Feb 062015
 

How Money is Created

For a country’s GDP to grow there needs to be economic expansion, which means people must earn and spend more money. But in order for additional money to exist somebody has to create it first. That’s where you and I come in. 🙂 Money is created whenever we borrow money from a bank. When we take out a $1,000 loan, for example, $1,000 of bank credit is instantly created which we can cash out and spend, which adds $1,000 into the existing currency supply in the economy. This $1,000 did not exist in the world yesterday, but it does now because we created the money by borrowing it into existence. This increases the country’s nominal economic output. Nice. 🙂  Most of the world’s money today is created this way. Even though we are now $1,000 in debt, the nation overall is better off because our extra spending just becomes income for other people.

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The opposite phenomenon can also happen. If we pay off our $1,000 loan then that money would cease to circulate in the economy and be destroyed forever through debt cancellation. This is deflationary and is what every Central Banker in the world wants to avoid. 😕

Monetary Policies

Generally if the money supply is growing then the economy is seen as healthy. More currency flowing around means more economic activities, which means more jobs, higher disposable incomes, positive inflation, and more money for everyone to save. But if the money supply is shrinking then the economy is slowing down. Too much of one or the other can have negative consequences on people’s lives so most central bankers use monetary policy to find a happy balance between inflationary and deflationary pressures by controlling the supply of money in circulation. 🙂

Interest Rates

The most common way to control the supply of money is through interest rate policies. At lower rates people are inclined to assume more debt because the cost of borrowing is cheap. The more money people borrow the more currency will be created which increases the overall money supply. On the other hand higher interest rates will stall economic growth and inflation. So if borrowing gets out of hand then making it more costly to borrow will encourage people to pay down their debts rather than borrow more money.

Printing Money

When interest rates are at zero however and can’t drop any lower central banks will often introduce newly created money into the economy. Both the U.S. and Japan have done this already, and Europe is planning to do the same soon. When consumers in the U.S. prioritize paying down their debts rather than borrowing more money they are destroying the currency supply. This increases the value of the currency and makes the country less globally competitive. The Fed desperately wants to deter a drop in the money supply so it has printed its own money several times since 2009. The U.S. dollar is just like any other commodity. The less of it there is the more desirable it becomes.

Since the last recession Americans are trying to get out of debt while Canadians continue to pile on more. The Fed, in the U.S. has injected trillions of dollars into the economy to combat the immense deflationary force of money supply reduction caused by average Americans paying down their debts.

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However, the Bank of Canada doesn’t need to print money. Canadians are already borrowing and creating enough new money to grow the economy organically. And the large commercial banks are more than happy to facilitate our appetite for debt. Canadians now owe over a trillion dollars just in residential mortgages. No wonder our banks are more profitable than ever. 😐 With so much dough already being created there is no need for the Steve Po to print any mo! 😉

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Random Useless Fact:

Although known as a classic French dish, the quiche originated in Germany.

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9 Comments on "Debt Leads to Growth – How Monetary Policies Work"

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RICARDO
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RICARDO
Should I then not pay off my credit card every month so as to keep the money in circulation. Don’t think so. All that is a good financial way to look at how money circulates in the economy. It all makes sense. But I still wonder if it would be all that bad if there was no debt and we bought what we wanted when we could pay for it, Although vary simplistic (hard to save up the cash for a house) it is never the less what numerous blogs preach…don’t spend more than you earn. Naturaly at some time we do eventually have to borrow, like that house, a few dozen F35’s, or a fleet of new destroyers or a space shuttle or two but the debt does have to be paid down at some time. What gets me the most is that a lot of people, mainly the fed, prov or mini bureaucrats think it is the government’s money (that is why they are always asking for higher wages than Joe Blo who is getting taxed to pay them) that they are spending and not the tax payers taxes (read money). It still amazes me that the government(s)… Read more »
Chris
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Chris
Hey Ricardo – You said ” Naturaly at some time we do eventually have to borrow, like that house, a few dozen F35’s, or a fleet of new destroyers or a space shuttle or two but the debt does have to be paid down at some time.” Although that is mostly true for individuals, it does not seem to be for governments. We do not like to keep excessive debt into old age, as our earning power is usually reduced, so the goal is to pay it off. Governments don’t have a lifespan, and tax revenues continue, so they can just keep rolling their debt over and over forever. In theory, it is nice if they don’t add to it, but even if it never gets paid down, assuming the world continues to grow and there is some inflation, then the same amount of debt in 50 years is actually worth a lot less. I would be happy if governments got their books in order, but I don’t think they are under the same pressure to actually pay off their debts as we are as individual people – that’s just how I see it – I could be wrong. (It… Read more »
Liquid Independence
Editor

Nice rant. Yup, it all depends on the cost of borrowing and if borrowers can continue to service their debts. 🙂 High interest rates on credit card balances should be pay off but low HELOC rates can be leveraged to make gains in the long run and provide stimulus for the economy.

JR
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JR

Liquid, I know your a really smart guy. I see that your trying to simplify the issue so as to not ramble; but you’ve left some very large gaps in your explanation of how money is created with fractional reserve banking. The banks don’t issue credit, they themselves borrow from another entity (depositors and central banks).

Money is a giant cycle. Saving is on one end, borrowing/spending is on the other; and there is a natural balance to the cycle in the free market. This cycle can be shifted by government intervention (ex: interest rates).

I like to use the example of a private citizen spending money (or borrowing) to buy a F150, vs that citizen investing in a business who then borrows money to buy a F150. Money flows in a cycle.

I do however believe that Yes, the velocity of money has slowed down since 2008. I don’t think it’s wise to just think it’s just from people not borrowing enough. We are also facing some huge demographic issues in North America, Europe, and Japan; and it’s possible that with retiring baby boomers, it might be awhile before we see a return to same velocity of money.

Liquid Independence
Editor

I like your example with the truck. I hear the F-series is the best selling line of pickups in Canada. I wanted to explain fraction reserve banking, the inevitable demographic predicament, and the velocity of money, but I didn’t want the post to seem too wordy lol. All great topics for future posts though. 🙂

Financial Underdog
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Good god, just once in my life I wish we were more like Americans 🙂

Liquid Independence
Editor

Excuse me while I go super size my meal and play some handegg. 🙂

Paul N
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Paul N
I’m a little bit with Ricardo on this one. In theory some borrowing is good, but unfortunately IMO politics, bad decisions, and no exit plan (for QE) throw out any real sensible way to use credit wisely in that regard. QE is an experiment. No one really knows the outcome. There are some things going on in the world economically that we have never seen before in our lifetimes. Look at Greece. This is your “Debt leads to Growth model” out of control. As for the big gap between the US and Canada, I believe I can offer a simple explanation for that. House prices here have not taken a 75% haircut like they have for the Americans after 2008 till now. I can purchase many quality properties in the US, that would compare to mine in Canada for 25% of the price. So in the USA your mortgage may be $75,000.00. On the same house here it may easily be $300,000.00 or more. I think a lot of that gap is house debt which again only time will tell may be bad or good.. Maybe I don’t see where you are going with this series your doing, but its… Read more »
Liquid Independence
Editor

Too much poorly managed debt can lead to disaster. Greece is a good example of that as you’ve pointed out. It’s almost incomprehensible how the country got to 180% debt to GDP lol. I didn’t really have an end goal for this series when I began. I just wanted to show readers a different perspective on debt and how it can affect our lives in many indirect ways. 🙂 But of course some people like yourself already know all of this.

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