How is money created?
How does it work?
Money is more than banknotes and coins. If you have a bank account, you can use what’s in it to buy things, typically with a debit card. Because you can buy things with your bank account, we think of this as money even though it’s not cash.
Therefore, if you borrow £100 from the bank, and it credits your account with the amount, ‘new money’ has been created. It didn’t exist until it was credited to your account.
This also means as you pay off the loan, the electronic money your bank created is “deleted” – it no longer exists. You haven’t got richer or poorer. You might have less money in your bank account but your debts have gone down too. So essentially, banks create money, not wealth.
Banks create around 80% of money in the economy as electronic deposits in this way. In comparison, banknotes and coins only make up three percent. Finally, most banks have accounts with us at the Bank of England, allowing them to transfer money back and forth. This is called electronic central bank money, or reserves.
Can banks create as much money as they like?
No, they can’t.Regulation limits how much money banks can create. For example, they have to hold a certain amount of financial resources, called capital, in case people default on their loans. These limits have become stricter since the financial crisis.
Banks also risk going bust if they lend out money left, right and centre. For instance, people borrowing money will probably spend it. If they make payments to people who have accounts at other banks, their bank will need to transfer the money to that other bank by sending it some of its electronic central bank money.
So if one bank lends out too much money, at some point it will not have enough electronic money in its account with us to pay the other banks.
Through the ages, money has taken various forms – from gold and silver through to the two types of money used today: cash and bank deposits. The vast majority of all money in the UK is held electronically as deposits, with just a small proportion held in physical form as cash (banknotes and coins).
People deposit money in banks in part for security reasons, because holding large amounts of cash is risky as it could get lost or stolen. But cash continues to be important.
What can you do with money?
Money makes it easy for people to buy and sell things. It is seen as a reliable medium of exchange between buyer and seller. But money has other uses, too. It helps you to store value.For instance, if you were given an ice cream worth £2, you could enjoy it right now, but if you didn’t it would melt – and that ‘value’ would disappear. But if you were given £2 instead, you could spend it any time you liked.
Businesses use money when they price things. If you get your car fixed by a mechanic, you’ll be charged in pounds and pence. The price could be listed in other units (bags of rice, pints of milk, etc) but money offers a shared standard that everyone can use,
making it easy to compare prices. What has money been like in the past? Throughout history, people have used all sorts of things as money such as gold, feathers and cowrie shells.
What’s the difference between commodity and fiat money?
Historically, as trade increased through the centuries, commodity money such as gold and silver was used in most countries. In the 16th century, goldsmiths began storing gold coins for customers and issuing them with receipts, which could be converted back into gold on demand.
Carrying precious metals around is a considerable physical burden. Over time, people started to use the receipts instead. These receipts became a form of money themselves – and forerunners of the banknotes used today.
We have been issuing banknotes for more than 300 years. For most of that time, banknotes could be exchanged, on demand, for the equivalent amount of gold. But the link between banknotes and gold, known as the Gold Standard, finally ended in 1931. Since then, banknotes have been a form of "fiat money": money that is not convertible to gold or any other asset.
One advantage of a system that uses fiat money is that the amount of money in circulation can be responsive to changing economic conditions. This can support the smooth functioning of the economy. By contrast, the total amount of money circulating in the economy during the Gold Standard was ultimately limited by the amount of gold that could be mined.
How do card payments work?
Let’s say you pay for a coffee with a Visa Debit contactless card. As you tap your card to pay, it conveys information about the purchase to the card reader. Sometimes you may be asked to insert your card and enter your PIN as an extra security check. The machine beeps and says: “Card accepted”. That’s it – fast, easy and secure. A few hours or days later you will notice your balance has gone down. In the meantime, the company providing the card reader tells Visa about the payment. Visa then works with your bank and the company providing the card reader to move your money to the coffee shop’s account. Since many people and shops use the same banks, Visa needs to know how much the individual banks owe each other at the end of the day and then work out the difference. This way they avoid having to make thousands of transactions throughout the day – and need to move less money overall. This process is called settlement.
How does paying for stuff work?
Let’s say you pay for a coffee with a Visa Debit contactless card. As you tap your card to pay, it conveys information about the purchase to the card reader.
Sometimes you may be asked to insert your card and enter your PIN as an extra security check. The machine beeps and says: “Card accepted”. That’s it – fast, easy and secure. A few hours or days later you will notice your balance has gone down.
In the meantime, the company providing the card reader tells Visa about the payment. Visa then works with your bank and the company providing the card reader to move your money to the coffee shop’s account.
Since many people and shops use the same banks, Visa needs to know how much the individual banks owe each other at the end of the day and then work out the difference. This way they avoid having to make thousands of transactions throughout the day – and need to move less money overall. This process is called settlement.
So once a day, Visa tells us, the Bank of England, how much the customers’ banks owe the card reader providers. Many banks have an account with us that allows them to transfer money to other banks. We move the money between these accounts. The card reader provider can then send the money it received for your coffee from your bank to the shop’s bank.
Depending on the type of payment, this process will differ slightly. If you pay online or make a big payment, your bank needs to authorise the payment and it shows quickly in your account.
What about big payments?
Buying a coffee and car is not quite the same. If you buy something expensive, you want to know when the seller gets the money. That’s why we run a system called CHAPS. Most people use CHAPS if they buy a house. Football clubs also use it when paying for a player, or art collectors buying a pricey painting. Some of the largest CHAPS payments are worth over a billion pounds.
When you buy a coffee, there’s a large gap between when the money leaves your account and when it actually leaves your bank. Big payments happen much quicker. And there is no risk the receiver’s bank will not get the money.
Why is the Bank of England involved in payments?
As the UK’s central bank, our role is to help keep the economy safe and stable. We make sure people, businesses and banks receive the money being paid to them. It’s a big deal – if people couldn’t pay for things like food and fuel, the whole country would grind to a halt.
In 2017, we processed payments for nearly £90 trillion. If you add people, businesses and banks selling financial assets like shares that’s £155 trillion.
What is deflation?
Imagine a world where the price of things kept going down… sounds great, right? This is called ‘deflation’. But it’s not all it’s cracked up to be.
To buy or not to buy?
What would you do if you knew the £100 bike you wanted to buy today, was going to be reduced to £90 tomorrow? You would probably wait to buy it for the cheaper price. When prices begin to fall, people expect they will continue to go down. This expectation results in people spending less today, in hope of buying at a cheaper price tomorrow. This is bad for businesses.
If prices fall, businesses are likely to make less profit. Businesses don’t like to see their profits fall, so they will try to do something about it. Let’s go back to that bike you wanted to buy. The owner of the bike shop is now getting £10 less for each bike and so may try to cut costs to make up for this loss.
This is where deflation can negatively affect employees. Businesses’ biggest cost is usually staff. To reduce staff costs, businesses have two options: to cut wages or staff numbers. In other words, deflation could lead to you losing your job.
If prices fall on a large scale, then there may be many job losses. People typically spend less when their incomes fall, so they might not be able to afford the bike at £90. So now, the business could be forced to cut prices further in order to sell anything at all.
This creates a spiral effect as prices need to be reduced again and with falling income, comes unemployment if businesses can no longer afford to keep workers. This spiral of falling prices and unemployment is often associated with a recession.
If prices fall… does my debt?No – in fact, the opposite happens. Many people have some sort of debt – a mortgage, a student loan or a credit card. Deflation can make it more expensive to repay your debts. Regardless of the general prices for goods and services, the amount of money you owe remains the same.
If you borrow £100 to buy your bike today but prices fall, you will still owe £100 tomorrow. This means you are effectively spending more money than the bike is now worth.
Now say you bought a house and its value dropped by £10,000, but you are still paying off the mortgage. Even though the house isn’t worth its original value, you still have to pay the same amount. This is bad news when you think about all the other things you could have spent that £10,000 on…
Of course there’s nothing wrong with occasional offers. There are also plenty of examples where prices fall as technology advances (imagine how much a computer would have been worth 50 years ago, when almost no one else had one) but there are more consequences from falling prices than meets the eye.
What are interest rates?
Interest rates affect most of us. You might not realise it, but a change in interest rates can impact your day-to-day life; from the cost of getting a loan, through to the prices of everyday goods.
An interest rate is a percentage charged on the total amount you borrow or save. Even a small change in interest rates can have a big impact. It’s important to keep an eye on whether they rise, fall or stay the same.
If you’re a borrower, the interest rate is the amount you are charged for borrowing money – a percentage of the total amount of the loan. You can borrow money to buy something today and pay for it later.Interest is what you pay for the privilege. It’s a bit like hiring a car. Interest is what you pay to ‘hire’ someone else’s money. If you’re a saver, it’s the same except the interest fee is paid to you – because banks are paying to hire your money.
What is Bank Rate?
‘Bank Rate’ is the single most important interest rate in the UK. You can find our bank rate here. In the news they often call it ‘the interest rate’ but some people refer to it as the ‘Bank of England Base Rate’.
We use Bank Rate in our dealings with other financial institutions, which influence all the other interest rates in the economy. This includes the various lending and savings rates offered by high street banks and building societies.
An example of this is 2016, when the Bank Rate was cut from 0.5% to 0.25%. This reduced the rates at which high street banks could borrow money from the Bank of England. Banks were more likely to charge lower interest rates on the loans they made, such as mortgages, but also offered lower interest rates on savings accounts.
Why are there so many different interest rates?
The number of different interest rates available when you borrow or save can be confusing. The interest rates commercial banks set depend on more than just Bank Rate. For loans, other factors are considered, including the risk of the loan not being paid back: the greater the risk, the higher the rate the bank will charge.
Why do interest rates matter to me?
If interest rates rise, borrowing could become more expensive for you. Whether you are looking to get a mortgage to buy a house, or a new car on credit, it’s crucial to think about what steeper costs mean for you.
Imagine you have a £130,000 mortgage with an interest rate of 2.5% and a mortgage term of 25 years (meaning your monthly repayments would pay the loan off in 25 years’ time).
Monthly you would pay £271 in interest which amounts to £3252 each year.
If the rate increases by 1% you will pay £109 more monthly, spending an extra £1308 a year. This would cost you an extra £32,565 over the length of your mortgage term.
However interest rates can go down as well as up. On the same mortgage contract, a decrease in the rate by 1% means you pay £109 less monthly, saving £1308 a year instead.
It’s key to understand how a change in interest rates could impact your money. You can use a mortgage calculator to work out how your monthly payments might be affected.
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