Where does money come from?
 

This page describes the creation of money, where the money comes from, and how the money supply varies with time. Also discussed is private money creation, economic downturns, war, and natural disasters.

 

When there is a severe economic downturn, such as that resulting from a pandemic, war, or natural disaster, economic activity reduces and the amount of money in circulation decreases. The decrease happens because of uncertainty. In uncertain times, people will not borrow money and will reduce their expenditure. This has a negative impact on employment and businesses. To counter this fall in economic activity, governments will act to increase the money supply.

 

Additional money created to increase the money in circulation 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 to gift money to some individuals, such as those in need.
     

  • Governments obtain the money by creating a central or Reserve Bank from which they borrow money that the bank creates for the government to use. 
     

  • Because the amount of money created is limited, it has value and can be exchanged for goods and services. 
     

  • Because money has value, 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 maintains value because governments work to keep both the amount of money and the value of the money in circulation per person at a near-constant level in order 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 they are able to buy at a future date.
     

  • Because governments limit the amount of money in circulation in order 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 but will always ensure that sufficient money remains in circulation. 
     

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

Private money creation
 

  • Commercial banks also create money when they lend it to businesses and individuals as loans and mortgages.

    • When commercial banks lend money, the banks create debt and ask for the money to be repaid over time with interest.

    • Commercial banks do not lend the deposits they hold in individual bank accounts to others as is sometimes thought, they create new money in order to lend.

    • The money that individuals deposit is always available for them to withdraw so the total amount of money in circulation increases as the banks create money.

    • To create money, the banks simply adjust the amount of money shown in the bank account of the borrower but at the same time, they establish a legal debt agreement that the borrower must pay the money back.

      • Consequently, the amount of debt is equal to the amount of money created.​

    • Over time, the money returned to banks as loan repayments will cancel out the money lent, but at any one point in time banks will have created more money than has been returned and this increases the amount of money in circulation. Some 98% of the money in circulation is created this way.

    • The interest banks charge on loans enables the banks to pay their staff, meet their costs, and make a profit.

    • Making a profit is necessary for a bank to stay in business. Profits are either retained and reinvested in the bank or paid out as dividends to the bank's owners.
       

  • However, the creation of money by the commercial banks and the charging of interest results in a net flow of money from those who borrow the money to the commercial banks. 
     

  • 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 in order to maintain the value of money.

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

    • As a consequence, falling interest rates will result in higher house prices when the supply of houses is limited.

    • Rising interest rates will tend to stabilise house prices and sometimes even result in house prices falling. 
       

  • Money is also created when credit cards are used or people buy goods and services on credit. Again, buying goods and services on credit results in a debt that must be paid back over time.
     

Population Increase

  • Increasing population has negative impacts on people's standard of living. Larger families are more expensive to feed and house and immigration can put pressure on housing supply and local body resources. New housing subdivisions are required to house the extra population.

  • 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 bid prices up to higher levels. Consequently, people buying houses often do not benefit from the lower interest rates as they borrow more and pay more for a house so need to pay just as much back on their mortgage.

    • If there is a stable population or the population decreases due to emigration, house prices may fall. However, the reluctance of people to sell houses for less than they paid for them tends to slow any fall in house prices. 
       

  • With a population increase, there is a need for more money in circulation to keep the amount of money per person constant.

    • If the majority of money or all of the increased money in circulation is created by borrowing the total debt and the average debt per person will rise. This is because not all money in circulation was created by creating an equal amount of debt.

    • In the past, some money was simply created without debt, or if the money was created with debt, the debt may have subsequently been forgiven resulting in debt-free money. 

    • Insisting on creating all-new money using debt will over time result in a net flow of money from those who need to borrow to those who have money or are able to create or lend money.

    • This becomes part of the trickle-up problem resulting in a net flow of money from those who have little to those who have a lot.
       

  • Some Basic Income advocates recommend creating a regulated amount of debt-free money, also known as sovereign money, on a regular basis and paying it out to all citizens as a Basic Income. This can then be taxed back with regular taxation over time from those who have the money.
     

  • 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, more people are likely to lose their employment and taxes will fall again. Governments cutting expenditure to match their falling tax income are likely to trigger a severe economic depression.

    • To counter a slide toward a depression, governments will boost the economy by spending more to increase the amount of money in circulation. This will 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.

    • Alternatively, if they borrow from commercial banks, 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 additional money from the Reserve Bank.

    • This creates new money for the government to use with little or no interest charges.

    • Money is created just as money is created when commercial banks lend money for private use, but if the amount of money in circulation was falling the creation of new money is required to stop the fall in the amount of money in circulation to keep the economy moving and to prevent a depression.
       

  • 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 will match the money taxed back.
       

  • However, during a severe economic crisis when the money in circulation is decreasing rapidly, 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 on low incomes.

    • Governments also risk subsidising highly profitable businesses that do not require subsidies.

    • Because more money trickles up than down, subsidising business is not the best way to support those who need money the most.

    • Providing a Basic Income to all citizens is the most efficient way of ensuring that those who need money the most receive the money and of achieving economic recovery with an 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 usually 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. Some of the debt could be written off.

  • Experience has shown that money paid out to businesses in order to pay wage subsidies during an economic downturn has not always been well spent. While such payments have helped to keep some firms afloat others have profited unduly. 

    • It is likely that a better result could have been achieved by paying a Basic Income to all citizens.


War and natural disasters 

  • After a war, the economy of a country can be all but destroyed. After a natural disaster, the economy of a region or local area can be largely destroyed. 

    • In either case, paying a Basic Income to the citizens of a country or to those of the local region or area can be the fastest and most efficient way of restoring the economy.                                                                                                                                                                                                                                                                                                                                                                                        

Created 28 May 2020. Revised 28 May 2020, 17 May 2022.