The definition of "money" has generated almost endless debate. The best view, though it does not say much, is that money is a "social construct", meaning it does not have an ontological existence independent from the human community. Ann Pettifor concisely remarks: "There is an alternative understanding of money, one that is periodically lost to history. This understanding informs the work of some of our greatest and most influential economists. They have all understood that money is not and never has been a commodity, nor is it based on a commodity. Instead money is a social construct – a social relationship based primarily and ultimately on trust".
Of course, "money must serve three economic functions:  a medium of exchange,  a store of value, and  a unit of account. The phrase "medium of exchange" means that people are willing to accept the "token" in exchange for payment of goods or services, or payment of debt. The phrase "store of value" means that the "token" holds its value over time; it is more or less stable in terms of its value. The phrase "unit of account" means that when we use the "token", the good or service may be measured in standard units, such as 1 EUR or 1.50 EUR.
However, let's take an imaginary scenario where 100 people find themselves on an island. There is no government, no financial firms, no money. Assume the people decide to issue money. What is the source? At this stage, the source is the group decision to issue money. Assume further that they have two barrels. The first barrel contains all the money the group created. The group empties this barrel, and fills the second barrel from which each individual takes an equal share of the money.
We designate the first barrel as the Common Organisation [CO]. The second barrel is the money in circulation on the island. Since all money was distributed, how can the CO get some back? Let's assume the CO has the power of taxation. The CO taxes the community at 10%. Hence, the CO has 10% of the total money in circulation and the community has 90%. But why tax? Why not just create more money?
This is the issue raised by the New Monetary Policy. Provided the island does not have any debt in another currency, the CO can produce more money as needed until the supply of money creates a problem like inflation. Questions
1. Does the hypothetical scenario, more or less, accurately describe the creation of fiat money?
2. How does the creation of money, or supply of money, cause inflation? Assume our inhabitants of the island engage in productive activity and produce goods and services. Where would inflation kick in?
3. Assume further that some inhabitants create financial institutions. Why would they create such institutions? How would these institutions make a profit? Money "Out of Thin Air" Explained
We use the Federal Reserve system for a reference point but the same logic applies to any Nation State using "fiat money
". Up until 2020, the Federal Reserve System required commercial banks to hold a designated percentage of their customers' checking account balances with the FED, the central bank. This requirement was called keeping some money "in reserve". Banks had two choices to meet this obligation: hold cash in its vaults and/or hold commercial bank deposit balances with the FED. For example, suppose a commercial bank held customer checking deposits in the amount of 1 billion. If the "reserve requirement" were set at 10%, then the commercial bank would need to hold 100 million in reserve. This explanation, and the ensuing test, is based upon "Understanding Money Mechanics" published by Mises
First we review how the United States counts or measures "money". M0 is the narrowest definition of money. M0 comprises paper notes and coins plus all commercial bank deposits with the Federal Reserve. M1 comprises all paper currency and coin held by the public, excluding actual paper currency and coin held by commercial banks, plus demand and checking account deposits, plus traveler's checks issued by nonbank institutions. M1 attempts to measure how much money is held by the public. M2 consists of M1 plus savings deposits, retail money market mutual funds and certificate of deposits less than 100,000 USD. Other monetary aggregates such as M3 are not discussed.
A central bank creates money by electronically increasing the quantity of "fiat currency
". In a fractional reserve system, commercial banks also create money by making loans. Suppose, as stated in the first paragraph, that commercial banks have in the aggregate 1 billion in customers' checking account balances, and the central bank imposes a 10% reserve requirement. The total amount of money in the system equals 100 million in reserve and 900 million in checking account balances. However, the fractional reserve system provides a way for banks to earn income through lending and charging interest on loans greater than that paid on deposits.
Taking the example to its logical conclusion, the lending practice plays out until only 10% of the checking account balances are held in reserve. The result is the creation of an additional 900 million thereby increasing the money supply from 1 billion to 1 billion 900 thousand. The additional 900 thousand was spun out of thin air by the process of lending. This event is the mystery of banking. Note that not only the original condition is backed up by nothing but that the consequential condition is backed up by nothing.Central Bank Activity Affecting Bank Reserves - Conventional Theory
The central bank, the FED in our illustration, may attempt to alter interest rates, at least in the short term, by conducting open market operations. Conventional thought holds that when the FED thinks it necessary to lower interest rates, perhaps to stimulate the economy, the FED purchases debt [usually sovereign debt but not necessarily so] held by dealers. The FED pays for the purchase by writing a check on itself and transferring it to the dealer. The dealer then deposits the proceeds in its checking account with a commercial bank, say Citibank. This open market operation increases the banks' value of customer checking accounts and increases its reserves held by the FED. The consequence is an increase in the quantity of money available to be lent by commercial banks. Like any other commodity an increase in supply leads to a reduction in its price. The price of the money is the interest rate; hence interest rates fall.
Assume that the FED purchases 10 million of debt. Assume further that Citibank, the depository institution that has received the proceeds from the dealer, deposits these funds in its account with the FED. The bank's reserves have increased by 10 million and its liabilities have increased by 10 million. If the conventional theory is correct, Citibank holds more reserves than it needs. Applying the ten percent rule, Citibank may create an additional 90 million in money through the lending process.
By contrast, if the FED wants to reduce the supply of money, the FED sells debt to dealers in the private sector. The FED may undertake such an action to constrain inflation in a hot economy. In effect, the sale of debt raises the price of money, that is short term interest rates. Whether this explanation of the combined activity of a central bank and commercial banks is an accurate portrait is subject to question as explained in the textbook. The Federal Funds Rate
The Federal Funds Rate is the price of money that commercial banks lend their reserves overnight. The rate is negotiated by lenders and borrowers. The weighted average is the Federal Funds Rate. Commercial banks that have excess reserves lend to commercial banks that require reserves. The FFR is influenced by open market operations as explained above. As of November 2021, the Federal Funds Rate was 0.08%. See the Federal Funds Effective Rate
. The Central Bank Balance SheetPreliminary Note: The summary is based on the Bank of England Report entitled "Understanding the central bank balance sheet". Central banks and their operations are shrouded in mystery. This summary attempts to shed light. "According to the American writer Joyce Carol Oates, the only people who claim that money is not important are people who have sufficient money that they are relieved of the ugly burden to think about it". (Deane and Pringle 1994) Unless otherwise indicated, quotations in the text refer to the Bank of England report.
"A central bank
is a state institution that usually has the power to regulate commercial banks, create monetary policy, and provide financial services. They help stabilise the currency of the nation, prevent inflation, and keep unemployment low". A central bank also is the institution that has the legal authority to issue currency - physical notes and coin.
The oldest and longest running central bank in the world is the Riksbank
of Sweden. In 1668, the Swedish parliament, comprising four estates, established the Bank of the Estates and of the Realm after its predecessor Stockholms Banco had failed. Noteworthy is the fourth estate - the peasants who made up 80% of Sweden's population - had no say in the matter. The Swedish central bank, like many others to follow, was established with one purpose: the insatiable appetite for war. The "Estates Bank" served the Crown and engaged in the provision of loans to the government. The Riksbank
evolved as a commercial bank with the government as its biggest customer. In 1688, the Bank of England was created explicitly to finance the Nine Years' War with France. But these matters digress from the present discussion.
A "balance sheet" is a financial statement depicting the financial position of an entity on a particular date. A balance sheet, the result of double-entry bookkeeping, consists of assets, liabilities and shareholder equity. Assets equal liabilities plus shareholder equity. A central bank is an atypical entity. When a central bank "issues currency, conducts foreign exchange operations, invests its funds, engages in emergency liquidity assistance, and ... conducts monetary policy operations", these operations affect its balance sheet thereby requiring an understanding of the balance sheet. Means of Settlement
According to the Bank of England, money is an IOU "allowing agents to settle transactions". "Money" is recorded on the central bank's balance sheet as a liability. The latter comprises physical bank notes and commercial bank deposits held by the central bank called reserves
. Settling transactions in banknotes is easy requiring physical transfer among agents. Physical notes, however, do not make up the majority of money. "Instead commercial bank deposits for the majority of money". These deposits are held by economic agents, such as firms and individuals, at commercial banks. In this instance, "settlement" takes place by transferring funds from one deposit account to another deposit account. The central bank enters the picture when "settlement" involves more than a single commercial bank.
In the latter case, the common currency involved in the settlement is the commercial bank reserves
held on account at the central bank. These reserves
move across the balance sheet of the central bank; one commercial bank's account is debited while another commercial bank's current account is credited. The interbank market assures that no commercial bank will overdraw its account with the central bank. The latter provides a mechanism of settlement for commercial banks arising from activity generated by customers of the commercial banks. Note that settlement may be deferred and not in real time
The liabilities of a central bank are commercial bank reserves
, bank notes, and capital and reserves. Commercial bank reserves
are discussed in depth later. Physical banknotes issued by the central bank are conceptually easy to grasp except for the varying quantity, also discussed later.Equity Capital
A central bank is incorporated similarly to a private corporation and carries capital on its balance sheet. However, a central bank is not subject to regulatory requirements as are private institutions. Capital is funded by the establishing government. However, unlike private entities, the capital buffer, is not increased by retained earnings or from raising additional capital from existing shareholders or investors in the primary or secondary markets. A central bank raising additional capital encounters fiscal constraint by governments.
Another factor distinguishes a central bank from a private firm. The objective of a central bank is its goals; that if a firm is profit maximisation. This difference explains why a central bank may undertake a policy of losing money or taking greater risks. For example, in circumstances of QE, central banks buy government debt [and now privately issued debt] from institutions. When the market needs liquidity, the price of the debt will be high while the yield low, conforming to the behaviour of bonds. In the event the debt purchase works, then the central bank reverses its policy and sells debt at a lower price with a higher yield. This practice results in a loss, something a private firm deliberately would not do.
The BoE report rationalises this operation as follows: "Despite the financial loss it has been socially optimal for the central bank to undertake this programme as it has achieved its policy goal of encouraging growth and/or meeting its inflation target". Assets
The asset side of a central bank's balance sheet consist of: foreign assets, government balances, central bank operations [net], and other items. The first item is foreign currency denominated assets. These instruments generally are very liquid held either in cash or in debt of the government that has issued the foreign currency.
Foreign denominated currency or government debt generally is used to affect the value of a central bank's domestic currency in the FOREX market. For example, assume the central bank takes the view that its domestic currency is expensive vis-a-vis the currencies of its major trading partners, then the central may intervene and sell domestic assets in exchange for foreign assets to increase the quantity of its own currency and possibly increase the demand for foreign currency. The expected result is depreciation of the domestic currency. A central bank may undertake this action when the price of its products is expensive to consumers in the economies of its major trading partners. In other words, lowering the price of domestic currency relative to foreign currency supports net exports and deters net imports. The effect is to lengthen the central bank's balance sheet, that is, the central bank now holds more foreign currency denominated assets.
By contrast, a central bank may intervene to offset depreciation of its own currency by selling foreign currency in exchange for domestic currency denominated assets. "This has the joint impact of increasing the supply of foreign assets and reducing the supply of domestic assets" which should increase the relative price of the domestic currency. The effect is to shorten the central bank's balance sheet as it holds less foreign currency denominated assets.Does Central Bank Capital Matter
The question is perplexing. We start by examining the European Central Bank [ECB]. The capital of the ECB amounts to approximately EUR 10,825007,069.71. The source of this capital is the National Central Banks of the European Union that have adopted the EUR. I won’t get into allocations.
The NCBs, therefore, are shareholders in the ECB. However, this raises the question: where did the NCBs get the funds to contribute to the capital of the ECB. The answer requires an examination of each of the NCBs participating in the eurozone. Guesses include taxation and profit from investments, including lending to commercial banks or foreign entities. Ultimately, we are faced with an infinite regression trying to seize the ultimate source.
Ordinary corporations need equity capital to satisfy legal and regulatory requirements. Capital comes from the founders. Additional capital may be sourced from retained earnings or capital raised by expanding the shareholder base. But the ECB is distinctly different from an ordinary corporation as it does not pursue profit maximisation as its main goal but policy objectives as mandated by the Treaties and its statute. Yet the ECB's capital is designed to serve as a buffer to absorb losses.
Reviewing the ECB’s balance sheet, or statement of financial position is of no avail. The asset side contains some gold and gold receivables, loans to credit institutions [constituting by far the greatest asset] and securities purchased from euro residents. The other items are minuscule.
The liability side of the BS unsurprisingly comprises the physical banknotes in circulation and commercial bank deposits held by the ECB. Capital and reserves are basically equal to the figure in paragraph one.
The question raised: what is the original source of any EURO or in fact any money that preceded the EUR. If one posits that the government created the currency, then it begs the question: where did the government get the currency - taxation? If the answer is taxation, then the question arises from what source did the taxpayer get the currency. If the answer is the government, we are in an infinite loop. More on Reserves
The meaning of the term "reserves" is difficult to define. The difficulty stems from discrepant explanations in the literature and the deliberate opacity of central banks. We first discuss reserves that commercial banks are required to hold with their central bank.
"Reserves" in the context of commercial banks is the amount that commercial banks must hold in their accounts with their respective central bank. The CB determines the minimum amount of reserves. But questions arise:  the origin of reserves, and  how are reserves funded.