money - a primer

Money is one of the least understood issues in public policy. This page is intended to provide an introduction about what money is and how it works.

what is money?

The most important and difficult thing to understand is what money isn't - modern money is not a real commodity like gold, silver or wheat which are all inherently useful. You can't eat money wear it, or build houses from it.

what uses does money have?

Money is used mainly as a medium of exchange. If you can pay your bills with it, it is probably money. Money has no inherent value except what people are willing to trade for it. If those responsible for the money supply mismanage it, money can become worthless.

Who's responsible for it ?

Responsibility for the money supply now falls to the central bank in most nations. This was not always the case, in the past, banks have created their own money, or nations have used a valuable commodity (like gold) as money.

how does the central bank control the money supply?

The bank influences the amount of money that gets created by managing the the interest rate - which is more or less the "price of money". If money is expensive people will borrow less. If it is cheap, people borrow more. Using the tools of stewsinc at eol.ca" class="wiki wiki_page">monetary policy, the central bank essentially has in hand the "throttle" on the economy.

What difference does monetary policy make?

Monetary policy can make quite a bit of difference in the economy. In 1981, central banks in the US and Canada cranked up interest rates because they were freaking out about accelerating inflation. Over the next few months, their actions caused the sharpest economic downturn in modern history, loans were recalled, businesses went bankrupt, mortgage payments when through the roof just as thousands were made jobless. Similar inflation fighting in Canada prolonged economic woes in Canada from 1990 to 1997.

Money creation, Growth and Inflation

Money, the modern kind of which is called fiat money can be created at will by the central bank, and by the financial industry in the form of credit.

How banks create money.

Modern accounting makes it possible for banks to create money. Just like individuals who can spend more than they earn in any given month, banks can loan out more money than they currently have on hand. This standard practice is called fractional reserve banking. Just like individuals, as long as banks can keep paying their bills, they can keep doing business. If a bank loans out a million dollars and gets it back a year later, it does not really matter where the money came from. Wherever it came from - it is back - and the bank has the interest. In reality banks are limited in the amount of money the can create in two ways:
  • the number of borrowers who are reasonably sure to pay back the money.
  • reporting requirements to shareholders and regulators which should demonstrate that the bank is not engaging in careless lending.
Sometimes banks are careless and go bankrupt. for example, in the savings and loan scandal hundreds of billions of dollars created from thin air dissapeared again in a very messy way. The banks issued loans that never were repaid, and the US government ended up on the hook, rather than risk a banking collapse.

what prevents runaway printing of money?

Central bankers are very preoccupied by the possibility that too much money will be created. If too much money is created and inflation (a decrease in the value of money) will result. If central banks get careless hyperinflation can result. This happened most recently in Argentina in the 1990's.

what is wrong with inflation?

Most economsts agree that a little inflation (1-5% per year) is best. This avoids the risk of deflation if money was becoming more valuable over time then people might not spend it - and cause a recession as a result. High inflation is bad because prices are changing frequently this is not only a nusiance but it erodes trust in the government (inflation may go haywire, making the currency worthless). Accordingly central banks in many countries try to set targets for inflation between 1 and 5 percent.

[+] the icy road analogy of money supply

stewsinc at eol.ca" class="wiki wiki_page">monetary policy, monetary reform, economic growth, inflation interest rate