What is... | March 6, 2010

What is money?

Millions of people use money every day, yet few give much thought as to why it exists and where it comes from.

At the most basic level, money is the lifeblood of an economy. It is often defined as notes and coins in circulation and deposits in various types of bank accounts. 

The official word on money
The Bank of England says money has three purposes: being a unit of exchange (such as the euro); facilitating trade; and acting as a store of value. Over time, money has moved from something that can be converted to a physical asset to an agreement between people.

Technically, this is known as “fiat” currency. It is no longer possible to present a coin or note to a bank and ask for a certain amount of gold or another physical asset in return.

How central banks make money
Central banks have the responsibility for printing the notes and making the coins that usually make up the majority of what is known as the “money base”.  The money base can be used by banks to lend to businesses and other financial institutions. The original money base is loaned several times, creating credit and money multipliers. Broader measures of money such as M2 and M3 take account of this. 

Ensuring the correct amount of money is in circulation is one of the main jobs of central banks. If too little money is in circulation, households and businesses will likely struggle to pay for daily expenses or get loans. Companies would likely go out of business, which, in turn, could increase unemployment. On the other hand, if there is too much money in circulation, loans could be readily available and people may spend more quickly and freely – potentially pushing up prices and leading to inflation. 

Well-known economist and Nobel Prize recipient Paul Krugman outlined the mechanics of managing the money supply in a famous article that compared it to a baby-sitting co-operative. The Federal Reserve Bank of New York, a branch of the United States central bank, outlined two different definitions of the money supply and the European Central Bank outlined three.

Turning on the taps
Early in 2010, the year this article was written, some measures of the money supply had fallen as lending from banks has weakened.

Figures from the US showed M2 – as it is technically known – fell -0.3% in the three months to April. A newspaper story using unofficial estimates of M3 – a broader measure of money – suggests M3 money supply in the US plunged “at 1930s pace” from $14.2 trillion to $13.9 trillion in the three months to April 2010.

Similarly, European Central Bank numbers showed M3 declined by -0.2% in the year to March in Europe.  Central banks in some countries have responded to the weakness in bank lending by trying to stimulate demand through increasing the amount of money in circulation to such an extent that interest rates fall to very low levels – and close to zero in the US.

A word of warning: Printing money is not printing wealth
The phrase “printing money” has become a common saying amid action taken by several governments to stem the global financial crisis.

While might sound like a way of making households richer, in fact there is a risk that it will make them poorer in the long run because extra money in the system could push up inflation and reduce the value of the money supply. Central banks will try to avoid this by reducing the supply of money as growth returns.

Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics