Credit money often exists in parallel with other money such as fiat money or commodity money, and from the user's point of view is indistinguishable from it. Most of the western world's money is credit money derived from national fiat money currencies.
Strictly speaking a debt is not money, primarily because debt can not act as a unit of account. All debts are denominated in units of something external to the debt. Hence credit money is not strictly money at all. However, credit money certainly acts as a money substitute when it comes to the other functions of money (medium of exchange and store of value). As such the existence of credit money may dampen demand for the real money and in so doing alter the dynamics of money's market value.
When paper money is merely an IOU for something such as gold, then the paper itself is not a unit of account but merely a convenient medium of exchange. Under a rigid gold-standard with convertiblity, paper currency is merely a debt instrument. However, when paper money floats, its value is not defined by reference to an external unit of account. It is no longer a debt instrument but rather it becomes purely monetary and its value is a product of the dynamics of supply and demand. Typically a central bank forces supply and the private sector forces demand. See open market operations.
Credit money tends to arise as a byproduct of lending and borrowing money. The following example illustrates this.
Imagine you have deposited some gold coins in a bank vault. The bank might lend the coins to a second person based on a promise to pay equivalent coins back with a few extra at a time in the future. The second person can in the meantime use the coins normally as money. But you still own the coins, and you also could still use them - you could transfer their ownership to another person to pay for something you have bought by telling the bank to transfer them from your account to the other person's account. You might do this by writing a check. So in this simple example there are two people using the same coins as money at the same time. It's as if new money has been created by the act of lending. Taking it another step, if the second person spends the coins at a shop, and they end up being deposited back into the bank by the shopkeeper, the bank can lend them again. Now you and the shopkeeper can use the coins in the same way, by writing checks or the equivalent in this example, and whoever borrows the coins a second time can use the coins directly as money. So there are three people with financial use of the coins. This can go on with many people ending up simultaneously using the same coins financially, but for each extra user there is a promise to pay equivalent coins back. These arrangements where many people use the same money simultaneously are in many respects the same as if there was extra money. The extra money that there appears to be is known as credit money. It is in regulating the amount of money a bank can lend that the controlling authority can set the money supply and change monetary policy. The credible promises to repay in a reasonable time give the extra money its value. It tends to exist in parallel with another form of money such as fiat money or commodity money, wherever banking-style loans are used, and occurs as a by-product of lending. It could occur without banks, but banks provide a degree of stability to the whole process by taking and evaluating the risk involved in each loan.
During the Crusades in Europe, precious goods would be entrusted to the Catholic Church's Knights Templar, who effectively created a system of modern credit accounts. Over time this system grew into the credit money that we know today, where banks create money by approving loans - although the risk and reserve policies of each national central bank sets a limit on this, requiring banks to keep reserves of fiat money to back their deposits. Sometimes, as in the U.S.A. during the Great Depression or the Savings and Loan Scandal, trust in bank policies drops very low and government must intervene to keep the industry of credit in operation.
In many countries, the issue of private paper currencies has been severely restricted by law. In Australia the Notes Act of 1910 basically shut down the circulation of private currencies by imposing a prohibitive tax on the practice. Many other nations have similar such policies that eliminate private sector competition.
Today there are several privately issued digital currencies in circulation that function as money. Transactions in these currencies represent an annual turnover value in billions of US dollars.
Many of these private currencies are backed by older forms of money such as gold.
Some examples of digital gold currencies include:-
How did it come into existence ?
Historically money was a metal (gold, silver, etc,) or other object that was difficult to duplicate, but easy to transport and divide. Later it consisted of paper notes, now issued by all modern governments. With the rise of modern industrial capitalism it has gone through several phases including but not limited to:
A. Bank notes - paper issued by banks as an interest-bearing loan. (These were common in the 19th century but not seen anymore.)
B. Paper notes, coins with varying amounts of precious metal (usually called legal tender) issued by various governments. There is also a near-money in the form of interest bearing bonds issued by governments with solid credit ratings.
C. Bank credit through the creation of chequable deposits in the granting of various loans to business, government and individuals. (It is critical that we understand that when a bank makes a loan, that is new money and when a loan is paid off that money is destroyed. Only the interest paid on it remains.)
How is it destroyed ?
When any bank loan is paid off or any government bond is redeemed the money value of the contract or bond is destroyed - taken out of circulation. This destruction also happens if any paper bills are burned or taken out of circulation by the central bank. (But it should be remembered that legal tender constitutes less than 4% of the money supply.)
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