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A more accurate model of the modern UK banking system, based on primary research, is described in Chapter 4. Now both the original depositor and the new borrower think they have money in their bank accounts. Figure 2 shows this step-by-step process, with the additional lending and the new money created as a result shown in black. Figure 2: The money multiplier model This model implies three important things. First, it implies that banks cannot start lending without first having money deposited with them.

In an economy with just a single bank, it would have to wait until someone deposited money the amount shown in black in Figure 2 , before it could lend anything, whatever the reserve ratio.

So this model supports the concept of banks being primarily intermediaries of money. Alternatively, if the amount of money at the base of the pyramid Figure 3 is doubled, but the reserve ratio stays at 10 per cent, then the total amount of money in the economy will also double.

With a 10 per cent reserve ratio, there is an increase in the money supply for the first approximately cycles, but after this point there is no discernible increase, because the amounts being effectively re-lent are infinitesimal.

This model of money creation can therefore be envisaged as a pyramid Figure 3 , where the central bank can control the total money supply by altering the size of the base, by controlling the amount of base money and the steepness of the sides by changing the reserve ratio. Consequently, economists and policymakers following a simple textbook model of banking will assume that: 1. Banks are merely intermediaries and have no real control over the money supply of the economy.

Central banks can control the amount of money in the economy. There is no possibility that growth in the money supply can get out of control because it is mathematically limited by the reserve ratio and the amount of base money. Unfortunately this textbook model of banking is outdated and inaccurate and, as a result, these assumptions will be untrue. Problems with the textbook model The textbook model of banking implies that banks need depositors to start the money creation process.

Banks do not wait for deposits in order to make loans. Bank deposits are created by banks purely on the basis of their own confidence in the capacity of the borrower to repay the loan. That is, banks extend credit by creating money. Paul Tucker, Deputy Governor at the Bank of England and member of the Monetary Policy Committee, 22 In the UK, there are currently no direct compulsory cash-reserve requirements placed on banks or building societies to restrict their lending Section 6.

In reality, rather than the Bank of England determining how much credit banks can issue, we could argue that it is the banks that determine how much central bank reserves and cash the Bank of England must lend to them. This is particular obvious in the case of countries where compulsory reserve requirements have been reduced to zero — such as the UK.

This will be explained in more detail in Chapter 4. The only significant impact was a decrease in the ratio between commercial bank money and base money. However, an increase in bank credit creation will have a positive impact on the value of economic transactions. Figure 5: Growth rate of commercial bank lending excluding securitisations, Source: Bank of England26 Figure 6: Change in stock of central bank reserves, Source: Bank of England27 Our research finds that the amount of money created by commercial banks is currently not actively determined by regulation, reserve ratios, the Government or the Bank of England, but largely by the confidence of the banks at any particular period in time.

The current arrangements are not inevitable, however. The Bank of England or the Government could intervene in order to influence or control money created by commercial banks, as they did in the past and as we explore in chapter 3.

In other words, the authorities are not free of responsibility for results produced by the largely unchecked behaviour of the banking sector. When banks are confident, they will create new money by creating credit and new bank deposits for borrowers. When they are fearful, they rein in lending, limiting the creation of new commercial bank money.

If more loans are repaid than issued, the money supply will shrink. The size of the commercial bank credit balloon, and therefore the money supply of the nation, depends mainly on the confidence and incentives of the banks. Banks can create deposits for their customers, but they cannot create capital directly for themselves. Banks must ensure at all times that the value of their assets are greater than or at least match their liabilities.

If the value of their assets falls, and they do not have enough of their own capital to absorb the losses, they will become insolvent.

Once a bank is insolvent, it is illegal for them to continue trading. Equally, while banks can create deposits for their customers, they cannot create central bank reserves. Therefore, they can still suffer a liquidity crisis if they run out of central bank reserves and other banks are unwilling to lend to them.

We explore solvency, liquidity and banks going bust in greater depth in Section 4. When a central bank chooses to adopt a laissez-faire policy concerning bank credit, as now in the UK, boom-bust credit cycles are likely to result, with all their implications for economic analysis and policy. This is obvious if we think about the link between credit creation and economic activity.

When banks create credit, and hence expand the money supply, whether the money is used for GDP or non-GDP transactions is crucial for determining the impact on the economy.

Unproductive credit creation for nonGDP transactions will result in asset price inflation, bursting bubbles and banking crises as well as resource misallocation and dislocation. In contrast credit used for the production of new goods and services, or to enhance productivity, is productive credit creation that will deliver non-inflationary growth.

This may explain why the Bank of England, like most central banks, used to impose credit growth quotas on banks, as we show in Chapter 3. However, such credit controls were abolished in the early s.

If you are keen to understand in more depth exactly how money is created by the banking system today, then you may wish to skip ahead to Chapter 4. However, it is important to see how money and banking have developed over time to give us the current system.

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References 1 Defoe, D. Essay on Projects London , quoted in Davies, G. A History of Money. Wales: University of Wales Press, p. History of Economic Analysis.

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Quoted in Werner, R. New Paradigm in Macroeconomics. Basingstoke: Palgrave Macmillan, p. June Public attitudes to banking. Issues Paper: Call for Evidence, pp. Can credit unions create credit? The transition mechanism of monetary policy. Bank of England Quarterly Bulletin, August , p. Interpreting movements in Broad Money. Bank of England Quarterly Bulletin Q3, p. Proposals to modify the measurement of broad money in the United Kingdom: A user-consultation.

Money and Credit: Banking and the macroeconomy, speech given at the monetary policy and markets conference, 13 December , Bank of England Quarterly Bulletin , Q1, pp. Committee on Banking and Commerce, Ottawa.

Government Printing Bureau, quoted in Rowbotham, M. The Grip of Death. Oxford: John Carpenter Publishing, p. Domestic payments in Euroland: commercial and central bank money. Chicago: Federal Reserve Bank of Chicago. Geld und Geldpolitik, as cited and translated by Werner, R. Frankfurt: Goethe University 19 Phillips, C. Bank Credit. New York: Macmillan 20 Nicols.

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Towards a Quantity Theory of Disaggregated Credit. Just as it is irrelevant whether a [physical measuring instrument] consists of iron, wood or glass, since only the relation of its parts to each other or to another measure concerns us, so the scale that money provides for the determination of values has nothing to do with the nature of its substance.

This ideal significance of money as a standard and an expression of the value of goods has remained completely unchanged, whereas its character as an intermediary, as a means to store and to transport values, has changed in some degree and is still in the process of changing.

Georg Simmel , Sociologist and Philosopher1 Money is not metal. It is trust inscribed. And it does not seem to matter much where it is inscribed: on silver, on clay, on paper, on a liquid crystal display. Niall Ferguson , Historian2 3. The functions of money Money is clearly fundamental to capitalist systems. It is hard to envisage a modern economy without it.


While the medium of money may change with technological developments — from coins to notes to cheques to credit and debit cards and online e-payments — the activity of exchanging, storing, and accumulating units of value called money has been with us for centuries and shows no sign of going away.

Yet money and banking, as subjects for serious examination in their own right, have been largely neglected by orthodox economics over the past years. Money is generally described by economists in terms of its functions rather than any kind of overarching property or essence.

It is generally viewed as having four key functions:4 1. Medium of exchange — enables us to conduct efficient transactions and trade with each other.

Unit of account — without a widely agreed upon unit of measurement we cannot settle debts or establish effective price systems, both key elements of capitalist economies. Whilst there is some consensus that these four functions are all important in constituting money, there is less agreement about their relative importance and their role in the origins of money and relationship to banking.

Classical economics and money Classical economists, Adam Smith, John Stuart Mill, David Ricardo, and Karl Marx argued that real economic value lay not in money but in land, labour, and the process of production. Money is simply a symbol representing that value. It is a machine for doing quickly and commodiously what would be done, though less quickly and commodiously, without it; and, like many other kinds of machinery, it only exerts a distinct and independent influence of its own when it gets out of order.

Hence, gold and silver coins, possessing all these properties, became the dominant medium for money, according to the classical account. The classic example is the prisoner-of-war camp where cigarettes became a substitute for money. They are fairly homogenous, reasonably durable, portable and of a convenient size for the smallest or, in packets, for the largest transactions divisible.

Money enters the picture only in the modest role of a technical device that has been adopted in order to facilitate transactions This deity enabled Walras to happily ignore money. Since money was a commodity, it must also have a production function and, since everyone wants it, also a utility function.

What was special about money was that it had unique properties of durability and very high velocity speed at which it circulates through the economy in transactions , both of which reduced its relative production costs to near zero. Problems with the orthodox story If this description of the role of money in the economy seems a little strange to you, you will be pleased to know you are not alone in questioning it.

Any economic model requires generalisations, assumptions, and simplifications in order to tell us something interesting about how things work. The most obvious failure is that the theory is internally inconsistent. If you take the assumption of perfect information to its logical conclusion, there would be no need for money or indeed any other kind of intermediating financial service including banking in the economy at all.

So, paradoxically, under conditions of perfect information and certainty, money becomes redundant, which of course undermines neoclassical explanations of the origins of money in commodity-exchange in the first place.

Think about any of the successful entrepreneurs you know. You will probably find that most of them started out with very little money and had to get loans from the bank, friends, or family before they could begin selling their services or products on the market.

So building a model that starts with market clearing and allocation and then tries to fit in money as a veil on top of this makes little sense. As American economist Hyman Minsky argues This means that nominal values money prices matter: money is not neutral. Money is simply called forth by individual demand — but there is no account for how and why individuals handle money or why the demand for or supply of money is at a certain level, at a particular point of time.

You cannot change it into gold or silver. Credit theory of money: money as a social relationship Have a look in your wallet to see if you have any sterling notes. It appears this money is a future claim upon others — a social relationship of credit and debt between two agents.

This relationship is between the issuer of the note, in this case the state, and the individual.

It does not appear to have anything to do with relations of production, between an agent and an object, or with the exchange of commodities objectobject relations. These researchers of money come from various academic disciplines. They include: heterodox economists including some early twentiethcentury economists , anthropologists, monetary and financial historians, economic sociologists and geographers and political economists.

Money as credit: historical evidence From an historical perspective, the earliest detailed written evidence of monetary relations is to be found in the financial system of Babylon and ancient Egypt.

These civilisations used banking systems thousands of years before the first evidence of commodity money or coinage. As the monetary historian Glynn Davies puts it: Literally hundreds of thousands of cuneiform blocks have been unearthed by archaeologists in the various city sites along the Tigris and Euphrates, many of which were deposit receipts and monetary contracts, confirming the existence of simple banking operations as everyday affairs, common and widespread throughout Babylonia.

Indeed, historical evidence points to the written word having its origins in the keeping of accounts. The earliest Sumerian numerical accounts consisted of a stroke for units and simple circular depression for tens. If enough people recorded their debts with a single bank, that bank would be in a position to cancel out different debts through making adjustments to different accounts without requiring the individuals to be present.

Modern banks still undertake this clearing activity by entering numbers into computers as we shall see in Chapter 4.

Whilst clay tablets were used in Babylon, tally sticks were used in Europe for many centuries to record debts. The sticks were notched to indicate the amount of the download or debt and then split in two to ensure that they matched in a way that could not be forged. They were used in England until and can still be seen in the British Museum today. These became increasingly formalised and determined in public assemblies as societies developed.

In contrast to the orthodox story, they were not the result of individual negotiation or exchange. The role of the state in defining money Another important part of the story has been the role of the state in ensuring the acceptability of such tokens.His father was imprisoned for debt, and Dickens' shines a spotlight on the fate of many who are unable to repay a debt when the ability to seek work is denied.

Summary 7. But for now let us just consider whether it is really meaningful to describe the balance in your bank account as anything other than money. Therefore, they can still suffer a liquidity crisis if they run out of central bank reserves and other banks are unwilling to lend to them. A workbook on Bank Reserves and Deposit Expansion.

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