Demystifying Money: How It’s Created and Controlled
Money should, in theory, be a relatively easy thing to understand. We interact with it every day after all. Unfortunately, it’s not quite as simple as just ‘the money in your account’. That being said, just because something isn’t straightforward doesn’t mean we should seek to make it harder than it needs to be.
For many people, money is just what we have in our account and use to buy things, pay bills, and save. For others who’ve read a little deeper, they recognise the different phases of money’s maturity, from store of value to medium of exchange. Then there are the news segments and economists who start referring to the different layers of money, which I suspect is where they quickly lose most peoples attention.
I thought it might be useful to distil what is a complex and wide-ranging topic into some core elements that will arm you with useful information. This will come in especially handy when it comes to interpreting the endless news on the economy, interest rates, inflation, and recession. Given that I suspect we’re likely to face a relatively inflationary decade ahead, you’ll probably be hearing more, not less, about these terms.
The cynic in me suspects the over-complication of money is by design rather than accident. I can’t help thinking of Henry Ford’s famous quote.
“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”
If we keep the populace confused, they stop asking the right questions. But if we educate them? Maybe we start asking the right questions, especially during election cycles when governments talk about stimulating growth or reducing inflation as their key policies.
What the Hell Is M0, M1, M2 & M3 Anyway?
Let’s start by breaking down the categorisations of money often used but rarely explained. You’ll often hear the terms monetary base, M1, M2, and M3 in discussions about the state of the economy or central bank policy.
Simply put, these are measures of how much money exists within the economy, divided by how easily it can be accessed or spent. Essentially, it helps classify how liquid it is.
M0 is often referred to as the monetary base or narrow money. It represents the total of all physical cash in circulation plus the reserves that commercial banks hold with the central bank. It’s the purest, most basic form of money. When you hear people talk about “governments printing money,” this is the layer they’re technically expanding. You can think of M0 as the foundation that supports the wider structure of credit and deposits that make up our modern monetary system.
M1 captures the first layer of broad money, which is the money actually circulating through the economy on a day to day basis. It includes cash held by the public and funds sitting in current or checking accounts that can be spent immediately. It’s essentially the money you can access and use without delay i.e. the most liquid part of the money supply.
M2 expands on M1 by including money that isn’t quite as liquid, such as savings accounts or small-term deposits. You can access it relatively quickly, but it’s not generally used for day-to-day spending.
M3 is the broadest category. It includes everything in M1 and M2 plus larger deposits, institutional funds, and other forms of “money” that circulate higher up in the financial system. This is the least liquid category, often held by corporations, pension funds, and banks.
A simple wrap up explanation is that you can think of M0 as the foundation, M1 as what’s actively circulating, M2 as close enough to move easily if needed, and M3 as still part of the system but much slower moving.
Why Do We Even Need Different Categories?
It’s a fair question. Most of us only think about the money we have in our current or savings account, so why bother splitting it into categories at all?
The simple reason is that not all money moves in the same way. Cash in your wallet behaves very differently to funds tied up in long-term corporate deposits. By breaking it down, we can see where money sits in the system and how easily it can move.
If money is increasing at the M1 layer, it suggests more day-to-day spending power in the economy. If it’s instead rising in M3, it tends to mean more is tied up in large institutional accounts and financial instruments.
These categories evolved as economies and banking systems became more complex. Back when most transactions were cash-based, M0 and M1 covered nearly everything. As new forms of saving, lending, and investing developed, economists needed a way to track how much “money-like” value existed beyond notes and coins in circulation.
The categories don’t have to be confusing if they’re explained properly, however I notice that often when they’re cited in the news its without accompanying explanation. Hopefully this brief overview helps arm you with the right understanding for future reference.
Now, although this gives you an understanding of the categories of money, there is more to the story. Base layer money may be where physical new money is created however it’s not where the majority of new money in the system comes from. To better understand that we need to look at how debt works and why it’s at the heart of modern money creation.
How Debt Creates Money
This is the point at which some peoples understanding can start to fray but it doesn’t have to be. If governments aren’t regularly expanding the base layer, then where is the extra money coming from and what has debt got to do with it?
When you take out a loan, the bank doesn’t transfer someone else’s deposits into your account since they’re not operating with a fixed pool of funds to serve all clients. Instead, the bank creates new money by basically typing numbers on a screen. Voila! Just like that a loan for you becomes an asset for them. The previously non-existent loan has now injected additional money into the system through its creation. With every new loan, the money supply expands a little further.
Why Are Banks Allowed to Do This?
Everyone’s journey into understanding money is different, but this is usually the point where people ask, “Hold on a second. How are banks just allowed to create money?”
The answer lies in the fact that we operate in a world of fractional reserve banking. Not necessarily directly advertised but I think something that’s becoming increasingly better understood is that banks are only required to hold a small fraction of their customers’ deposits on hand at any given time. The rest can be lent out as part of their ongoing operations.
To bring it to life, imagine you deposit £1,000 into your account. The bank might keep £100 as a reserve and lend £900 to someone else. That £900 is then spent, deposited into another account, and 90% of that can be lent out again. The process repeats, multiplying the amount of money in circulation far beyond the original deposit.
No physical cash is being created i.e. no base layer money. It’s just digital credit, however its further expanding the supply in the system.
Why This Matters for Central Banks and Interest Rates
Central banks like the Bank of England, Federal Reserve, or ECB don’t directly create most of the money in circulation. They do however influence how much is created through one of their most powerful tools: setting the interest rate.
Lower interest rates make borrowing cheaper, encouraging more loans and expanding the money supply. Higher rates make borrowing more expensive, slowing down lending activity and contracting the money supply.
When central banks talk about “tightening policy” or “containing inflation,” they’re effectively trying to slow monetary expansion. The theory goes that by preventing too much new money in the system from chasing the same amount of goods and services, they can curb price rises. The problem is that the very act of creating new money is already inflationary. As more money enters the system, the value of existing money is diluted, meaning you need more of it to buy the same goods i.e. monetary debasement.
The deeper dynamics of inflation deserves another article, however it’s difficult to have any discussion on money without at least touching on it. Understanding how money is layered, how debt creates new money, and how interest rates influence it though should help give you a clearer view of what’s really happening behind the economic headlines you see on an ongoing basis.
Why Understanding Matters
Money sits at the heart of our economies, and the health of those economies sits at the core of countless political promises, policy debates, and daily headlines. Growth, inflation, recessions, they’re all tied to the monetary system and central banking decisions.
Central banks and governments will continue to present their rate decisions and budgets as finely tuned responses to the ongoing global pressures. In reality however, the challenges we face are products of years of compounded mismanagement of systems they both created and maintain. They know the situation we currently face is precarious, but it’s not exactly a tenable position for them to come out and say:
“The monetary and debt system is out of control and we don’t know how to fix it.”
Once you start to understand the nuts and bolts of the underlying system you realise that inflation isn’t an accident, it’s a built-in feature of the system. That in turn helps you start to understand that government parties will espouse their various policies to ‘fix inflation’ yet they’re all bound by the same fiscal and monetary constraints. To date I’ve seen no party put forward a fully thought out solution for funding their policies let alone a good one.
We can’t change the system simply by understanding it however gaining a better handle of it makes you harder to mislead. Every election cycle brings promises of growth, stability, and “fiscal responsibility,” yet few offer concrete plans. An informed public is one that can question those promises and call BS if and when empty responses come back.
Understanding money fully takes a lot more reading and learning than a single article can cover, however hopefully this has cleared up a few terms that previously went misunderstood.
Money isn’t going anywhere, nor is its impact on your life. As with anything else, what you understand, you can better control.