Money, inflation and how banks create deposits

Money performs three jobs: a medium of exchange, so trade does not require a double coincidence of wants; a unit of account, so prices are comparable; and a store of value, so earnings can be held for later.

Nothing about those jobs requires gold or any commodity. Modern money is fiat money: it has value because it is generally accepted and because taxes must be paid in it, not because it is backed by metal.

Most money in circulation is not cash. It is commercial bank deposits, and it is created when banks make loans. A bank issuing a mortgage does not hand over someone else's savings; it credits the borrower's account, creating a deposit and a matching debt at the same moment.

That process is constrained by capital requirements, by the demand for creditworthy borrowers, and by the central bank's influence over interest rates. When loans are repaid, that money is destroyed, which is why credit cycles drive so much of the economy.

Inflation is a sustained rise in the general price level, which means each unit of currency buys less. It is measured with a basket of typical purchases, and the choice of basket is itself contested, since different households buy very different things.

The causes divide into demand pull, where spending outruns the economy's capacity to produce, and cost push, where input costs such as energy rise and feed through to prices. Expectations matter independently: if people expect higher prices they demand higher wages and set higher prices, which can make inflation self-sustaining.

• It erodes savings held in cash and fixed incomes that do not adjust.
• It redistributes from lenders to borrowers, since debts are repaid in less valuable money.
• It obscures price signals, making it harder to tell a real change in relative value from a general rise.
• Unpredictable inflation discourages long-term contracts and investment.
• Deflation carries its own dangers: falling prices encourage delayed spending, and real debt burdens rise.

Monetary policy is run by a central bank and works mainly through interest rates. Raising rates makes borrowing costlier and saving more attractive, cooling demand. Lowering them does the reverse. Quantitative easing, buying assets to push down longer-term rates, was added when short rates reached their floor.

Fiscal policy is run by government through spending and taxation. Both are blunt and act with delays, which is why timing is the hardest part of macroeconomic management and why policy is argued about even when the mechanics are agreed.