles (a period of time where prices of goods consistently fall), most modern economies have an inflation target. The Bank of England’s target inflation rate is 2% per year, set by government.

In a deflationary period, consumers expect prices to fall over time. This means they are motivated to hold off making purchases as they expect goods to be cheaper in the future.

If this continues over time, this can create a cycle where consumers keep putting of purchases because they expect prices to keep coming down. This lack of spending can cause the economy to go into recession if left to continue over time.

So, the Bank of England’s inflation target is an important factor in maintaining price stability: consumers expect a gradual, but not too sharp, increase in prices over time. This creates the incentive for them to purchase goods and services now rather than wait until a point in the future where prices would be higher.

This process of money creation is one of the key drivers of inflation in the economy. The option to use newly created money as debt to make purchases (such as a home in the above example) causes prices to rise.

On a simple level, more money in the economy means that ultimately consumers have a greater ability to spend. This means they can buy more goods, or they can ‘outbid’ other consumers for the same amount of goods using debt.

Both of these increase demand and, according to the laws of supply and demand, when demand for something is higher its price goes up.

Just like with mortgages, credit cards are another form of newly created money. If you take out a new credit card and purchase something with it, that purchase has taken place using new money.

The credit card company deposits the amount required to make the purchase with the seller. At the same time, you have the obligation to repay the credit card company the amount of money that was just created.

When you repay the credit card company, that money is destroyed. So, anyone who regularly uses a credit card is creating and destroying money each time they use it to make a purchase and then pay off their credit card bill.

Paying with a credit card

Creating new money

This continuous cycle of creating new money and allowing it to flow through the economy is what drives most measures of economic growth (such as Gross Domestic Product, or GDP). A business may want to invest in new machinery to automate some of their production processes, so they might take out a loan to fund the purchase of equipment.

Over time we know that, generally, money is being created more than it is being destroyed. This can be seen by looking at the measure of inflation in the economy over time.

As we know, the Bank of England is set a 2% inflation target by the government and therefore one of the core purposes of monetary policy is to achieve this target.

Another reason the 2% target is important is for economic and financial planning purposes, particularly around government spending.

Interest And Compounding

As we have seen, new money is invented when a loan is granted “at the stroke of bankers’ pens when they approve loans”1, so we can see that over time new money is created as long as new loans are granted.

But what about interest on these loans? In the above mortgage example, we ignored the role of interest but when a new loan is granted, typically the borrower must pay back to the bank the amount they have loaned plus interest.

The interest due is almost always compounded, which in simple terms means that interest is added to the outstanding loan amount (usually a daily calculation) to increase the amount owed, and then further interest is added on top of this balance. In short, interest is charged on top of interest.

Over time, the borrower must pay back more money than was invented at the time the loan was granted.

This creates an economic incentive for the money supply to increase over time and for consumers to seek above-inflation pay rises and compounded returns on their investments.

What Does This All Mean For You?

We know that new money is created all the time through new loans. We know that the government mandates that the central bank targets 2% inflation over time, which means the money supply will increase over time.

We also know that an obligation to pay interest is created on top of the newly created money. This interest is compounded – that is, interest is charged on top of interest.

Taking this information, then, means that we know that there is a constant need for growth in the economy. What does this mean for you?

Firstly, it means that if you leave your spare cash sitting around doing nothing, its value will likely be eroded over time through inflation by the constant creation of new money and a general rise in prices (of goods and assets).

Secondly, there is a clear incentive to get out of debt as fast as you can (if you have debt) in the current low inflation environment2. This website will help you to do so.

Thirdly, this constant need to create new money gives you an incentive to invest in assets over time to take part in this compounded growth. There are also opportunities to take advantage of declining asset prices too.

If you are interested in learning in more detail about money and its role in the economy, I will be writing more posts on this soon, including how to use this information to make good financial and investment decisions. I will link to them here once they’re up. In the meantime, sign up to the mail list so you get alerted when its published.

1. Bank of England Quarterly Bulletin, 2014 Q1, p.16 (link below)

2. ONS October 2020 CPI release (for Sept): 0.5%, 1.5% below the BoE target https://www.ons.gov.uk/economy/inflationandpriceindices/timeseries/d7g7/mm23

For further reading, and two of the main sources of inspiration for this article, see the below links to the Bank of England’s quarterly bulletins:

‘Money in the modern economy: an introduction’ & ‘Money creation in the modern economy’:

https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/

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