Help Me Understand Money - Where does it come from?

I know the textbook answer - that money comes from banks. Banks create money by loaning it into existence. The amount is governed by the fractional reserve requirement. So, for example, if the reserve requirement is 10%, banks can expand the money supply by a factor of ten. By loaning and re-loaning the same money again and again, banks can expand 10 units of money to 100 units.

But I’m still confused. For example, where does the initial money supply come from? Who, or what, primes the pump?

Also, when is money created? In the movie, It’s A Wonderful Life, George Bailey tells the irate townspeople, “Your money’s not here! It’s in Joe’s house right next to yours…” Which implies banks take money from depositors and give it to borrowers. But is that really how it works? Isn’t it more accurate to say the money banks loan out is created money, and not the depositor’s money at all?

The Federal Reserve tinkers with the money supply by doing ‘open market operations.’ Meaning, they buy and sell Treasury bonds. When they buy them, they inject money into the money supply. When they sell, they suck money out. But where does the money come from? They don’t specifically say so, but this is created money they’re using, isn’t it? Isn’t the net effect of the Fed’s policies (when it comes to buying and selling Treasuries) to quietly extinguish the Federal debt by inflating the money supply?

Finally… if all money is debt-based, what happens if Americans (for example) ever get around to reducing their collective debt? Wouldn’t that cause a contraction of the money supply? To put it differently, isn’t an ever-increasing level of debt a prerequisite for a debt-based money supply? Is it even possible (collectively) for people to pay off their debts?

Sorry for the long post. The more I think about money, the less it seems to make sense.

It grows on trees.

Someone once told me that money is backed by the stock market but that doesn’t make any sense to me. I thought money was backed by gold supply but I don’t think it is anymore.

In any case, I am very interested in hearing the answers in this thread.

And for a slight hijack: Can someone explain how the Euro is worth more than the U.S dollar? Is the value of the dollar decreasing? Or is everyone else’s currency just increasing?

  • Honesty

It doesn’t exactly come into existence because Banks loan it out. The Federal reserve creates a certain amount of cold, hard, cash every year. They also lend some (not cash) to other banks as needed, though I’m not certain if this is backed by anything except their word. They dont’ want to make too much because of inflation. They don’t want to make too little because that piches the money supply. So we settle for a little, reliable inflation.

Money isn’t backed by the stock market, but the market can create it, sort of, no really, all knds of qualifications. Ultimately, corporate stock is basically money. However, it’s specifically backed by the company’s value, primarily through dividends. If people think your dividends will be high in the future, your stock will go up as its value increases. Banks often do hold stock, but not always. It depends on the bank, the current market, the location, and culture.

Now, the Euro’s value is a bit of an odd question. I don’t understand all the specifics, but note I said that we (in America, that is) settle for a small amount of infaltion every year? That doesn’t happen in Europe. Their central bank has basically one overriding goal: zero inflation. Their currency will rise, but it will also slow economic development.

Now, this does have some good aspects: they can import goods more easily and travel easily (as Americans well know). But they can’t sell products very easily, which is one huge reason some of the smaller nations have resisted the Euro.

Right down at the very basics money is just a medium of exchange and is anything that someone will take in exchange for something you want.

As far as I can tell, the only requirement is that it be acceptable as a medium exchange over a wide area and by the general populace and by businesses.

“No” and “not any more”.

When people talk about the value of a currency, it’s always relative to other currencies. It’s called an “exchange rate”. Like stocks to companies, national currency represents people’s general confidence in a nations economy. There are many reasons the Euro may be rising relative to the USD:

-The EU as a whole has a larger economy than the US
-Growing confidence in the EU as an economic entity
-Concerns about American policies

No, that’s not true at all. First of all, money must be easily tradable. You can’t buy a stick of gum with your shares of Microsoft until you convert it to money. The stock market creates “wealth”, not money.

Actually that’s not correct either. Banks can lend out as much money as they want as long as they maintain a certain minimum reservere of deposits. Lets say that reserve is 10%. If I deposit $100, the bank can now lend out $1000. Where did the $900 come from? Nowhere really. But the bank expects that most of it will be paid back with interest and the Federal Reserve (or Fed) as the central bank will back up the other banks as a lendor of last resort. The Federal Reserve, by definition, doesn’t need more than it’s “word”.

As to inflation - high inflation is bad because it erodes savings. No inflation is undesirable because it comes at a sacrifice of economic growth. The Fed can adjust inflation by varying interest rates to control the money supply. High interest rates discourages borrowing and shrinks the money supply. Low interest rates encourages lending and increases it.

Also, there is a difference between “money” and “currency”. Hard currency is just a small portion of the total money supply. The money supply has little, if anything, to do with how many Benjamins the US Mint (NOT the Federal Reserve) prints each year.

The Mint doesn’t print money.

ah yes. That would be the Bureau of Engraving and Printing. I stand corrected.

Both are part of the Treasury Dept

For most of us, the important question about money is not “Where does it come from?” but “Where does it go?” :eek:

No one’s hit on exactly how the money gets created in the first place. The banks create money because when I deposit ten dollars, they say I have ten dollars. Then they hand Joe a $10 bill, so he has ten dollars, even though it’s the same money, counted twice. My original 10 bucks is now 20. When Joe buys a shirt, the store deposits the money in the bank and it goes around again.

So what’s holding it all up? It’s not gold anymore. The answer is “absolutely nothing”. The value of anything is based upon what someone will trade you for it. Those extra ten dollars have meaning because Joe thinks someone out there will trade him a shirt for it. Your ten dollars has meaning because you believe that at any time, you can get it out of the bank. Thus, it’s all based on confidence. Anything can be money so long as you know (think?) you can trade it back again for other goods and services.

On inflation, you shouldn’t think that it’s an all-bad thing. Every time someone is hurt by it, someone else benefits from it. For example, if I loan you ten dollars today and expect a 10% interest to be paid on it in the future, I can expect $11. Unfortunately, if the term of the loan is too long, that $11 might be less valuable than the original $10. That’s bad for me, but great for you! If I promise you a pension of $100 a month when you retire, that $100 will be worth less and less as time passes. That’s bad for you, but benefits me. So even with the “evil monster” of inflation, there’s two sides to the coin (pun fully intended).

It sort of evolved. People used to trade pigs and chickens. Then some king decided that gold was valuable, so they used that. Later, governments decided that a piece of paper representing gold was more convienient to carry around.

No, that’s not how it works. You give $10 to the bank. The bank can now loan out $100 (or some multiple). Joe borrows $50 from the bank (they don’t just hand it out). Your $10 is still there if you want it. Eventually, Joe has to pay back the bank plus interest (say $5). So now there’s $65 in the bank.

Actually, what’s holding it all up is the Federal Reserve’s power to limit the money supply.

Money talks. Mine mostly says “Goodbye!”

Cecil on money.

Well, I’ve read a number of posts on this board that clearly indicates that all money comes from the government, which gets it by ruthlessly extracting it from the pockets of helpless libertarians at gunpoint. So, um, all money comes from libertarians.

The bottom line is this. Some bureaucrats at the Federal Reserve have an account with some number written in it, say $1000. Then they erase that number and replace it with another, say $2000. In that way, they’ve created a thousand dollars. They can then trade the new thousand dollars to a bank to use as a fractional reserve.

You may be trouble by the fact that our entire society is based on something that certain government officials simply make up. You may wonder why the system functions. Well, the system functions because people believe that it functions. If people stopped believing that money had value, it would cease to have value.

Weird, huh?

Not on any tree in my garden it doesn’t :frowning:

No way. Money comes from evil capitalists exploiting the honest, toiling proletarian masses.

Money is one of those weird concepts.

First we have barter. I offer you 5 chickens, you give me 6 bushels of wheat in return. Except the problem with this is, what if I have chickens, and you want chickens, and you have wheat, but I want something else besides wheat?

And so the next evolution is the concept of a key good. This is a good that people are willing to trade for, not because they want the good itself, but because they know they can trade that good to someone else to get the thing they really want. Lots of things have been used as key goods…cacao beans, cigarettes, whiskey, cows, shells…and metals. If I have 5 chickens I can trade them to you for 3 bottles of whiskey. I don’t want the whiskey, but I know if I take that whiskey to the person who has the goods I want, he will readily take the whiskey in exchange. And he might not want the whiskey either, but he knows that he can trade it for what he wants.

Goods that make useful key goods are compact, valuable, fungible, durable, storable, transportable, interchangeable, and divisible. You want something you can easily carry around, something where each bit is equivalent to each other bit, something that can be broken apart without losing value. And it turns out that metals, especially certain rare metals, make excellent key goods. Gold can be used to make jewelry and other ornaments, that’s its main use. But gold is compact, it lasts forever, it can be cut up into small bits without losing value, every lump of gold is equivalent to every other lump of gold, so you don’t have to haggle over whether this is an especially high quality or low quality lump of gold.

So I can trade you my chickens for a few lumps of gold or silver. However, it makes things easier if we have standardized ingots so we don’t have to weigh and assay the metal each time. These ingots are called “coins”, and they make barter very easy, no one barters directly for they goods they want, instead they barter for the metal ingots and use the metal ingots to barter for what they want. And so precious metals became the most important key good in the ancient world, and you could travel from Spain to China with gold in your pockets and know that you could exchange that gold for other goods no matter where you were. But note that gold or silver coins, while they are money, are still just a key good that can be used to facilitate barter.

Now we next have an interesting development. Gold can be stolen easily. So people would sometimes arrange to keep their gold in a safe location. And this was often at a goldsmith’s shop. Since the goldsmith had a lot of gold sitting around, he had to have a secure safe to keep it. And so other people would give their gold to the goldsmith, and he would keep it safe for them and give them a reciept. Now, this reciept is very interesting. Because it is a paper representation of actual gold.

If you’ve got gold deposited at the goldsmiths, but want to buy some good, you’d have to go to the goldsmith, withdraw your gold, and trade it to the person who had the good. But suppose you could instead just trade him the reciept? You hand him a piece of paper, and he hands you the goods, because the peice of paper entitles him to go to the goldsmith’s and get the gold himself. And now we can see that this reciept is really the first form of paper money.

But the goldsmith can do some interesting tricks. He doesn’t have to issue reciepts for the exact same gold you deposited, he can instead just promise to give you a certain weight of gold, and it can be any gold, just as long as you get the same weight back you don’t care. And so the goldsmith can issue more reciepts than he has actual gold, he doesn’t have to keep every ounce of gold in the safe, as long as he guarantees to return a certain amount of gold. And so the goldsmith isn’t really a goldsmith anymore, but is now a banker. He can issue paper reciepts that entitle people to a certain amount of gold, and it doesn’t matter how much gold he actually has, as long as he’s able to pay back anyone who wants the actual gold. Most early paper currencies were of this type. The British Pound was a receipt for a literal pound of silver.

But of course we see the possibility for mischief. If the banker goldsmith issues lots of notes, and suddenly everyone wants their gold and silver, then he’s in trouble because he doesn’t have it all in the vault. And of course, governments decide to get in on the game rather than leaving it to bankers. Goverments have been issuing gold and silver ingots, but now they start issuing paper money. And this is the “gold standard”. But then someone notices something interesting. Nobody actually wants the gold, they just want to be able to trade easily. You can have fractional reserves, where only a small amount of gold is available for redemption. And this reserve can get smaller and smaller. But what if the reserve is zero? Why should that make any difference?

And so we trade pieces of paper that do not represent a promise by the government to redeem for a certain weight of precious metal. All it represents is a promise that you can pay your taxes and debts with this piece of paper. And no one cares, because no one wanted the gold anyway, gold was just a proxy. So now we have fiat currency.

And of course, it doesn’t stop there. How often do you use paper money? I get paid electronically through direct deposit from my employer to my bank account. And I pay my bills electronically through a credit card, and transfer the amount from my bank account to the credit card company every month. No actual worthless paper has changed hands, all that changes is the number written on some bank’s computer memory. And so we have the ultimate form of money, electronic money that isn’t represented by anything, not even a piece of paper. Just try buying a house or a car or anything important by bringing in a wheelbarrow full of paper money, the mortgage company will look at you like you tried to bring in a truck full of chickens to barter for your house.