The common belief is that the government requires funds to support its spending, Central Banks print currency, and banks lend and expand customers’ money in a fractional reserve banking system. However, this is far from the truth.
There are two separate tiers of money in our monetary system: real-economy money (which has the potential to be inflationary) and financial-sector money (which can cause asset-price inflationary). Governments and commercial banks produce real-economy money, while central banks print financial-sector money.
Real-economy money is used by non-financial private sector agents such as households and corporations for transactions that contribute to economic activity. If there is more real-economy money in circulation, economic growth is more likely to be robust. However, a sudden increase in real-economy money when the supply of goods and services can’t keep up can lead to significant inflationary pressure.
On the other hand, financial-sector money is used by financial institutions such as banks, pension funds, and asset managers.
Contrary to popular belief, QE (Quantitative Easing) doesn’t equal money printing. Rather, QE results in more financial-sector money instead of real-economy money.
Banks create real-economy money through the creation of new bank deposits every time they issue a loan. They don’t lend reserves or existing deposits. When making new loans, banks expand their balance sheet and credit the customer’s account out of nowhere.
The government is another real-economy money generator. When the government spends more than it receives in taxes (deficits), new real-economy money is typically created. Deficit spending boosts the private sector’s net worth without adding any liability to it. Moreover, deficit spending increases the volume of non-financial private sector deposits (i.e., real-economy money) as long as households do not need to purchase the Treasuries issued by the government.
In conclusion, banks and governments produce real-economy money, while central banks print financial-sector money.
Source Credits: Bloomberg, Reuters, Mr. Alf
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