This is just a short article on some simple thoughts regarding money-creation in the economy.

Money, nowadays, is created by the central banks of the world. They do this by lending new (electronic) money to ‘normal’ banks. The banks lend it on (usually more than once) to businesses. The businesses use the money to account for their making of things.

In this way, a record can be kept for each participant in the economy of how much they have contributed and how much they are allowed to consume.

A little bit of history

So, reading the internet, quite a few people seem to think money supply is of paramount importance in an economy. It is obviously an important factor, but history shows it is not the only determining factor for the money in circulation. Even in explaining inflation. I sometimes wonder if money-supply-demand has any influence on the economy at all, in the long term. In the short term, it probably will because money enters the economy at a certain point and only thereafter gets distributed.

Consider this chart:

It shows that even when the money supply increased because of the huge influx of gold from the Americas, inflation in Europe did not increase nearly as much. Even over a 100-year timespan…

How come?

There may be another side of the equation: the demand side. Is there such a thing as demand for money?

There are stories about people melting golden church statues to get their hands on money (meaning there was too little money in the economy at the time?). At other times, people made gold-statues and put them in churches (a sign of too much money in the economy?).

Nowadays an equivalent mechanism could for example be savings accounts: people put money away and do not actively use it. The money in circulation is increased or decreased by the users of the money. 

Anecdotal evidence, but there could be a ‘buffer’ of people making money more passive so the transactional money in circulation changes. The central bank would have no influence on this.

Money supply

When the central bank (CB) lends money to the economy, they will get more money back the next year: interest has to be paid as well.

Where does this extra money come from?

For example: if the CB lends/creates 100 in the first year at 7% interest, they will need to be repaid 107 at the beginning of the next year. But at that point in time, there is only 100 in the entire economy.

The solution is simple: before the repayment is due, the CB creates/lends new money to replace the earlier batch. Otherwise the economy would have nothing left. But it will need to create 107 for the economy to be able to repay the earlier loan plus interest.

You get the picture: the next year, the CB will need to create 107 + interest = 114.5 etc.

The money-stock will increase exponentially and the inflation rate in the long-term is going to be 7% (not considering other factors like technological development, demographics…)

This can go on forever and there is nothing really wrong with this, it appears.

Money demand

So, what would be the interest rate the CB needs to charge for the next year, if we did take into account other factors?

This would probably also be set by the demand for money: If the economy needs little money, the CB would not be able to replace the existing money stock plus interest at the current interest rate and the rate would need to decline. And vice-versa.

Now, it may be interesting to speculate about the reasons demand for money changes. I can think of the current money stock (if it has grown a lot recently, that may curb demand), demographic changes (a declining population may require less money), wage-growth (globalization will keep salaries in check), natural resource availability, technological advances etc.

Bitcoin

Just one thought about Bitcoin: the idea of a people-independent system of money creation is very appealing. Human behavior will have less influence. Also, the method of hacker-proving the system in Bitcoin seems good.

However, by fixing the supply side, Bitcoiners are ignoring the demand side of money requirements. Sometimes it may be appropriate to create more money. For example if a population is growing rapidly.

By ignoring the demand side of money and fixing the supply side, Bitcoin value is prone to wild swings in price.

A virtual currency would need a way to match demand and supply for money, preferably without human interference and probably price-based. How to set up such a ‘marketplace’?

Conclusion

The interest rate is set by the supply AND demand for money in the real economy. The interest rate, in the long term, equals the inflation rate of the economy. (and this is really also a definition for ‘inflation rate’).