This article explains the credit theory of money — how money is created, circulated, and destroyed in a modern economy. Explanations are given from first principles using simple examples to show what money really is and the best way to think about it. Although it may not be obvious at first, the theory actually applies to all kinds of money once people are willing to owe money to one another. A brief overview of the different kinds of money is given next.
Economists generally recognise three kinds of money: commodity money, representative money and fiat money. Commodity money is any commodity that people choose to use as a medium of exchange. Examples are: gold, silver, peppercorn and cigarettes. Representative money is money that is backed by a commodity, such as gold-backed notes and silver certificates. Fiat money is neither commodity money nor representative money, but often considered to be debt-based or debt-backed money. The UK's pound sterling and the US dollar are both kinds of fiat money. Cryptocurrencies are, arguably, a fourth kind or money. These are neither commodity-backed nor debt-backed.
As a side note, fiat — from the Latin 'let it be so' — money is also the money a government decrees to be legal tender, and by which a debt can be settled in a court of law. In this sense, fiat money could be any kind. Today, as of writing this article*, debt-based fiat money is also legal tender fiat money.
* Article was written in 2019 and first published on 3rd March 2020.
- Part 1. The purpose of money
- Part 2. The rules of money
- Part 3. Interbank transfers
- Part 4. Interbank settlements
- Part 5. How money is created
- Part 6. How money is destroyed
- Part 7. How banks earn money
- Part 8. How banks lose money
- Part 9. How banks go bankrupt
- Part 10. How debt circulates
- Part 11. How central banks create money
- Part 12. How central bank settlements work
- Part 13. How circulated debt is paid back
- Part 14. How banks fail
- Part 15. How governments borrow money
- Part 16. How governments pay back money
- Part 17. How quantitative easing works
- Part 18. How banks are bailed out
- Part 19. How banks are bailed in
- Part 20. How notes and coins circulate
- Part 21. Conclusions