As more value is created via economic activity, new money must be introduced in the system so that the economy can continue to flow.
Grossly oversimplifying, new fiat money is created by Commercial Banks. The extent to which they create new money is rationed by the Central Bank. These are common ways:
- Providing credit, like loans to a new customer that become deposits.
- Buying existing assets which again become deposits
- Providing overdraft facilities, which are deposits that can be spent.
This rationing is a delicate balance. On the one hand, if too little money is created, spending slows down and the economy may grind to a halt. In practice, this almost never happens.
On the other hand, if too much money is created, then the value of the entire supply is diluted, prices rise, and everyone loses purchasing power. This is called inflation, and in extreme cases turns to hyperinflation, which may lead to a whole country going bankrupt. Historically, this tends to happen rather often with national currencies.
Either way, human institutions are ultimately in charge of the levers to the money supply, meaning there’s no real scarcity. This is why fiat currencies, by definition, can’t be considered sound money.
As we’ve just seen, centralised systems can be vulnerable. However, up until 2009, it was arguably the only way to make a secure digital money (but not a sound one).
Bitcoin breaks with this approach from the very beginning and we’ll explore exactly how in the next lesson.
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