Monday, December 13, 2010

Monetary System


In common situation, lending occurs when there is something to lend. Did you ever heard about the lending itself creating the thing to be lent? The things itself doesn’t exist anywhere before the lending activities occurred. This is what actually happens today in a so called monetary system. To understand the monetary system, we need to look on the history of money creation.
                The money begins as receipts issued by goldsmith. People who want to claim their gold from goldsmith, all they need is to show the receipts. After a long time, people start to use the receipts in the market because it was more convenient as compared to the gold coins.  The goldsmith start to realize that the likelihood of all of the people would come at the same time to claim their gold is almost impossible.  They begin to manipulate the situation in order to gain more profit by producing receipts or money more than the gold they have in repository. The money created was given as loan to the people and they charge interest on it.  Today’s monetary system occurs almost the same way as the above situation even though the current system involved the use of some new terms like debt, bond, fractional reserve system and inflation. We would go one by one into detail.
                Whenever government need money or fund, it would goes to central bank (in US it was called Federal Reserve System, it name varies among countries). The government would write a check or called as bond. Let say the government produce 100 dollars bond and then it goes the central bank. The central bank would then type 100 dollars into the government account. The bond itself is the debt instrument which means that the government owe the central bank for 100 dollars.  The 100 dollars money was then deposited into commercial bank.  The money is available to the public through loan. However, under fractional reserve system, it was stated that the bank must kept 10% from its deposit as reserve, and so, 90 dollars were available for loan. It was quite straightforward to understand that the 90 dollars come out from 100 dollars deposit. However, it was not actually the case. The 90 dollars were simply created on top of 100 dollars deposit and now the total amount of money is 190 dollars. This is how the money supply was expanded. Now we could understand that the money is created whenever there is demand for it or loan. Previously, the money doesn’t exist anywhere; it was just created when there is loan. This is the explanation for the situation given in the first paragraph.
                The previous 90 dollars creates another 81 dollars which are available for a new loan. This loan cycle can created 900 dollars from 100 dollars. The expansion of money supply creates inflation in which the buying power of the money is gradually reduces. For example, central bank has 1 ounce gold and the bank produce 100 dollars money to represent that 1 ounce gold. From time to time, with the expansion of money; more money would be created. Taking the previous situation in which the total amount of money in circulation is 1000 dollars, that amount now represent 1 ounce gold instead of 100 dollars previously. This is how the money value reducing with the expanding of money supply. Beyond than that, the inflation is the hidden tax charge to the public without their conscious. Whenever the government produce more money for funding its program, the more money the public would pay for purchasing goods through the reducing of the money’s purchasing power.
                The purpose of this article is not to judge the present monetary system; it is just to show how it works in brief. Any comments are welcomed. If this article is can’t be understood at all, please click log on to the original sources provided below:

Money as Debt
Zeitgeist: Addendum
Money, Banking and the Federal Reserve (HQ)