Introduction to Money

Money is really anything that people use to pay for goods and services and to pay people for
their work. Historically, money has taken different forms in different cultures everything from
salt, stones, and beads to gold, silver, and copper coins and, more recently, virtual currency has
been used. Regardless of the form it takes, money needs to be widely accepted by both buyers
and sellers in order to be useful. (Boyle, 2006)
Functions Money
Medium of Exchange
A medium of exchange is an item that buyers give to sellers when they want to purchase goods
and services. A medium of exchange is anything that is readily acceptable as payment (Boyle,
2006)
Unit of Account
A unit of account is the yardstick people use to post prices and record debts.
Store of Value
A store of value is an item that people can use to transfer purchasing power from the present to
the future.
Liquidity is the ease with which an asset can be converted into the economy’s medium of
exchange (Boyle, 2006)
Without money, trade would require barter, the exchange of one good or service for another.
Every transaction would require a double coincidence of wants the unlikely occurrence that two
people each have a good the other wants.
Most people would have to spend time searching for others to trade with a huge waste of
resources.
This searching is unnecessary with money, the set of assets that people regularly use to buy g&s
from other people.
A monetary system is the set of institutions by which a government provides money in a
country's economy. Modern monetary systems usually consist of the national treasury, the mint,
the central banks and commercial banks.

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Money creation in a debt-based monetary system. ... In this case no new money is created but
money just changes hands. b) Money is "created" by central banks. If a government issues a
government bond the central bank can "buy" this bond. (Mishkin, 2007)
The Money Supply
The money supply (or money stock): the quantity of money available in the economy
What assets should be considered part of the money supply? Two candidates:
Currency: the paper bills and coins in the hands of the (non-bank) public
Demand deposits: balances in bank accounts that depositors can access on demand by writing a
check. (Mishkin, 2007)
Central Banks & Monetary Policy
Central bank: an institution that oversees the banking system and regulates the money supply
Monetary policy: the setting of the money supply by policymakers in the central bank
Money and Working of Monetary System
Even though almost everybody uses money on a daily basis, only few people know how the
monetary system itself works. This articles deals with the question, where money originates and
why the global monetary system is in an essential crisis: (Mises, 2011)
Money as debt
In the past money was backed by precious metals like gold or silver. At that time it was
theoretically possible to take your money to the bank and exchange it for an equivalent value in
precious metals. Today this is not the case anymore. The last western country with a gold backed
currency was Switzerland. When Switzerland joined the International Monetary Fund in 1992
they were forced to abandon the gold backing of the Swiss franc. (Mises, 2011)
Today all western currencies are only backed by debt. It is absolutely essential to understand the
implications of this fact: The backing which 100 years ago was done by gold has been replaced
by a promise to pay on a piece of paper. Contrary to gold a promise to pay can go poof if the
debtor goes bankrupt. Like a pair of scales with money on one side and gold on the other, today
we have money on one side and debt on the other. If this debt goes bad, because the debtor goes
bankrupt in today's system also the money looses its value, since it is not backed by anything
when the promise to pay becomes worthless. (Mises, 2011)

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Money creation in a debt-based monetary system
As just described, money is inseparably linked to debt in the existing system. When asking the
question "where does money originate" or how it is "created" there is a clear answer : Money can
only be "created" when somebody signs a debt obligation - in other words a promise to pay back
the loan. Two scenarios have to be differentiated:
a) If a company issues a loan, it can borrow money from private individuals who already have
this money. In this case no new money is created but money just changes hands.
b) Money is "created" by central banks (like the Federal Reserve Bank in America or the ECB in
Europe). If a government issues a government bond the central bank can "buy" this bond.
Contrary to the process described earlier the central bank does not need to have the money to pay
the government. Since a central bank has the monopoly to "create money out of thin air" it can
simply "create" money equivalent to the value of the bond. The government bond is then seen as
collateral for the newly created money and the government receives the money from the central
bank. (Mises, 2011)
During the financial crisis of the recent years, central banks (especially the American FED)
accepted also other collateral besides government bonds in order to print new money for it in
return. One example of inferior collateral that was accepted is what became know as "subprime"
loans given to heavily indebted home owners. These "subprime" loans were bundled in large
quantities by major banks and then handed over to the FED in exchange for money "created out
of thin air". (Greco, 2001)
Interest in a debt-based monetary system
As you just learned, the creation of new money in a debt-based monetary system always requires
that somebody takes on new debt. But any debt does not only have to be paid back in the future it
also requires a payment of interest on top of the initial loan. Since the interest has to be paid also
in form of money, this situation creates an insolvable problem: When money is created by
someone taking on debt, only the exact amount of money equaling the loan is created. When the
loan is paid back additional money is needed in order to pay the interest. Certainly there is other
money in circulation than just the money of this loan and the person owing the loan could work
in order to earn money and thus pay back his loan and the interest. But if you take a look at the
entire system including all money in circulation, then all money in circulation is in existence

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because somewhere somebody took on a loan and this loan needs to be paid back with interest.
So it should be clear that there is always a lack of money in the system equal to the interest
required for all issued loans. Due to the overlapping of the various credit periods, this problem is
not directly visible but if all loans in the world had to paid back on one particular day, it would
become obvious that only the loans themselves could be paid but there would be no money left
to pay the interest. (Greco, 2001)
Thus in a debt-based monetary system the amount of money in circulation is forced to grow
indefinitely due to the interest mechanism. The additional money required in order to pay the
interest has to be created by issuing new loans to somebody. If private individuals and companies
decide not to take on new debt (or they simply can't) then there is only one credit receiver of last
resort : The government. Thus the government has to constantly increase the amount of national
debt in order to inject new money into the system. (Greco, 2001)
National bankruptcy and monetary reform
The term national bankruptcy describes the situation when the government of a country can not
meet its payment obligations - in other words they run out of money. This can only happen if the
government neither can raise money by taxes or by issuing new government bonds. Issuing
government bonds becomes increasingly difficult if potential buyers loose faith in the ability of
the government to pay back their debt. In this case only the central bank can help out by making
use of their monopoly to create money out of thin air in return for receiving government bonds.
This process of turning government bonds into new money is also called "monetization" of
government bonds. (Greco, 2001)
Conclusion
Since monetization of government bonds causes an increase of the amount of money in
circulation, the money which was in circulation before this monetization looses part of its value -
especially if large amounts of government bonds are monetized. This loss in purchasing power is
also referred to as inflation. Within a debt-based monetary system there is no limit to the amount
of money the central bank can create. Thus this process usually causes hyperinflation, which
implies that money rapidly loses its purchasing power.

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References
Boyle, D (2006). The Little Money Book. The Disinformation Company. p. 37. ISBN 978-1-
932857-26-9
Greco T.H. (2001) Money: Understanding and Creating Alternatives to Legal Tender, White
River Junction, Vt: Chelsea Green Publishing. ISBN 1-890132-37-3
Mises, L. (2011) The Theory of Money and Credit, (Indianapolis, IN: Liberty Fund, Inc., 1981),
trans.
Mishkin, F.S. (2007). The Economics of Money, Banking, and Financial Markets (Alternate
Edition) Boston: Addison Wesley. p. 8. ISBN 0-321-42177-9