recession article

Where Does Money Really Come From?

Grace Girling explains how money circulates in the economy, unpacking the misconceptions of lending and borrowing that many of us hold.

By Grace Girling

Through no fault of our own, many of us have a very vague sense of what money is and where it comes from. Over the last two months, there has been a proliferation of news coverage unveiling the stimulus packages set up by governments across the globe in an attempt to protect economies against the very worst that Covid-19 has to offer. However, the central banks and governments are not the only ones with the power to create money – a fact that is often overlooked. 

When you deposit money into your local bank branch you may think that it is instantly locked away securely; untouched underground until you retrieve it again. A staggering one third of the UK public holds this perception of banking. 

Or, maybe you are familiar with the infamous money multiplier model theory in which banks use parts of such deposits to lend to borrowers. Using this theory, the reserve ratios imposed on commercial banks set constraints on the total money supply that can be created as a proportion of the amount of cash in the economy. However, these reserve ratios have not been in place in the UK since 1981. Despite this, this theory is the common and much-loved belief of economists and is still widely taught to economics and finance students. Should we be worried that the future policy makers of our country are learning the ins and outs of a completely outdated model? 

The misconception that commercial banks act simply as an intermediary is a potentially dangerous one. If this was the case, commercial banks would only be able to lend as far as the deposits of their customers would stretch, thereby setting time restrictions on reckless lending. This is not the reality. This alternative theory also leads to the propensity for economists to preach that savings are tantamount to investments, as it allows for more loans for businesses resulting in job growth. A follow up question therefore arises: will businesses become successful if consumers become parsimonious in the pursuit of economic growth? The money supply does not depend on the attitudes of savers and the funds that their deposits create. In fact, the opposite is true: lending creates money. 

Put simply, when an individual takes out a loan the bank credits the bank account belonging to this individual with a deposit equating to the size of this loan. Bank deposits are a form of broad money; a measure of the total amount of money held by households and businesses, making up 97% of the broad money in circulation in the UK. Most of these bank deposits are created by commercial banks. 

However, this is not to say there is absolutely no limit on the supply of money they can create for use in the economy. This leads to another misconception of how money creation works; it is commonly believed that the central bank controls the quantity of central bank money by choosing a certain level of reserves, consequently affecting the quantity of deposits and loans.

Adversely, central banks decide to set the price of reserves in the form of interest rates. We must not forget that commercial banks are profit-seeking enterprises and therefore will calculate their profitable lending opportunities as determined by the interest rates that are set. Their willingness to lend is also influenced by the confidence they have in an economic boom occurring. You could therefore argue that the money supply of our country is dependent upon the mood swings of senior bankers within these commercial banks. This thought is often excluded from economic models, but one that is certainly needed now more than ever. 

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