What Is Credit Money?
Credit money is monetary value created as the result of some future obligation or claim. As such, credit money emerges from the extension of credit or issuance of debt. In the modern fractional reserve banking system, commercial banks are able to create credit money by issuing loans in greater amounts than the reserves they hold in their vaults.
There are many forms of credit money, such as IOUs, bonds and money markets. Virtually any form of financial instrument that cannot or is not meant to be repaid immediately can be construed as a form of credit money.
Key Takeaways
- Credit money is the creation of monetary value through the establishment of future claims, obligations, or debts.
- These claims or debts can be transferred to other parties in exchange for the value embodied in these claims.
- Fractional reserve banking is a common way that credit money is introduced in modern economies.
How Credit Money Works
According to recent research done in economic history, anthropology, and sociology, scholars now believe that credit was the first form of money, preceding coin or paper currency. In ancient times, some of the earliest writings found have been interpreted to be tallies of debts owed by one party to another - before the invention of money itself. This form of value obligation - i.e. I owe you X - is essentially credit money as soon as that obligation can be transferred to somebody else in kind. For instance, I can owe you X, but you can transfer your claim against me to your brother, so now I owe your brother X. You and your brother have essentially transacted in credit money.
During the crusades of the middle ages, the Knights Templar of the Roman Catholic church, a religious order that was heavily armed and dedicated to holy war, held valuables and goods in trust. This led to the creation of a modern system of credit accounts that is still prevalent today. Public trust has waxed and waned in credit money institutions over the years, depending on economic, political, and social factors.
Credit Money and Fractional Reserve Banking
"Fractional reserve" refers to thefraction of depositsheld in reserves. For example, if a bank has $500 million in assets, it must hold $50 million, or 10%, in reserve. It can, however, lend out $450 million as essentially new credit money.
Analysts reference an equation referred to as the multiplier equation when estimating the impact of the reserve requirement on the economy as a whole. The equation provides an estimate for the amount of money created with the fractional reserve system and is calculated by multiplying the initial deposit by one divided by the reserve requirement. Using the example above, the calculation is $500 million multiplied by one divided by 10%, or $5 billion.
Credit Money and Debt Markets
As noted above, specific types of credit money include bonds. These are a major segment of the financial markets. For example, the market for U.S. government debt (Treasury bonds or T-bonds and Treasury notes or T-notes) ticked in at $17.79 trillion in 2021. In 2021, the size of the global debt markets (more than $226 trillion) was more than four times the size of the equity markets (more than $53 trillion). Together they form the global capital markets. The U.S. capital markets are the largest worldwide, with the U.S. equities market being 2.4x and the U.S. bond markets being 1.6x the size of the runner-up, the European Union. U.S. capital markets account for 65% of total funding for economic activity and drive domestic growth.
Bonds allow governments (at the national, state, and local level), corporations, and nonprofits like colleges and universities, to access funds for a variety of growth projects, including funding roads, new buildings, dams or other infrastructure. Corporations will often borrow specifically to grow their business, buy property and equipment, acquire other companies, or invest in research and development for new products and services.
Outside of banks, bonds allow individual investors to assume the role of a lender in these situations. Public debt markets can open up a particular loan to thousands of investors, providing opportunities to fund portions of the capital needed. These public markets allow lenders to sell their bonds to other investors or to buy bonds from other individuals – long after the original issuing organization raised capital.
FAQs
Credit money refers to a future monetary claim against an individual who has used the credit facility to buy goods and services. Credit money can be of different types such as the basic IOUs, negotiable instruments, debt instruments and so on.
How does money credit work? ›
Generally speaking, credit works like this: A lender, such as a bank or credit card issuer, approves a borrower's request to borrow a certain amount of money. In exchange for the money, the borrower agrees to pay it back to the lender, typically with interest.
What is credit and examples? ›
There are many different forms of credit. Common examples include car loans, mortgages, personal loans, and lines of credit. Essentially, when the bank or other financial institution makes a loan, it "credits" money to the borrower, who must pay it back at a future date.
What is credit how it works? ›
It's a financial commitment to repay money borrowed plus interest in a timely manner. Failure to repay your credit as agreed can affect your ability to borrow, rent, or even get a job.
What are 3 examples of types of credit? ›
What are the Types of Credit? The three main types of credit are revolving credit, installment, and open credit.
Which of the following is an example of credit money? ›
Any future monetary claim against an individual that can be used is called credit money. Token coins, circulating promissory notes issued by the government, and demand deposits in the bank are the forms of credit money.
What is credit money in simple words? ›
Credit money is the value created by making claims, obligations, or debts for the future. These claims or debts can be given to other people in exchange for their value. Adding credit money to modern economies is often done through fractional reserve banking.
What is credit in simple words? ›
Credit is an agreement between a lender and a borrower that allows the borrower to obtain funds, goods or services now and repay them later. Credit can also refer to your history of borrowing and repaying money.
Is credit money a form of money? ›
Credit money is a form of currency created through lending and borrowing activities. It differs from fiat money, which is government-issued and not backed by physical commodities.
What is an example of credit in a sentence? ›
He shared the credit with his parents. You've got to give her credit; she knows what she's doing. Verb Your payment of $38.50 has been credited to your account. The bank is crediting your account for the full amount.
Credit activity (as defined in the National Credit Act) includes:
- providing credit under a credit contract or consumer lease.
- benefiting from mortgages or guarantees relating to a credit contract.
Card A has a $1,000 credit limit and carries a balance of $450. Card B has a $2,000 credit limit and carries a balance of $300. This means your total outstanding debt is $750, and your total available credit is $3,000. Therefore, your credit utilization ratio is $750 divided by $3000, which equals 0.25, or 25%.
How credit money is created? ›
Commercial banks perform the function of credit creation in an economy. Therefore, the money that is created by commercial banks is known as credit money. This is achieved by the commercial banks in the form of purchasing securities and providing loans.
How does credit work in banks? ›
A credit is a more flexible form of finance that allows you to access the amount of money loaned, according to your needs at any given time. The credit sets a maximum limit of money, which the customer can use in part or in full. The customer may use all the money provided, part of it or none at all.
How does credit save money? ›
“A high credit score means that you will most likely qualify for the lowest interest rates and fees for new loans and lines of credit,” McClary says. And if you're applying for a mortgage, you could save upwards of 1% in interest.
What is the simple definition of credit money? ›
Credit money is monetary value created as the result of some future obligation or claim. As such, credit money emerges from the extension of credit or issuance of debt.
What is credit money also known as? ›
Any future monetary claim against an individual that can be used to buy goods and services is known as Credit money or bank money. There are many forms of credit money, such as bonds, money market accounts etc.
What is the example of give credit to? ›
I will give credit to the rest of the team, too. Sometimes you have to give credit to the opposition. I would give credit to the players as well. We often give credit to actors, but not to the behind-the-scenes staff.
What is an example of paper money? ›
Most modern paper currencies are fiat currencies, including the U.S. dollar, the euro, and other major global currencies.
