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Money

From Academic Kids

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Money is any marketable good or token used by a society as a store of value, a medium of exchange, or a unit of account. Money objects can meet some or all of these needs. Since the needs arise naturally, societies organically create a money object when none exists. In other cases, a central authority creates a money object; this is more frequently the case in modern societies with paper money.

Commodity money was the first form of money to emerge. Under a commodity money system, the object used as money has inherent value. It is usually adopted to simplify transactions in a barter economy; thus it functions first as a medium of exchange. It quickly begins functioning as a store of value, since holders of perishable goods can easily convert them into durable money. In modern economies, commodity money has also been used as a unit of account. Gold-backed currency notes are a common form of commodity money.

Fiat money is a relatively modern invention. A central authority creates a new money object that has minimal intrinsic value. In this case, the public's faith in the money exists only because the central authority mandates the money's acceptance. In cases where the public loses faith in the fiat money, there is little a central authority can do to prevent the adoption of other money objects by society.

Contents

Overview

Money itself must be a scarce good. Many items have been used as money, from naturally scarce precious metals and conch shells through cigarettes to entirely artificial money such as banknotes.


Modern money (and most ancient money too) is essentially a token -- an abstraction. Paper currency is perhaps the most common type of physical money today. However, goods such as gold or silver retain many of the essential properties of money.

The origin of the word "money" comes from the Latin word "moneta", which comes from the temple of Hera the Moneta where the Roman money came from, in the early days of Rome.

In Greek language, "Hera Mone tas" means the lonely Hera ("Mone tas" is in Doric Greek, it is "Mone tes" in Ionic dialect). Zeus, once upon times, punished Hera and tied her with a golden chain between earth and sky. Hera , because she was alone between sky and earth tied with gold, was called moneres or mone (μόνη) which means lonely, and this is where the word money comes from. Hera, with the help of Hephaestus, broke the golden chain and released herself. It is said that all gold found on earth (which forms approximately a single cube 20 m a side, so you can imagine how Hera looked inside it) originates from the fragments of this golden chain, which fall from the sky and became human's mone(y).

Maybe due to this fable, gold was used in ancient Greece only in temples, graves and jewels and there is not any ancient Greek golden coin, until the days around 390 BC, when the Greek king Philip II of Macedon coined golden coins. The first golden coins in history were coined by Lydian king Croesus , around 560 BC. The first Greek coins were made initially of copper, then of iron and this is because copper and iron were powerful materials used to make weapons. Pheidon king of Argos, around 700 BC, changed the coins from iron to a rather useless and ornamental metal, silver, and, according to Aristotle, dedicated some of the remaining iron coins (which were actually iron sticks) to the temple of Hera[1] (http://www.metrum.org/money/heraion.htm). King Pheidon coined the silver coins at Aegina, at the temple of the goddess of wisdom and war Athena the Aphaia (the vanisher), and engraved the coins with a Chelone, which is used until nowdays as a symbol of capitalism. Chelone coins[2] (http://www.snible.org/coins/hn/aegina.html) were the first medium of exchange that was not backed by a real value good. They were widely accepted and used as the international medium of exchange until the days of Peloponnesian_War, when the Athenian Drachma replace them. According other fables, inventors of money were Demodike(or Hermodike) of Kyme (the wife of Midas), Lykos (son of Pandion II and ancestor of the Lycians) and Erichthonius, the Lydians or the Naxians.

The word money in Greek language is not μόνη (money), it is νόμισμα (nomisma or numisma) which derives from the word νομίζω (nomizo=putative,I think so,I suppose so) and from the word νόμος (nomos=law). So numisma gives the exact meaning and definition of mone(y). It is something we think it has value, or something that someone convinced us it has, but in reality it has not. Also, in case we are not convinced that mone(y) has value and we do not recognize the mone(y) maker authority, mone(y) is also something that we are enforced by law to use it as the unique medium of exchange in trades. In case an individual or a community refuses to accept mone(y) as the unique medium of exchange, then the powerful mone(y) maker authority, using violence and the taxes procedure, steals the real value goods (home,food,transport,energy) that the individual or the community owns. Thats why many individuals or communities hide their goods from mone(y)-maker authorities. The crime of hiding goods from a mone(y)-maker authority is called tax evasion.

One of the words for money in the Hebrew language is mammon. Mammon does have more than one meaning depending on its linguistic and etymological contexts. The Hebrew and Christian Bible gives the word mammon a broader context in terms of its socioeconomic,cultural,and theological usages. Mammon, a word of Aramaic origin, means "riches", but has an unclear etymology; scholars have suggested connections with a word meaning "entrusted", or with the Hebrew word "matmon", meaning "treasure". It is also used in Hebrew as a word for "money" - ממון. The Greek word for "Mammon", mamonas, occurs in the Sermon on the Mount (Matthew vi 24) and in the parable of the Unjust Steward (Luke xvi 9-13). The Authorised Version keeps the Syriac word. Wycliffe uses "richessis". Other scholars derive Mammon from Phoenician "mommon", benefit. An interesting notice is that if you consider the word mammon(as) (μαμωνTemplate:Polytonicς) as a Greek word and as a composite one (the majority of Greek words are composites), then the two parts "mam-mon(as)" could be explained (in Greek doric) as "lonely mother", which reminds Hera's myth mentioned above. Other explanations could be mamm(means "mother" or "food")-onas(means "a place where you can find mamm"), also mam(means "mother" or "food")-m(means "with")-on(means "being")-as(with Circumflex, means "owner or seller").

"To him that overcometh will I give from the hidden manna and will I give him a white vote, and on the vote a new name written, which no one can understand except the one receiving it" (Apocalypse B-17).


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Moneybillscoins3.jpg
Bills and coins of several countries and values.

Essential characteristics of money

Money has the following three characteristics.

1. It must be a medium of exchange

When an object is in demand primarily for its use in exchange -- for its ability to be used in trade to exchange for other things -- then it has this property.

This characteristic allows money to be a standard of deferred payment, i.e., a tool for the payment of debt.

2. It must be a unit of account

When the value of a good is frequently used to measure or compare the value of other goods or where its value is used to denominate debts then it is functioning as a unit of account.

A debt or an IOU can not serve as a unit of account because its value is specified by comparison to some external reference value, some actual unit of account that may be used for settlement.

For example, if in some culture people are inclined to measure the worth of things with reference to goats then we would regard goats as the dominant unit of account in that culture. For instance we may say that today a horse is worth 10 goats and a good hut is worth 45 goats. We would also say that an IOU denominated in goats would change value at much the same rate as real goats.

3. It must be a store of value

When an object is purchased primarily to store value for future trade then it is being used as a store of value. For example, a sawmill might maintain an inventory of lumber that has market value. Likewise it might keep a cash box that has some currency that holds market value. Both would represent a store of value because through trade they can be reliably converted to other goods at some future date. Most non-perishable goods have this quality.

Many goods or tokens have some of the characteristics outlined above. However no good or token is money unless it can satisfy all three criteria.

Credit as money

Credit is often loosely referred to as money. However credit only satisfies items one and three of the above "Essential Characteristics of Money" criteria. Credit completely fails criteria number two. Hence to be strictly accurate credit is a money substitute and not money proper.

This distinction between money and credit causes much confusion in discussions of monetary theory. In lay terms credit and money are frequently used interchangeably. Even in economics credit is often referred to as money. For example bank deposits are generally included in summations of the national broad money supply. However any detailed study of monetary theory needs to recognize the proper distinction between money and credit.

The rest of this article frequently uses the term money in the looser sense of the word.

Desirable features of money

To function as money in a modern economy a good or token should possess a number of features:

  • It must have a stable value.
  • It must be difficult to counterfeit.
  • It must be easily divisible and transportable.
  • It must be fungible. That is, one artifact of the token or good must be equivalent to another.

Modern forms of money

When using money anonymously, the most common methods are cash (either coin or banknotes) and stored-value cards.

When using money substitutes in such a way as to leave a financial record of the transaction, the most common methods are checks, debit cards, credit cards, and digital cash.

Money and economics

Money is one of the most central topics studied in economics and forms its most cogent link to finance.

The amount of money in an economy directly affects inflation and interest rates and hence has profound effects. A monetary crisis can have very significant economic effects, particularly if it leads to monetary failure and the adoption of a much less efficient barter economy. This happened in Russia (for instance) during the 1990s.

Modern economics also faces a difficulty in deciding what exactly 'is' money. See money supply

There have been many historical arguments regarding the combination of money's functions, some arguing that they need more separation and that a single unit is insufficient to deal with them all. These arguments are covered in financial capital which is a more general and inclusive term for all liquid instruments, whether or not they are a uniformly recognized tender.

History of money

Before money

Prior to the introduction of money, barter and gifting were the only ways to exchange goods. Bartering has several problems, most notably timing constraints. If you wish to trade pigs for wheat, you can only do this when the pigs and wheat are both available at the same time and place - and without proper storage that may be a very brief time. With a trade standard like gold, you can sell your pigs at the "best time" and take the gold coins. You can then use that gold to buy wheat when the harvest comes in. Thus the use of money makes all commodities become more liquid.

Where trade is common, barter systems usually lead quite rapidly to the emergence of several key goods with monetary properties. In the early British colony of New South Wales in Australia, rum emerged quite soon after settlement as the most monetary of goods. When a nation is without a fiat currency system it is quite common for the fiat currency of a neighbouring nation to emerge as the dominant monetary good. In some prisons where conventional money is prohibited it is quite common for goods such as cigarettes to take on a monetary quality. Gold has emerged naturally from the world of barter again and again to take on a monetary function. It should be noted that the emergence of monetary goods is not dependent on central authority or government. It is a quite natural market phenomenon.

Commodity money

 have been a common form of money, such as this  from .
Enlarge
Precious metals have been a common form of money, such as this gold from Sveriges Riksbank.

The first instances of money were objects which were useful for their intrinsic value. This was known as commodity money and included any commonly-available commodity that has intrinsic value; historical examples include pigs, rare seashells, whale's teeth, and (often) cattle. In medieval Iraq, bread was used as an early form of currency.

Spices have been used as commodity money for long. Definite indications are available that both black and white pepper have been used as commodity money for hundreds of years before Christ, as also several centuries thereafter. Being a valuable commodity, pepper has naturally been used as payment. Attila the Hun reportedly demanded 3,000 pounds in weight of pepper in 408 AD as part of a ransom for the city of Rome. In the Middle Ages, there was a French saying, 'As dear as pepper'. In England, rent could be paid in pounds of pepper, and so a symbolic minimal amount is known as a "peppercorn rent".

Even in the industrialised world, in the absence of other types of money, people have occasionally used commodities such as tobacco as money. This last happened on a wide scale after World War II when cigarettes became used unofficially in Europe, in parallel with other currencies, for a short time.

Another example of "commodity money" is shell money in the Solomon Islands. Shells are painstakingly chipped into rough circles, filed down, and threaded onto large necklaces, which are then used during marriage proposals; for instance, a father may charge twenty shell money necklaces for his daughter's hand in marriage.

One interesting example of commodity money is the huge limestone coins from the Micronesian island of Yap, quarried at great peril from a source several hundred miles away. The value of the coin was determined by its size — the largest of which could range from nine to twelve feet in diameter and weigh several tons. Displaying a large coin, often outside one's home, was a considerable status symbol and source of prestige in that society. (Due to the great inconvenience, islanders would often trade only promises of ownership of an individual coin instead of actually moving it. In some cases, coins which had been lost at sea were still used for exchange in this way. These agreements could be thought of as a kind of representative money, described below.)

An 8-foot "coin" from the village of Gachpar, on .
Enlarge
An 8-foot "coin" from the village of Gachpar, on Yap.

Once a commodity becomes used as money, it takes on a value that is often a bit different from what the commodity is intrinsically worth or useful for. Being able to use something as money in a society adds an extra use to it, and so adds value to it. This extra use is a convention of society, and how extensive the use of money is within the society will affect the value of the monetary commodity. So although commodity money is real, it should not be seen as having a fixed value in absolute terms. Its value is still socially determined to a large extent. A prime example is gold, which has been valued differently by many different societies, but perhaps none valued it more than those who used it as money. Fluctuations in the value of commodity money can be strongly influenced by supply and demand whether current or predicted (if a local gold mine is about to run out of ore, the relative market value of gold may go up in anticipation of a shortage).

Money can be anything that the parties agree is tradable, but the usability of a particular sort of money varies widely. Desirable features of a good basis for money include being able to be stored for long periods of time, dense so it can be carried around easily, and difficult to find on its own so that it is actually worth something. Again, supply and demand play a key role in determining value.

Metals like gold and silver have been used as commodity money for thousands of years, being in the form of metal dust, nuggets, rings, bracelets and assorted pieces. Eventually the Lydians began coining gold and silver around 560 BC.

Gold and silver are both quite soft metals, and coins minted from the pure metals suffer from wear or deformation in daily use. Fortunately these metals are also easily alloyed with a less expensive metal, frequently copper, in order to improve the durability of the resulting coins. Typically alloys of coinage metals, such as sterling silver or 22 carat (92%) gold, are used to make coins more durable. These are alloys of 90% or more precious metal as alloys of less than 90% do not improve hardness or durability very much, and so are typically considered to be on the slippery slope into monetary debasement.

Standardized coinage

A  , a standardized  coin.
A Roman denarius, a standardized silver coin.

It was the discovery of the touchstone that paved the way for metal-based commodity money and coinage. Any soft metal can be tested for purity on a touchstone, allowing one to quickly calculate the total content of a particular metal in a lump. Gold is a soft metal, which is also hard to come by, dense, and storable. For these reasons gold as a money spread very quickly from Asia Minor where it first gained wide use, to the entire world.

Using such a system still required several steps and some math. The touchstone allowed you to estimate the amount of gold in an alloy, which was then multiplied by the weight to find the amount of gold alone in a lump.

To make this process easier, the concept of standard coinage was introduced. Coins were pre-weighed and pre-alloyed, so as long as you were aware of the origin of the coin, no use of the touchstone was required. Coins were typically minted by governments in a carefully protected process, and then stamped with an emblem that guaranteed the weight and value of the metal. It was however extremely common for governments to assert that the value of such money lay in its emblem and to subsequently debase the currency by lowering the content of valuable metal.

Although gold and silver were commonly used to mint coins, other metals could be used. Ancient Sparta minted coins from iron to discourage its citizens from engaging in foreign trade. In the early seventeenth century Sweden lacked more precious metal and so produced "plate money," which were large slabs of copper approximately 50cm or more in length and width, appropriately stamped with indications of their value.

Metal based coins had the advantage of carrying their value within the coins themselves — they induced on the other hand manipulations: the clipping of coins in attempts to get and recycle the precious metal. The bigger problem was the simple co-existence of gold, silver and copper coins in Europe's nations. English and Spanish traders valued gold coins at a higher rate of silver coins than their neighbours would do, with the effect that the English gold-based guinea coin began to rise against the English silver based crown in the 1670s and 1680s and with the consequence that silver was ultimately pulled out of England for dubious amounts of gold coming into the country at a rate no other European nation would share. The effect was worsened with Asian traders not sharing the European appreciation of gold altogether — gold left Asia and silver left Europe in quantities European observers like Isaac Newton, Master of the Royal Mint observed with uneasiness (http://www.pierre-marteau.com/currency/ed/newton-1717-09-25.html;).

Stability came into the system with national Banks guaranteeing to change money into gold at a promised rate, it did, however, not come easily. The Bank of England risked a national financial catastrophe in the 1730s when customers demanded their money to be changed into gold in a moment of crisis. Eventually London's merchants saved the bank and the nation with financial guarantees.

See also: Roman currency, coinage metal, for conversions of the European coins before the introduction of paper money: The Marteau Early 18th-Century Currency Converter (http://www.pierre-marteau.com/currency/converter.html).

Representative money

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5_Silver_US_Dollars_1896.jpg
An example of representative money, this 1896 note could be exchanged for five US Dollars worth of silver.

The system of commodity money in many instances evolved into a system of representative money. In this system, the material that constitutes the money itself had very little intrinsic value, but none the less such money achieves significant market value through being scarce as an artifact.

Paper currency and non-precious coinage was backed by a government or bank's promise to redeem it for a given weight of precious metal, such as silver. This is the origin of the term "British Pound" for instance; it was a unit of money backed by a Tower pound of sterling silver - hence the currency Pound Sterling.

For much of the nineteenth and twentieth centuries, many currencies were based on representative money through the use of the gold standard.

Fiat money

An example of fiat money is the new, international currency, the . Its introduction changed the face of money, superseding many of the world's oldest currencies.
An example of fiat money is the new, international currency, the Euro. Its introduction changed the face of money, superseding many of the world's oldest currencies.

Fiat money refers to money that is not backed by reserves of another commodity. The money itself is given value by government fiat (Latin for "let it be done") or decree, enforcing legal tender laws, previously known as "forced tender", whereby debtors are legally relieved of the debt if they (offer to) pay it off in the government's money. By law the refusal of "legal tender" money in favor of some other form of payment is illegal, and has at times in history (Rome under Diocletian, and post-revolutionary France during the collapse of the assignats) invoked the death penalty.

Governments through history have often switched to forms of fiat money in times of need such as war, sometimes by suspending the service they provided of exchanging their money for gold, and other times by simply printing the money that they needed. When governments produce money more rapidly than economic growth, the money supply overtakes economic value. Therefore, the excess money eventually dilutes the market value of all money issued. This is called inflation. See open market operations.

In 1971 the US finally switched to fiat money indefinitely. At this point in time many of the economically developed countries' currencies were fixed to the US dollar (see Bretton Woods Conference), and so this single step meant that much of the western world's currencies became fiat money based.

Following the first Gulf War the president of Iraq, Saddam Hussein, repealed the existing Iraqi fiat currency and replaced it with a new currency. However, the old currency continued to be used in the politically isolated Kurdish regions of Iraq. Despite having no backing by a commodity and with no central authority mandating its use or defending its value it continued to circulate within this Kurdish region. It became known as the Swiss Dinar. This currency remained relatively strong and stable for over a decade. It was formally replaced following the second Gulf War.

Credit money

Credit money often exists in parallel with other money such as fiat money or commodity money, and from the user's point of view is indistinguishable from it. Most of the western world's money is credit money derived from national fiat money currencies.

Strictly speaking a debt is not money, primarily because debt can not act as a unit of account. All debts are denominated in units of something external to the debt. Hence credit money is not strictly money at all. However, credit money certainly acts as a money substitute when it comes to the other functions of money (medium of exchange and store of value). As such the existence of credit money may dampen demand for the real money and in so doing alter the dynamics of money's market value.

When paper money is merely an IOU for something such as gold, then the paper itself is not a unit of account but merely a convenient medium of exchange. Under a rigid gold-standard with convertibility, paper currency is merely a debt instrument. However, when paper money floats, its value is not defined by reference to an external unit of account. It is no longer a debt instrument but rather it becomes purely monetary and its value is a product of the dynamics of supply and demand. Typically a central bank forces supply and the private sector forces demand. See open market operations.

Credit money tends to arise as a byproduct of lending and borrowing money. The following example illustrates this.

Imagine you have deposited some gold coins in a bank vault. The bank might lend the coins to a second person based on a promise to pay equivalent coins back with a few extra at a time in the future. The second person can in the meantime use the coins normally as money. But you still own the coins, and you also could still use them - you could transfer their ownership to another person to pay for something you have bought by telling the bank to transfer them from your account to the other person's account. You might do this by writing a check. So in this simple example there are two people using the same coins as money at the same time. It's as if new money has been created by the act of lending. Taking it another step, if the second person spends the coins at a shop, and they end up being deposited back into the bank by the shopkeeper, the bank can lend them again. Now you and the shopkeeper can use the coins in the same way, by writing checks or the equivalent in this example, and whoever borrows the coins a second time can use the coins directly as money. So there are three people with financial use of the coins. This can go on with many people ending up simultaneously using the same coins financially, but for each extra user there is a promise to pay equivalent coins back. These arrangements where many people use the same money simultaneously are in many respects the same as if there was extra money. The extra money that there appears to be is known as credit money. It is in regulating the amount of money a bank can lend that the controlling authority can set the money supply and change monetary policy. The credible promises to repay in a reasonable time give the extra money its value. It tends to exist in parallel with another form of money such as fiat money or commodity money, wherever banking-style loans are used, and occurs as a by-product of lending. It could occur without banks, but banks provide a degree of stability to the whole process by taking and evaluating the risk involved in each loan.

During the Crusades in Europe, precious goods would be entrusted to the Catholic Church's Knights Templar, who effectively created a system of modern credit accounts. Over time this system grew into the credit money that we know today, where banks create money by approving loans - although the risk and reserve policies of each national central bank sets a limit on this, requiring banks to keep reserves of fiat money to back their deposits. Sometimes, as in the U.S.A. during the Great Depression or the Savings and Loan crisis, trust in bank policies drops very low and government must intervene to keep the industry of credit in operation.

Private currencies

In many countries, the issue of private paper currencies has been severely restricted by law.

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Delaware_Bridge_Company_Dollar.jpg
A private $1 note, issued by the "Delaware Bridge Company" of New Jersey 1836-1841.

In the United States, the Free Banking Era lasted between 1837 and 1866, during which almost anyone could issue their own paper money. States, municipalities, private banks, railroad and construction companies, stores, restaurants, churches and individuals printed an estimated 8,000 different monies by 1860. If the issuer went bankrupt, closed, left town, or otherwise went out of business the note would be worthless. Such organizations earned the nickname of "wildcat banks" for a reputation of unreliability and that they were often situated in far-off, unpopulated locales that were said to be more apt to wildcats than people. In the other hand, according to Lawrence H. White's article in FEE (http://www.fee.org/vnews.php?nid=2794) "it turns out that “wildcat” banking is largely a myth. Although stories about crooked banking practices are entertaining—and for that reason have been repeated endlessly by textbooks—modern economic historians have found that there were in fact very few banks that fit any reasonable definition of wildcat bank." The National Bank Act of 1863 ended the "wildcat bank" period.

In Australia, the Notes Act of 1910 basically shut down the circulation of private currencies by imposing a prohibitive tax on the practice. Many other nations have similar such policies that eliminate private sector competition. In Scotland and Northern Ireland private sector banks are licensed to print their own paper money by the government.

Today there are several privately issued digital currencies in circulation that function as money. Transactions in these currencies represent an annual turnover value in billions of US dollars. Many of these private currencies are backed by older forms of money such as gold (digital gold currencies). Of course, because money is the fruit of power and can be used for wielding or gaining more power, the one who accepts gold as legitimate money gives power to the people who own gold's stocks. In the other hand gold is stable over thousands of years and has survived the test of time. All the other materials have become less important as gold has proved itself the superior unit of account. Basically, price fluctuations of gold are not because the value of gold has changed, but because the value of the currency has changed. The same happens with some other materials, like food or energy or transport or accommodation. A plate of food has always the same value, whatever its price is.

It is possible for privately issued money to be backed by any other material, although some people argue about perishables materials. After all, gold or platinum or silver have in some regards less utility than previously (their electrical properties notwithstanding), while currency backed by energy (measured in watts) or by transport (measured in kilogramme*kilometre/hour) or by food [3] (http://www.economist.com/markets/bigmac/displayStory.cfm?story_id=3503641) is also possible and may be accepted by the people, if legalised. It is important to understand though that, as long as money is above all an agreement to use something as a medium of exchange, its up to the community (or to the minority which holds the power) to decide whether money should be backed by whatever material or should be totally virtual.

Money supply

Main article: Money supply

The money supply is the amount of money available within a specific economy available for purchasing goods or services. The supply is usually considered as four escalating categories M0, M1, M2 and M3. The categories grow in size with M3 representing all forms of money (including credit) and M0 being just base money (coins, bills, and central bank deposits). M0 is also money that can satisfy private banks' reserve requirements. In the United States, the Federal Reserve is responsible for controlling the money supply (monetary policy).

Growing the money supply

Historically money was a metal (gold, silver, etc,) or other object that was difficult to duplicate, but easy to transport and divide. Later it consisted of paper notes, now issued by all modern governments. With the rise of modern industrial capitalism it has gone through several phases including but not limited to:

  1. Bank notes - paper issued by banks as an interest-bearing loan. (These were common in the 19th century but not seen anymore.)
  2. Paper notes, coins with varying amounts of precious metal (usually called legal tender) issued by various governments. There is also a near-money in the form of interest bearing bonds issued by governments with solid credit ratings.
  3. Bank credit through the creation of chequable deposits in the granting of various loans to business, government and individuals. (It is critical that we understand that when a bank makes a loan, that is new money and when a loan is paid off that money is destroyed. Only the interest paid on it remains.)

Thus, all debt denominated in dollars -- mortgages, money markets, credit card debt, travelers checks -- is money. However, the creation of dollar-denominated debt (or any generic obligation) only creates money when a financial institution is granting the debt).

Shrinking the money supply

Perhaps the most obvious way money can be destroyed is if paper bills are burned or taken out of circulation by the central bank. But, it should be remembered that legal tender usually constitutes less than 4% of the broad money supply.

Another way money can be destroyed is when any bank loan is paid off or defaulted upon or any government bond is redeemed the money value of the contract or bond is destroyed — taken out of circulation.

Money can be destroyed if savers withdraw funds from a bank, in which case that money can no longer be used for lending. Bank savings are actually a kind of loans — savers loan their money to a bank at a low interest rate or merely in exchange for the benefit of convenience or its security (accepting that they lose a small amount of value to inflation). The bank then uses this loan to loan to other people, at a higher rate of interest (so it can make a profit). When this happens the money exists in two (or more) places at once, and so the money supply increases. When a saver withdraws money, the loan is "paid off" and it can no longer exist in more than one place at once, and this "double money" disappears.

In extreme forms, a bank run or panic may drive a bank into insolvency and, if uninsured, the savings of all its depositors are lost. Such bank failures were a major cause of the tremendous contraction in the money supply that occurred during the Great Depression, particularly in the United States. In that country many banking reforms were subsequently enacted during the New Deal, including the creation of the Federal Deposit Insurance Corporation to guarantee private bank deposits.

The most common and influential method for destroying money is through federal taxation. By definition, a federal surplus means the federal government takes more money out of the economy through taxes than it replaces through spending.

Because a growing economy requires a growing supply of money, a federal surplus, which removes money from the economy, always has a negative effect on the economy. Every depression in American history has immediately been preceded by years of surpluses, and cured by federal deficits. The Great Depression of 1929, coincided with 10 years of federal surpluses, beginning in 1920, and the recovery coincided with the federal deficits of the New Deal and World War II.

The most recent recession was preceded by four years of the Clinton surpluses, and the recovery began with the Bush deficits.

See also

External links

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