Money, like everything else in the economy, is a commodity that depends on the supply and demand. In the United States the supply of dollars is determined by the number of people (including illegal aliens) who want to convert their local currency into the more widely accepted US dollar. The number of coins currently in circulation is limited. And no matter how many billions of new “pieces” are introduced into the market each year, the demand for dollars still declines.
So how does money creation get started? Commercial banks create money when they lend it to individuals or institutions. The most popular form of commercial bank money creation is created by creating loans out of the proceeds of real estate transactions. These commercial bank loans are called commercial mortgage loans.
Private money creation then occurs when an individual, family, or business creates money from its own production. Examples of this include merchant accounts, savings accounts, and certificates of deposits. Governmental institutions can also create national currencies from the money they issue. One example is the issuance of the US currency. This happens in order to regulate the supply and demand of the money supply.
A relatively unknown category of financial intermediaries is referred to as government mints. These government mints issue coins and other types of legal tender. The most famous example of a government mint is the US mint. Any coin that contains the symbol of the US government is considered legal tender. Although these intermediaries do not directly contribute to the supply of money, they are important to our understanding of money creation.
The hyperinflation that occurred in the Weimar Republic during the period of World War I inspired the growth of the concept of central bank power. With hyperinflation, money supply increases without a corresponding increase in demand. As a result, money was printed that was the exact amount of the currency in circulation. Governments needed the newly printed currency to finance the war effort. Eventually, the hyperinflation process ended with the formation of a hyperinflationary environment which is characterized by sudden and drastic changes in monetary quantities.
Since the formation of the United States, our currency has always been derived from a precious metal, usually gold. Because gold is a depreciating asset, it is used primarily as a denomination for high-denomination bank notes and coins. Because of the significant historical importance of the dollar in the United States, changes in the face value of this “back-to-the-future” money make a substantial difference in our standard of living. Unlike pre-hyperinflationary days, the federal reserve maintains a fixed rate for the discount rate. Changes in this rate affect both the supply and demand for money in the United States.
Monetary policy, including the discount rate, was never seriously discussed by the framers of the US Constitution. Federal laws regulating the issuance of money are based on the “power of Congress” and are not affected by state action. The historical significance of paper currency was minimal and did not factor into the decision of the Continental Congress to pass the US constitution. Paper currency was considered “free money”, because it was not backed by a real asset that could be taken from the States or the People. This limited the power of the federal government to borrow money against its currency.
In modern times, the use of fiat money is still widespread, but with a different purpose. Central banks print money to satisfy the demand for it in international trade. Interest rates are usually determined by the central bank in its capacity as a lender of credit. Interest rates are still based on the supply and demand in a world where specialization and globalization have reduced trade costs worldwide.