Before producing money and putting it into circulation in the form of cash (coins and notes), countries' central banks, which are responsible for issuing money, plan the measures needed to ensure the stability of the money supply. Another type of money is bank money, which is created by commercial banks. We want to explain what the difference is and how each of them works.
Have you ever thought that a country’s economic problems could be solved simply by printing more money and giving it to the public? While this may, at first sight, seem like a very attractive option, the reality is that the economy doesn't work like that. In fact, it requires planning since printing cash without following a monetary policy can harm the financial wellbeing of society, starting with the rapid devaluation of its currency, or with inflation.
The only organisations that have the power to issue money in cash, namely notes and coins, are the central banks of each country or specific region. They do this while following a monetary policy that ensures price stability and economic growth. In other words, these institutions make decisions with the aim of tailoring the money supply to meet different economic objectives.
What is Modern Monetary Theory?
Broadly speaking, the idea behind this economic theory is that governments governments with a fiat currency system under their control can and should print (as much money as they need to meet their financial obligations, such as repaying debts, purchasing services or boosting the economy through their own investments. Since they have an unrestricted ability to put money into circulation, they cannot be insolvent when it comes to meeting their obligations, since they can always create as much money as they need.
Issuing cash to inject liquidity into the economy
In general, issuing new money is designed to provide the economy with liquidity. For example, it creates incentives for consumption and access to finance which promotes industrial growth, economic development and innovation. In general, properly issuing money is linked to economic expansion. As a reminder, the functions of money include acting as a tradable currency for purchasing goods and services, determining the price of those goods and services in commercial transactions (unit of account), and acting as a store of value.
In practice, coins and notes circulate in the places where they are a means of payment (shops, restaurants, public transport etc.). Some cash may leave these areas if it is used to make payments in other places or as a safe-haven asset for other countries whose own currency has become devalued. Central banks need to issue money to ensure that there is an adequate flow of coins and notes that allows the economy to function properly.
What factors are taken into account when issuing money in cash?
The money circulating in the street is a reflection of a country's wealth. As such, when a central bank decides to print more money, it must be sure that it has sufficient assets to back the value of the issue it is going to make. The process of obtaining these assets is called monetary base creation, and it is an essential step to ensure that the circulation of the new money reflects the economic reality and that the economy grows in a healthy way.
There are several options available for central banks to increase their monetary base. The most common are buying precious metals such as gold, increasing the loans granted to the public sector and the banking system, and investing in the debt market, among other types of asset acquisition. The more assets a central bank has, the more money it can justify issuing.
However, what happens if it decides to issue money without increasing its assets? In this case, let's imagine that the central bank has in its reserves 1 kilogram of gold, which is represented by €1000 (or dollars, pounds, pesos etc.) that are in circulation. In other words, every euro is backed by 1 gram of that gold. If it prints an extra €1000, it will also need to have one more kilogram of gold to back this up. If it doesn't have it, the money circulating (both old and new) will now only be worth half the original amount: €2000 euros backed by the same 1000 grams of gold means 0.5 grams per euro. This is a reduction in the value of the money, or devaluation.
Differences between cash and bank money
In addition to cash, which in reality represents a small part of the total amount of money circulating in an economy, there is another type of money known as bank money, which is created by commercial banks. This second type of money refers to the amounts that users have in bank deposits and that are available at any moment, either through ATMs, means of payment such as bank cards, or electronic payments.
The banks also need to have reserves. These are a set minimum percentage of the total amount of deposits and current accounts (known as the reserve requirement) and their purpose is to deal with potential withdrawals of funds. The rest of the money in its assets can be used to offer loans or financing to other users, thereby increasing the amount of money operating in the economy. Let's look at an example that will make this easier to understand:
Andrew pays €1000 euros into his account. The bank sets aside €100 for its reserve requirement, and the other €900 is lent to Daniel, who in turn uses it to buy something online via a bank transfer. In summary, Andrew's original €1000 have led to a process that included three different transactions (a deposit, a loan and a transfer) with one single initial amount.
Therefore, the decision to issue new coins and notes depends on various factors. To ensure price stability, meaning an absence of significant changes in prices in an economy, money is issued in an organised manner in keeping with the economic situation in the countries or regions where the money will circulate.