The Mechanics of Money Creation

How We Create Money

The U.S. dollar (USD) and other national monies are defined by governments but issued by banks. New money is created when a customer signs a reciprocal debt contract with a commercial bank. Existing money circulates from account to account, in and out of cash now and then. Money is destroyed (disappearing from the money supply) each time this debt principal is reduced by repayment.

Not all money is created by debt contracts. There are many examples, past and present. All 13 American colonies issued paper "scrip" (1690-1780s), and the WIR franc in Switzerland (1934-present) provides a supplemental trading medium for ~70,000 members of its business circle. Many complementary currencies are in circulation today.

However, this class will focus on the official national monies (+ the euro), and the government-granted privilege to create IOUs which function as money because they trade at par (1-1) with the national currency (coins and bills). We will look at how the current bank-dominated system functions, and discuss some of its shortcomings. How, when and where is new money created? destroyed? How does the payment system work? When I pay for something by check, debit card and such, what is going on between my bank and the receiver's bank? Is any other bank involved? What are "reserves"? What does "liquidity" mean? How can an IOU from a bank function as a medium of exchange?

Money is a social relationship backed by the state. National government defines the unit (US dollar; British pound; Japanese yen; . . .). Commercial banks issue most of the money. What works well? What needs improvement? What role do we play in this?

Reference Textbook

Further Reading