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What Is Money III: How Money Is Created - Lifestyle Articles - Love Ambassadors Ministries

WHAT IS MONEY III: How Money Is Created

Source: Investopedia.com

The Three Categories of Money In An Economy

Sure money is the $10 bill or one thousand note you lent to your friend the other day and don’t expect back any time soon. You really think so? Let's find out.

But come to think of it, exactly how much money is out there and what forms does it take?

Economists and investors ask this question everyday to see whether there is inflation or deflation. To make money more discernable for measurement purposes they have separated it into three categories:

    M 1: This category of money includes all physical denominations of coins and currency, demand deposits, which are checking accounts and NOW accounts, and travellers checks. This category of money is the narrowest of the three and can be better described as the money used to make payments.
    M 2: With broader criteria, this category adds all the money found in M 1 to all time related deposits, savings deposits, and non-institutionalised money-market funds. This category represents money that can be readily transferred into cash.
    M 3: The broadest class of money, M 3 combines all money found in the M 2 definition and adds to it all large time-related deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets. By adding these categories together, we arrive at a country’s money supply or total amount of money within an economy.

How Money Is Created

Now that we’ve discovered why and how money, a representation of perceived value, is created in the economy, we need to touch on how the central bank can manipulate the money supply. As already stated, we will not be looking at how an individual can created money (currency notes) but specifically at how the Central Bank in a nation creates and manipulates the money supply in the country.

Among other things a central bank has the ability to influence the level of a country’s money supply. Let’s look at a simplified example of how this is done.

If it wants to increase the amount of money in circulation, the central bank can of course simply print it, but as we learned, the physical bills are only a small part of the money supply.

Another way for the central bank to increase the money supply is to buy government fixed-income securities in the market.

When the central bank buys these government securities, it puts money in the hands of the public. How does a central bank pay for this? As strange as sounds, they simple create the money out of thin air and transfer it to those people selling the securities!

To shrink the money supply, the central bank does the opposite and sells government securities. The money with which the buyer pays the central bank is essentially taken out of circulation.

Keep in mind that we are generalising in this example to keep things simple.


Remember as long as people have faith in the currency, a central bank can issue more of it. But if the central bank issues too much money the value will go down, as with anything that has a higher supply the demand.

So even though technically, it can create money “out of thin air”, the central bank cannot simply print money as it wants.

PS: What Are Fixed-Income Securities

A fixed-income security is an instrument that provides a return in the form of fixed periodic payments and the eventual return of principal at maturity.

Unlike a variable-income security where payments change based on some underlying measure such as short-term interest rates, the payments of a fixed income security are known in advance.

An example of a fixed income security would be a 5% fixed rate government bond, where a $1000 investment would result in an annual $50 payment until maturity when the investment would receive the $1000 back.

Generally, these types of assets offer a lower return on investment because they guarantee income.