What is credit money?
Credit money is monetary value created as a result of a future obligation or claim. As such, credit currency emerges from the granting of credit or the issuance of debt. In the modern fractional-reserve banking system, commercial banks are able to create credit money by issuing loans in excess of the reserves they hold in their coffers.
There are many forms of credit money, such as IOUs, bonds, and money markets. Virtually any form of financial instrument which cannot or is not intended to be redeemed immediately can be interpreted as a form of credit money.
Key points to remember
- Credit money is the creation of monetary value by establishing future claims, obligations or debts.
- These receivables or debts can be transferred to other parties in exchange for the value embodied in these receivables.
- Fractional reserve banking is a common way to introduce credit money in modern economies.
How credit money works
According to recent research in economic history, anthropology and sociology, researchers now believe that credit was the first form of money, preceding coin or paper money. In ancient times, some of the earliest writings found were interpreted as accounts of debts owed by one party to another – before the invention of money itself. This form of value obligation – that is, I owe you X – is essentially credit money as soon as that obligation can be transferred in kind to someone else. For example, I can owe you X, but you can transfer your claim against me to your brother, so now I owe your brother X. You and your brother have basically done money transactions on credit.
During the Crusades of the Middle Ages, the Templars of the Roman Catholic Church, a heavily armed religious order dedicated to holy war, held valuables and property in trust. This led to the creation of a modern system of credit accounts that still prevails today. Public confidence has risen and fallen in lending institutions over the years, depending on economic, political and social factors.
Credit money and fractional reserve banking
“Fractional reserve” refers to the fraction of deposits held on reserves. For example, if a bank has $ 500 million in assets, it must hold $ 50 million, or 10%, in reserve. It can, however, lend $ 450 million in the form of essentially new credit money.
Analysts refer to an equation called the multiplier equation to estimate the impact of reserve requirements on the economy as a whole. The equation provides an estimate of the amount of money created with the fractional reserve system and is calculated by multiplying the initial deposit by one divided by the reserve requirement. Using the example above, the calculation is $ 500 million multiplied by one divided by 10%, or $ 5 billion.
Credit and Debt Money Markets
As noted above, specific types of credit money include bonds. It is a major segment of the financial markets. For example, the US government debt market (treasury bills or treasury bills and treasury bills or treasury bills) amounted to $ 14 trillion in January 2018. In 2018, the size of global debt markets Debt (over $ 100,000 billion) was nearly double the size of the stock markets (nearly $ 64 trillion). Together, they form the world’s capital markets. U.S. capital markets are the largest in the world, with the U.S. equity market being 2.4x and U.S. bond markets 1.6x the size of the second largest, the European Union. US capital markets account for 65% of total financing of economic activity and drive national growth.
The bonds allow governments (at national, state and local levels), businesses and non-profit organizations like colleges and universities to access funds for a variety of growth projects, including financing roads, new buildings, dams or other infrastructure. Businesses often borrow specifically to expand their business, purchase real estate and equipment, acquire other businesses, or invest in research and development of new products and services.
Outside of banks, bonds allow individual investors to assume the role of lender in these situations. Public debt markets can open a particular loan to thousands of investors, thus providing the opportunity to finance some of the required capital. These public markets allow lenders to sell their bonds to other investors or to buy bonds from other people, long after the original issuing body has raised capital.