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Home > News and Publications > Quarterly Bulletin 2014 Q1 pre-release articles

Quarterly Bulletin 2014 Q1 pre-release articles

Money in the modern economy: an introduction (535KB)
By Michael McLeay, Amar Radia and Ryland Thomas

What is money? While most people in the world use some form of money on a daily basis to buy or sell goods and services, to pay or get paid, or to settle contracts, there is not universal agreement on what money actually is.

Assuming no prior knowledge of economics, this article explains that money today is a type of IOU, but one that is special because everyone in the economy trusts that it will be accepted by other people in exchange for goods and services. It is because money is a form of IOU that banknotes still have the ‘promise to pay’ inscription: but money today is fiat or ‘paper’ money that is not convertible to any other asset (such as gold or other commodities). In addition to currency, bank deposits and central bank reserves are the main types of money in the modern economy. Each one represents an IOU from one sector of the economy to another. Most of the money circulating in the economy is in the form of bank deposits which, as the companion article below explains, are created by commercial banks themselves. A box in the article briefly outlines some recent developments in payment technologies, including e-money and digital currencies.

Money creation in the modern economy (111KB)
By Michael McLeay, Amar Radia and Ryland Thomas

In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood. The principal way in which they are created is through commercial banks making loans: whenever a bank makes a loan, it creates a deposit in the borrower’s bank account, thereby creating new money. As this article explains, though, banks cannot create money in this way without limit: how much banks lend will rest on the profitable lending opportunities available to them which will, crucially, depend on the interest rate set by the Bank of England. In this way, monetary policy acts as the ultimate limit on money creation.

This description of how money is created differs from story found in some economics textbooks. For instance, in normal times, the central bank does not in practice choose the amount of money in circulation. Nor is central bank money ‘multiplied up’ into more loans and deposits. Rather, the Bank of England implements monetary policy – which is set to be consistent with low and stable inflation – by setting the interest rate on central bank reserves (‘Bank Rate’). This then influences a range of interest rates – including those on bank loans – and, in turn, the aggregate amount of spending in the economy.

When interest rates are reduced to their effective lower bound, the focus of monetary policy may shift to boosting the quantity of money in the economy directly, via a series of asset purchases, or ‘quantitative easing’ (QE). The article explains how QE works to stimulate spending in the economy. It also dispels a number of misconceptions relating to QE:
  • Just as in normal times, the reserves created by QE cannot be ‘multiplied up’ into additional loans and deposits.
  • Nor can reserves be directly lent out, since only commercial banks hold reserves accounts.
  • And while banks do earn interest on the newly created reserves, QE also creates an accompanying liability for the bank – the investors’ deposits following sales of gilts – which the bank will itself typically have to pay interest on.
Two short videos, filmed in the Bank of England’s gold vaults, explain what money is and how it is created in the modern economy.

The rest of the 2014 Q1 edition of the Bulletin will be published at 00:05hrs on 14 March 2014.
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