Over the centuries, the creation of money has significantly evolved – from trading physical commodities like gold and livestock to using digital currencies and modern credit systems.

Understanding the various forms of money and the monetary system can help demystify how economies operate and highlight the diversity in how value is represented and exchanged across the world.

In this blog, we’ll explore the key types of money, from traditional forms like commodity and fiat money to more recent innovations such as cryptocurrencies. Most importantly, we will answer the question, where does money come from?

Money is the foundation of modern economies, acting as the primary medium of exchange for goods and services.

Money can take several forms, each with its characteristics and uses. Each type of money has different roles in economies and financial systems, contributing to liquidity, stability, and exchange.

1. Commodity Money

Commodity money is a type of currency made from materials with intrinsic value. These materials are typically gold, silver, or other precious metals.

Historically, commodity money was widely used because the currency itself was valuable and could be traded directly for goods or services. However, this type of money relies heavily on the availability and desirability of the commodities, making it less accessible.

2. Fiat Money

Fiat money is a currency that has no intrinsic value but is established as legal tender by government decree. Most modern economies use fiat money, including paper bills and coins, as well as digital forms like bank deposits.

The value of fiat money is derived from the trust and confidence that people have in the stability of the government and economy. Unlike commodity money, its value is not tied physically but is backed by the issuing authority’s ability to maintain its value.

3. Representative Money

Representative money refers to a currency that is not valuable itself but can be exchanged for a specific amount of a commodity. Typically, precious metals like gold or silver.
It acts as a claim on the commodity, being easier to carry and exchange than the actual goods. The gold standard is a historical example of this, where paper notes could be

4. Digital Money

Digital money exists electronically and is used for online transactions, transfers and payments. It includes credit, debit, mobile payments and cryptocurrencies like Bitcoin.
Digital money can be centralised, as with traditional bank accounts and digital wallets, or decentralised, as in the case of blockchain-based cryptocurrencies. The ease of transactions and growing internet use has made digital money increasingly popular.

5. Cryptocurrencies

Cryptocurrencies are digital or virtual currencies that use cryptography to secure funds. Unlike traditional types of money, cryptocurrencies operate on decentralised networks based on a blockchain. This ensures transparency and security without the need for a central authority.
Bitcoin, Ethereum and other cryptocurrencies have gained popularity due to their potential for quick, low-cost transactions and investment value. However, they remain volatile and are not widely accepted as mainstream money.

6. Bank Money

Bank money primarily exists in digital form and is created through banking operations. This includes bank account deposits, which customers can transfer or withdraw through checks, debit cards, or electronic transfers.

Unlike physical cash, bank money exists mostly as an accounting entry on a bank’s ledger and can be moved around the financial system quickly and easily, primarily through the operations of private banks. This form of paper money represents a significant portion of the money supply in modern economies.

7. Central bank reserves

Central bank reserves are a specific type of money held by a country’s central bank. They are primarily used by commercial banks and financial institutions to settle interbank transactions and ensure liquidity within the banking system.

These reserves are not money in the hands of the public but serve as the foundation for other types of money, like commercial bank deposits and physical currency.
Through operations such as open market transactions, the central bank can adjust reserve levels, influencing interest rates and liquidity in the broader economy.

Central banks play a pivotal role in the creation of money. By influencing both money supply in an economy and the conditions in which it is created. The money creation process involves both physical currency (cash) and digital money created through banking activities, including central bank money.

Central banks have the exclusive authority to issue physical currency, such as banknotes and coins. This is often considered “base money” or “narrow money” and it forms the foundation of the money supply in an economy.

Commercial banks create most of the money in an economy through lending. However, central banks regulate this process by setting reserve requirements, which dictate the minimum reserves that banks must hold relative to their deposit liabilities.

Through tools like open market operations, central banks buy or sell government securities to influence bank reserves and liquidity.

They also control interest rates, making borrowing cheaper or more expensive, which impacts lending and money creation.

In times of crisis, central banks act as lenders of last resort, providing currency to ensure financial stability.

A country’s central bank or treasury manages the creation of physical currency, such as banknotes and coins.

Banknotes and coins are printed or minted at specialised facilities and they have security features like watermarks, holograms and unique serial numbers to prevent counterfeiting.

Banks request cash from the central bank to meet customer demand, particularly for ATM withdrawals, cash deposits and over-the-counter transactions.

Once in circulation, physical currency facilitates everyday transactions such as shopping, paying bills and wages. It acts as legal tender, meaning it must be accepted for goods and services within the issuing country.

Physical currency is still vital for certain uses but is just one component of the money creation process.

Open market operations (OMO) are a vital tool central banks use to control the money supply and influence economic conditions. In this process, the central bank buys or sells government securities (like bonds) in the open market.

When the central bank buys government securities, it injects money into the banking system. Therefore, increasing reserves and allowing banks to lend more expands the money supply.

When it sells securities, it reduces the money supply by taking money out of circulation, limiting banks’ ability to lend.

OMO also affects interest rates, with purchases lowering rates and sales raising them. This helps the central bank control inflation, economic growth, and financial stability.

Central banks influence money creation by setting interest rates. This can fluctuate through times of crisis that can cause economic hardship or prosperity.

When they lower rates, borrowing becomes cheaper, leading to more loans and an increase in the money supply. The increased availability of credit stimulates spending and investment, fuelling economic growth.

When they raise rates, borrowing becomes more expensive, reducing loan demand and contracting the money supply helping slow down excessive economic growth.

These interest rate changes impact how much commercial banks lend, helping central banks further manage economic growth and inflation.

Quantitative easing (QE) is a monetary policy tool central banks use to increase the money supply, particularly during economic crises or recessions when traditional methods (like lowering interest rates) are insufficient.

The central bank purchases large quantities of financial assets, such as government bonds, from financial institutions.

By purchasing these assets, the central bank boosts the reserves of commercial banks, giving them more liquidity. With more excess reserves around, banks are encouraged to lend more to businesses and individuals, creating new money in the form of loans and increasing economic activity.

Quantitative easing also lowers long-term interest rates by increasing demand for bonds and other assets. This helps make borrowing cheaper for businesses and consumers, further encouraging lending and investment, stimulating the economy.

QE aims to stimulate spending and investment, preventing deflation and economic growth. The International Monetary Fund (IMF) often provides guidelines and insights on the implementation and effects of quantitative easing.

Commercial banks create money through the process of lending, operating under a fractional reserve system. By lending out deposits, they increase the amount of money in supply in the economy, which has significant implications for economic activity and growth.

While commercial banks are essential in creating money, they are subject to regulation by central banks and financial authorities to ensure stability and prevent excessive risk-taking. These regulations help maintain confidence in the banking system and safeguard against bank runs or financial crisis.

When a commercial bank receives deposits, it can use a significant portion of those funds to make loans to borrowers (individuals or businesses).

When the borrower uses this loan to make a purchase, the money is deposited back into the banking system, allowing further lending.

This is because the bank also has a reserve requirement (changes dependent on the banking system), where a portion of the deposit is kept in the federal reserve. Reserves help banks manage risk that is essential for the stability and functioning of the banking system.

Firstly, this ensures liquidity, allowing banks to meet customer withdrawal demands and prevent liquidity crises.

Secondly, regulatory requirements from central banks mandate minimum reserve levels to promote financial stability and protect against insolvency.

They also contribute to interest rate control, as central banks adjust reserve requirements to influence lending.

Additionally, reserves facilitate interbank transactions for short-term liquidity.

Banks operate under a fractional reserve banking system, which means they are only required to keep a fraction of their deposits as reserves. This allows them to lend out the majority of their deposits while still meeting withdrawal demands.

When a loan is issued, it effectively creates new money in the economy. For example, when a borrower receives a loan and spends it, that money is typically deposited back into the banking system.

This creates a new deposit, allowing the bank to either inject money or lend out a portion of it again, thus expanding the money supply further.

Commercial banks also set interest rates for loans, which influence borrowing behaviour. Lower interest rates typically encourage more borrowing and spending, leading to an increase in new money.

Conversely, higher interest rates can discourage borrowing and reduce the money supply.

This lending process creates a multiplier effect, where the initial deposit creates multiple new deposits in the banking system.

The money multiplier can be calculated using the formula:

For a reserve requirement of 10%, the money multiplier would be 1/0.10 = 10. This means that for every dollar deposited, the total money supply could increase by up to ten dollars through successive rounds of lending and re-depositing.

The money multiplier explains how banks create money through the fractional reserve banking system by lending out a portion of deposits. This leads to a cascading effect of new loans and deposits, significantly increasing the availability of money.

Credit refers to the ability of individuals or businesses to borrow money with the promise to repay it in the future. When banks extend credit, they effectively create new money in the economy.

Banks expand the money supply by approving loans and establishing new deposits, enabling economic activity and growth. This process is underpinned by borrower repayment and interest payments, while regulatory oversight helps maintain financial stability.

Central banks provide reserves, influence interest rates and regulate commercial banks. While commercial banks create money through lending. This collaboration ensures a balance between economic growth and financial stability.

Through monetary policy, central banks influence interest rates, affecting how much commercial banks can lend.

Additionally, central banks use open market operations to adjust reserves and control the money supply. They also regulate commercial banks to ensure stability and prevent excessive risk-taking.

Digital and cryptocurrencies challenge the traditional money creation model. Cryptocurrencies offer an alternative system that operates independently of central banks. Meanwhile, CBDCs (Central Bank Digital Currencies) represent an evolution of fiat currency into the digital age.

Both forms of digital currency could influence how money is created, transferred and controlled, potentially reducing reliance on traditional banking intermediaries.

Digital currencies issued by central banks are digital forms of the nation’s official currency. While CBDCs are still under development in many countries, they function similarly to cash but exist in digital form only.

CBDCs could be distributed directly to consumers, businesses and financial institutions via digital wallets, making money creation more direct. Additionally, would enable central banks to implement monetary policies more efficiently.

Cryptocurrencies, such as Bitcoin and Ethereum are decentralised digital assets created and maintained using blockchain technology. Unlike traditional money, cryptocurrencies are not controlled by any central authority or government.

In cryptocurrencies like Bitcoin, new coins are created through mining, where powerful computers solve complex problems to validate transactions on the blockchain. Miners are rewarded with newly created coins, increasing the supply.

Some cryptocurrencies are pre-mined, with the total supply created at the outset, while others are issued through initial coin offerings (ICOs) or token sales to raise funds.

Many cryptocurrencies have a fixed supply cap (e.g., Bitcoin is limited to 21 million coins), making them deflationary compared to traditional currencies, which central banks can continuously issue.