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The Origin of Money – Part II: Book Money

The Origin of Money – Part II: Book Money

In economic life, people often use banknotes and coins to make small purchases. But when larger amounts are involved, they pay by credit transfer or with a bank card instead of cash.

This means that the money is transferred from the payer's bank account to the receiver's bank account. The payer's credit balance decreases while the receiver's balance increases.

The credit balance in a bank account is known as book money. The banks book their cus-tomers' payments to their bank accounts. When a bank customer withdraws money from his or her account, the book money is turned into cash. When its customer makes a cash pay-ment into the account, the cash becomes book money again. No new money is created by withdrawing from or paying into an account. The money merely changes its form. In the euro area, there is much more book money than cash.

But how is this book money created?

The banks create new book money when they grant loans. For example, Mr Müller needs a loan to buy a car. He negotiates this with the bank's loan officer. The bank grants a loan to Mr Müller. The loan amount is credited to his account and his credit balance increases. The bank has created new book money. It did this without needing to raise any savings deposits first.

Mr Müller has to pay interest on the loan. The interest is the price of the loan. Mr Müller can now use this credit balance for payments. For example, he can make a bank transfer to pay for a car. The bank then transfers the credit balance from his account to the car seller's ac-count. The book money "flows" from one account to the other, and Mr Müller gets the car.

he banks therefore create book money by granting loans.

There is also another way to create book money. A bank purchases assets – for example, shares, gold or property – from its customer, Ms Meier. The bank then credits Ms Maier's ac-count with the purchase amount. This procedure can also work in reverse. The bank sells assets to Ms Maier and then withdraws the purchase amount from her credit balance as payment. This decreases the stock of book money. Book money is also "destroyed" each time when Mr Müller pays back an instalment of the loan.

In an economy, new loans are being granted, old loans are being paid back, and assets are being bought and sold by banks all the time. The amount of book money is therefore con-stantly changing. Businesses can use loans for investment, for instance to buy new machin-ery and increase production. This enables the economy to grow. As a result, in a growing economy, stocks of book money usually grow, too.

But how much book money can banks create?

As described earlier, book money is largely created by granting loans. However, a business will only take out a loan if it has investment projects planned and if the expected returns are high enough to generate the required interest on the loan. The banks in turn check whether the borrower will be able to pay the interest and pay off the loan. Because if the borrower cannot pay the interest and repay the loan, the bank will incur a loss.

The banks also keep a constant eye on the costs that may incur by granting loans and creat-ing book money. For example, if the customer uses the new credit balance to transfer money to an account at another bank, from the bank's point of view money will be flowing out. The bank then often has to recover this money, for example by taking out a loan from another bank, or by "refinancing" itself with a loan from the central bank. Alternatively, it can persuade savers to invest cash or credit balances at the bank in the form of savings or fixed-term deposits.

As a rule, the bank has to pay interest on these refinancing measures. The banks' willingness to create book money therefore depends on how high the cost of interest is for the bank itself.

In addition, every bank has to stick to the banking supervision regulations. This, too, limits the banks' capacity to grant loans and create additional book money.

Central banks also exert influence on the creation of book money through their monetary pol-icy. In the euro area, these are the European Central Bank and the national central banks of the euro-area countries – in Germany, the Deutsche Bundesbank.

An important monetary policy instrument is the policy rate, which is applied throughout the euro area. It is the rate of interest that the banks have to pay to the central bank on their loans.

If inflation is looming, the central bank raises the policy rate. As a rule, interest rates on loans then go up, too, which scares off many customers. As a result, the banks grant fewer loans and less book money is created.

If there is a risk of deflation, the central bank lowers the policy rate. Interest rates on loans then generally go down as well. This encourages many customers to borrow, thus more book money is created.

In short, banks can create book money. The most important factors determining the creation of money are the economy's demand for loans, the cost of interest for borrowers and banks, the counterparty credit risk, banking supervision regulations and the central bank's monetary policy.

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