TOPIC 6

The alternative to a commodity money system is fiat money which is defined by a central bank and government law as legal tender even if it has no intrinsic value. Originally fiat money was paper currency or base metal coinage, but in modern economies it mainly exists as data such as bank balances and records of credit or debit card purchases,^[3] and the fraction that exists as notes and coins is relatively small.^[4] Money is mostly created, contrary to what is written in most textbooks, by banks when they loan to customers. Put simply, banks lending currency to customers creates more deposits and deficit spending.

In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits. Although commercial banks create money through lending, they cannot do so freely without limit. Banks are limited in how much they can lend if they are to remain profitable in a competitive banking system. Prudential regulation also acts as a constraint on banks’ activities in order to maintain the resilience of the financial system. And the households and companies who receive the money created by new lending may take actions that affect the stock of money – they could quickly ‘destroy’ the money or currency by using it to repay their existing debt, for instance.^[5]

Central banks control the creation of money by commercial banks, by setting interest rates on reserves. This limits the amount of money the commercial banks are willing to lend, and thus create, as it affects the profitability of lending in a competitive market.^[5] This is the opposite of what many people believe about the creation of fiat money. The most common misconception was that central banks print all the money, this is not reflective of what actually happens.