Since man’s very existence has been making settlements to stay, and then become sedentary, at that time, money already existed, but not as we know it now; the first means of payment were wheat and salt. In the 7th and 6th centuries BC, there is evidence of precious metal coins such as gold and silver and money called “fleece,” which was copper or bronze inlaid with silver. Money had value depending on the metal in which it was made.
Then in the Europe of the modern age, fiat money appears, the currency or paper does not have the value that it represents by itself, but banks must support through their reserves, what was called the gold standard, which means that the bank that issues it has reserves in gold, anyone could go to the bank, show the money and make the claim of the corresponding gold.
In 1971, the United States left the gold standard, and from that moment on, Fiat money came into force. Its value does not depend on a standard or on bank reserves but has value due to a legal standard. This Fiat money exists because the law provides it; it does not mean that it does not require the people’s trust, and it is that, although it does not have gold or other asset support, it must have economic support from the country or territory that issues it. Otherwise, the money will be worthless, especially if people do not trust it and do not use it as commercial currency.
Each country creates and issues its currency through its central bank. The central bank dictates each country’s monetary policy, sets money interest rates and the reserve requirement coefficient. We cannot say that the central banks are the ones that create the money; of course, they are the ones that issue legal tender bills and coins, that money represents 5% of the total money in circulation.
The central bank also “injects” or “retracts” liquidity through purchases or sales of financial assets in the primary and secondary market, in addition to making cash loans to commercial banks; this represents only a small part of the circulating money. Its participation is essential since it sets the interest that is applied, the cash ratio, and regulates the private banking sector.
Commercial banks are the ones that create the money that circulates, in addition to other financial entities such as industrial banks, public and private savings banks (95% of the money that exists is created by these banks). The central bank lends money to them, and between these entities, the money circulates until it finally reaches the individuals who would be the clients of those banks; the clients request loans and manage their money in the bank accounts.
A commercial bank carries out three types of operations:
- Cash operations: They grant credits through loans, credits, or discounts.
- Liability operations: They collect and save money in the form of deposits of all kinds.
- Banking services: Through payments, transfers, collections, purchase, and custody of securities, among other financial services.
Circulation of money: loans and credits
A bank’s ability to carry out asset operations, that is, to grant loans to its customers, is not limited by these resources since the bank goes one step further; for example, when a bank gives a loan, it does not deliver the money to the customer, but it is deposited in the client’s account.
That represents an accounting record. Physical money does not intervene; we call this money bank money, and 95% of that money will continue to be bank money since the payments and transfers that the client makes will be made in physical money from unused banking operations. The money will probably go to another bank for payment purposes, but it will remain an accounting record, nothing more.
The only limit the bank has to do this is the “reserve requirement ratio,” i.e. the percentage of real assets that it must keep concerning the assets it generates by granting loans. Previously, the reserve requirement ratio was around 15% or 20%, today, with the number of electronic transactions and payments, the cash ratio is around 1%. To learn more about electronic payments you can read our article entitled Fintech trends in payments for the year 2021.
What do you think about this topic? Did you know how Fiat money is created?
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