In this chapter we further enhance the realism of our model of money injections from Chapter 3. We now introduce the market for credit. Most money creation today occurs via the fractional-reserve banking industry or the central bank. Banks operate in the loan market, and this is where money is being injected into the economy in the real world. A functioning loan market would obviously also exist in a world of inflexible commodity money and without fractional-reserve or central banks. The loan market is one of the institutions that help channel savings into investments, which is an essential part of any capitalistic economy. To imagine how this would work without banks, one only has to look at today’s fund management industry, which also operates in the loan market (and the equity market) and which cannot print money.
In order to integrate bank credit into our model, we have to briefly clarify a few key concepts, such as investment, saving, capital goods, and interest. Even those readers who are knowledgeable about economics and familiar with these notions may benefit from the following explanation as it works out the features most relevant to our discussion and also refutes some common misconceptions about these concepts.
Consumption, Saving, and Investing
Everybody makes consumption and saving decisions. These are decisions about the use of economic resources, namely, how much of what is at our disposal today should we use for meeting ...