Where does money come from?

This page describes the creation of money, where the money comes from, and how money supply varies with time. When there is a severe economic downturn, such as that resulting from a pandemic, and the amount of money in circulation decreases, governments may act to increase the money supply. Additional money is best distributed using Basic Income payments, paid to all citizens equally.

  • In the beginning, governments create money and use the money to pay for labour or for goods and services, or gift money to some individuals, such as those in need. Governments obtain the money by creating a Reserve Bank from which they borrow money that the bank creates for the government to use.

  • Those who receive money from the government use it to buy goods and services from others or to pay for labour. It becomes a means to facilitate the exchange of goods and services.

  • Money has value because governments work to maintain the value of the money in circulation at a near-constant value by acting to prevent inflation or deflation.

  • When money has a stable value, people trust it and are willing to hold on to it and use it at a later date to trade for goods and services, or for labour. The more money that an individual has or accumulates, the more that individual can buy at a future date.

  • Because governments limit the amount of money in circulation to maintain the value of the money and prevent inflation, governments will tax back the money they issue over time to achieve a balance between the money they spend and the income they receive in tax. 

  • Governments spend in order to tax the money back. They do not, as is commonly supposed, tax in order to spend.

  • Commercial banks also create money when they lend it to businesses and individuals as loans and mortgages. When they lend money, the banks ask for the money to be repaid over time with interest. Banks do not lend the deposits they hold in individual bank accounts to others as is sometimes thought, they create new money. While the money returned to banks as loan repayments will cancel out the money lent over time, at any one point in time banks may have created more money than is being returned and the amount of money in circulation increases. Some 98% of the money in circulation is created this way. The interest banks charge on loans enables the banks to pay their staff, and to make a profit. Making a profit is necessary for a bank to stay in business.

  • To maintain the value of money, governments attempt to limit the money created by the commercial banks by controlling interest rates or by other means such as requiring larger deposits by people purchasing homes. 

  • Higher interest rates discourage or limit the amount of money borrowed, but when interest rates fall people are able to service larger loans and mortgages.

  • If there is a housing shortage, which can occur when house building does not keep up with the population increase, people will compete for the available homes and bid up the price. Because lowering interest rates enables people to service larger mortgages this may result in a rapid increase in house prices as people are able to borrow more and will consequently bid prices up to higher levels. Consequently, people may not benefit from lower interest rates.

  • More money is created when credit cards are used or people buy goods and services on credit.

  • Money borrowed by governments from the Reserve Bank or elsewhere creates government debt and the level of this dept is measured as a dept to GDP ratio. Governments generally try to keep this ratio at a relatively low or manageable level in case there is a need to borrow money during an economic downturn.

Economic downturns

  • When there is a severe economic downturn, the amount of money in circulation falls as business activity decreases and businesses and people borrow less. This can have very severe impacts on people as unemployment and poverty rise. Reduced economic activity results in government tax revenue falling as economic activity reduces. If governments reduce expenditure to match the fall in income the problem is compounded. To boost the economy governments will act to increase the amount of money in circulation by spending more, in order to boost the economy, employment, and tax revenue. 

  • In normal circumstances, when government spending exceeds taxation, governments will borrow money from the public or other sources to avoid increasing the money in circulation or borrow from commercial banks in which case new money is created. In either case, the government will pay the money back over time with interest. When money is obtained this way, the lenders of the money profit at the expense of the general population. Alternatively, in unusual circumstances, such as when the amount of money in circulation is falling rapidly and the government is seeking to increase the money supply, governments may borrow more money from the Reserve Bank. This creates new money for the government to use at little or no interest, just as money is created when commercial banks lend money for private use.

  • In normal circumstances, to avoid inflation, governments will tax the money that they spend back over a period of time to keep the money in circulation constant. Over time, the additional money created matches the money taxed back.

  • However, during a severe economic crisis when the money in circulation is decreasing, additional money can be created within limits to increase government expenditure and then taxed back later if considered necessary as the economy recovers. As an expanding economy during a recovery requires more money in circulation it may not be necessary to tax all the money back.

  • When a government is seeking to increase the money supply to boost the economy during a severe economic downturn resulting from a pandemic, the best way to distribute the money equitably is to pay money out as a Basic Income in equal amounts to all people. During normal times governments will tax the money back over time to ensure an ongoing balance. During a severe economic downturn, such as that resulting from a pandemic, governments can create more money than usual and tax it back slowly or only if considered necessary as the economy recovers.

  • Money distributed as a Basic Income is spent by those who receive it boosting the economy and supporting businesses and local and regional economies. The money trickles up.

  • There is no point in providing subsidies to businesses when individual people have no money to spend on the goods and services that the businesses provide. Subsidising businesses may result in the need to provide subsidies to some marginal businesses in perpetuity while the people who need money continue to live in poverty. Governments also risk subsidising highly profitable businesses that do not require subsidies. Because more money trickles up than down, subsidising business is not a good way to support those who need money the most. Providing a Basic Income to all citizens is the most efficient way of achieving economic recovery and equitable distribution of wealth.

  • During an economic downturn, government expenditure may exceed government income resulting in deficits. The need to maintain or increase government expenditure during a downturn requires money to be borrowed and this will increase the debt to GDP ratio. During good times that follow a recovery, governments may make annual surplusses which can be used to repay borrowed money reducing the debt to GDP ratio. However, if the GDP has increased, as it will do with an economic recovery, there is a need for more money in circulation so the government need not pay back all the money borrowed while maintaining the desired dept to GDP ratio. 

Created 28 May 2020. Last revised 28 May 2020