Block I · How money works · Module 4 # The mechanics of money ## Entering the module **One sentence:** most money today is not printed but **written down** — when someone takes out a loan. **After the module you will be able to:** - explain who creates banknotes and who creates the money in accounts; - say why "the bank lends out other people's [savings](https://pecuvo.eu/en/glossary/saving/)" is a myth; - explain what the [central bank](https://pecuvo.eu/en/glossary/central-bank/) does with the [interest](https://pecuvo.eu/en/glossary/interest/) rate and why money sometimes loses value fast. **Chapters:** 1. Who makes money 2. Lending creates money 3. Two myths 4. What holds banks back 5. Interest — the price of money 6. [Inflation](https://pecuvo.eu/en/glossary/inflation/) 7. [Hyperinflation](https://pecuvo.eu/en/glossary/hyperinflation/) → The iron principle of the module --- ## For the youngest · ages 6–7 🐣 **The youngest:** Most money today cannot be seen. It is written in a big notebook at the bank. When someone borrows, a new line is written there. What is borrowed is given back — often with a little extra. **Play together (5 minutes):** Make a "bank notebook" from a sheet of paper. The child lends 5 buttons to a teddy bear and writes: "Teddy owes 5." When Teddy gives them back, cross out the line together. **A question for the evening:** "Why do you think people believe what is written down?" --- ## Chapter 1 · Who makes money 👧 **Child** Banknotes and coins are made by the central bank. But did you know that they are only a small part of all money? Most money is **numbers in people's accounts**. Those are made by ordinary banks. 🧑 **Teenager** There are two kinds of money: - **central bank money** — banknotes, coins and the reserves that banks keep with it; - **commercial bank money** — the deposits in our accounts. In the United Kingdom, 97 % of the money people hold is [bank deposits](https://pecuvo.eu/en/glossary/deposit/), not banknotes. 🧔 **Adult** That is why the question "how much money is there?" is a question about **bank balance sheets**, not about printing presses. The central bank sets the framework: the interest rate, the rules, the reserves. Commercial banks create the bulk of money when they lend. In the euro area, the [ECB](https://pecuvo.eu/en/glossary/ecb/) and the national central banks — since 2026 also the [Bulgarian National Bank](https://pecuvo.eu/en/glossary/bnb/) — manage central bank money. **Myth → truth** - Myth: "Money is printed by the government." - Truth: banknotes are issued by the central bank. Most money, however, is created by banks as deposits. **Who [profits](https://pecuvo.eu/en/glossary/profit/)?** Banks earn interest on the loans they create. **Scene for 3D:** two machines — a small printing press for banknotes and a huge "recording machine" at the bank. The child sees how much more money comes out of the second one. **→ Continue at the source** - Bank of England — "Money creation in the modern economy" (2014): https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy **Sources** - ✔ Bank of England Quarterly Bulletin 2014 Q1 (97 % — the introductory article): https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/quarterly-bulletin-2014-q1 --- ## Chapter 2 · Lending creates money 👧 **Child** Imagine the bank has a big notebook. When Mum takes out a loan for a car, the bank writes on her page: "+€10,000 in the account". And on its own page it writes: "Mum owes us €10,000." That money **did not exist** before — it appeared with two entries. When Mum repays the loan, both entries are erased and the money disappears. It is not magic — it is bookkeeping. And the bank cannot write as much as it likes: rules and interest rates keep it in check (Chapter 4). 🧑 **Teenager** The Bank of England (2014) puts it plainly: **when a bank makes a loan, it creates a new deposit in the borrower's account.** It does not take the money from a saver's account. When the loan is repaid, the money is destroyed. That is why the amount of money in the economy grows when people and companies borrow, and shrinks when they repay. 🧔 **Adult** On the bank's balance sheet the loan is an **asset** (a claim) and the new deposit is a **liability** (an obligation). Both appear at the same time. When the borrower pays someone at another bank, the first bank has to transfer **reserves** (central bank money) to the second one. That is why banks keep [liquidity](https://pecuvo.eu/en/glossary/liquidity/) and lend to each other. This mechanism underlies everything in Module 1 (Stockholms Banco), Module 3 (a deposit is a claim) and Module 7 ([credit](https://pecuvo.eu/en/glossary/credit/) and interest). 🎓 **The academic basis:** education about credit works best **just before the decision** — the first [credit card](https://pecuvo.eu/en/glossary/credit-card/), the first [consumer loan](https://pecuvo.eu/en/glossary/consumer-credit/) (Fernandes et al., 2014; Kaiser & Menkhoff, 2017). That is why this chapter leads straight to Module 7 (interest and the [APR](https://pecuvo.eu/en/glossary/apr/)) and to the step in the portfolio. **Myth → truth** - Myth: "The money from your loan is someone's savings." - Truth: it is a new deposit, created at the moment of the loan. **Who profits?** The bank — from the interest. The economy — if the credit goes into work and production. It loses if it goes into bubbles (property that rises only because it is bought on credit). **Scene for 3D:** a notebook with two pages. The child presses "loan" — a number lights up on both pages. Presses "repay" — and both go out. **→ Continue at the source** - Bank of England — the article and its video: https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy - Perry Mehrling (Columbia) — "Economics of Money and Banking" (Coursera), for depth. **Sources** - ✔ McLeay, Radia & Thomas, Bank of England QB 2014 Q1 (the address above; PDF: https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy) --- ## Chapter 3 · Two myths 👧 **Child** Some people think the bank simply takes one person's money and gives it to another. Others think the bank "multiplies" money by some number. Neither is quite right. 🧑 **Teenager** The Bank of England rejects **two textbook models**: 1. "Banks are just intermediaries — they lend out savers' money." 2. "Banks multiply central bank money by a **money multiplier**." In reality, banks first make the loan and then look for the reserves they need. The central bank supplies them at the price it sets — the interest rate. 🧔 **Adult** Why the myth persists: it is convenient and "easy to picture". But it leads to wrong conclusions, for example that "if the central bank prints reserves, credit will automatically multiply". Quantitative easing (QE) after 2008 showed that huge reserves do not necessarily mean huge lending. Banks lend when there is demand and a profit at an acceptable risk. **Myth → truth** - Myth: "There is a fixed multiplier — 1 euro of reserves becomes 10 euros of credit." - Truth: there is no mechanical link. The interest rate, demand, risk and the rules decide. **Who profits from the myth?** The myth makes banks look like passive keepers of savings, not like creators of money who profit from it. **Scene for 3D:** an old textbook whose page on the "multiplier" crumbles, and underneath the real diagram with the notebook appears. **→ Continue at the source** - Bank of England, 2014 (the address in Chapter 2). **Sources** - ✔ Bank of England QB 2014 Q1 — the rejection of the two models. --- ## Chapter 4 · What holds banks back 👧 **Child** If the bank can write money in its notebook, why doesn't it write millions? Because people have to pay their loans back. If the bank lends to people who cannot repay, it loses. And there are guards who check on it. 🧑 **Teenager** Banks are limited by: - **the interest rate** set by the central bank — the higher it is, the fewer people want a loan; - **risk** — bad loans bring losses; - **the rules** — the capital a bank must hold against its loans, and liquidity; - **demand** — somebody has to need the credit. 🧔 **Adult** Capital requirements (the Basel rules) and supervision (in the euro area, the ECB through the Single Supervisory Mechanism) limit how many risky loans a bank can have relative to its capital ✔. The central bank influences credit mainly through the interest rate and through asset purchases. When all of this fails, banking crises follow — Module 2 (Bulgaria 1996) and Chapter 7. **Myth → truth** - Myth: "If banks create money, they can create it without limit." - Truth: every loan carries risk and capital costs. Banks fail when they forget it. **Who profits?** Supervision protects depositors and taxpayers, who would otherwise pay for the rescue. **Scene for 3D:** the recording machine has three brakes — interest rate, capital, risk. The child switches one off and sees the machine overheat. **→ Continue at the source** - ECB — banking supervision: https://www.bankingsupervision.europa.eu ✔ **Sources** - ✔ Bank of England QB 2014 Q1 (the constraints). - ✔ Basel III; the Single Supervisory Mechanism (operating since November 2014) — https://www.bankingsupervision.europa.eu --- ## Chapter 5 · Interest — the price of money 👧 **Child** Interest is "rent" for money. When you borrow, you pay rent. When you save at the bank, the bank pays you a little rent. 🧑 **Teenager** The central bank sets the key interest rate — the price at which banks borrow from it and leave money with it. When inflation is high, the rate goes up: loans become more expensive, spending slows down, prices rise more slowly. When the economy is weak, the rate comes down. The ECB's target is **2 % inflation over the medium term**. Since 2021 the target has been **symmetric**: inflation below 2 % is just as unwelcome as inflation above 2 %. 🧔 **Adult** From the central bank's rate to the rate on your loan there is a chain: the interbank market → rates on loans and deposits → the decisions of companies and households → prices. The chain takes months and is not precise. That is why central banks talk about "the medium term". The ECB's previous wording ("below, but close to, 2 %") was perceived as a ceiling and probably pulled expectations down. That is why it was changed in 2021. **Myth → truth** - Myth: "A low interest rate is always good." - Truth: it is good for debtors and bad for savers. If it stays low for too long, it can inflate property prices. **Who profits?** With high rates — savers and banks. With low rates — debtors and property buyers. **Scene for 3D:** a tap with an "interest rate" control above a big pool called "the economy". The child turns it and watches how fast the pool fills and whether it overflows (inflation). **→ Continue at the source** - ECB — the monetary policy strategy: https://www.ecb.europa.eu/mopo/strategy/html/index.en.html - ECB — explainers on interest rates (ECB explainers): https://www.ecb.europa.eu/ecb-and-you/explainers/html/index.en.html **Sources** - ✔ ECB, 2021 strategy (2 %, symmetric, medium term) — confirmed through Suomen Pankki and the Bank of Israel: https://www.suomenpankki.fi/en/Monetary-policy/ECBs-monetary-policy-strategy/ - ✔ BIS Review (the asymmetry of the old wording): https://www.bis.org/review/r220218i.pdf --- ## Chapter 6 · Inflation 👧 **Child** Inflation is when things get more expensive and the same money buys less. Like an ice cream that melts a little every day — it does not vanish all at once, but it gets smaller. 🧑 **Teenager** There are several causes, and they often work together: - **demand** is greater than what can be produced; - **costs** jump — energy, raw materials; - **expectations** — if everyone expects prices to rise, they raise prices earlier; - **money** grows faster than goods and services. "The central bank prints, and that is why there is inflation" is too simple. 🧔 **Adult** Moderate inflation (around 2 %) is considered safer than [deflation](https://pecuvo.eu/en/glossary/deflation/), because deflation makes people put off purchases and makes [debts](https://pecuvo.eu/en/glossary/debt/) heavier (Module 2, Chapter 3). The key is **expectations**. If people believe the central bank will hold inflation down, it stays low more easily. That is why trust is a real economic resource. **Myth → truth** - Myth: "Inflation comes only from printing money." - Truth: money is just one of the causes. Energy shocks, demand and expectations often weigh more. **Who profits?** Debtors with a fixed rate. Savers and people on fixed incomes lose. **Scene for 3D:** a shopping basket. The child "runs time" — the prices on the shelf rise, and the basket that €20 can fill gets smaller. **→ Continue at the source** - ECB — "What is inflation?" (ECB explainers): https://www.ecb.europa.eu/ecb-and-you/explainers/html/index.en.html **Sources** - ✔ ECB, the explainers (the list works; "What is inflation?" is inside) — https://www.ecb.europa.eu/ecb-and-you/explainers/html/index.en.html --- ## Chapter 7 · Hyperinflation 👧 **Child** Sometimes prices rise so fast that money is worth almost nothing. In Germany 100 years ago, people carried money in wheelbarrows for one loaf of bread. Then they made new money and stopped the madness. 🧑 **Teenager** Three stories: - **Germany, 1923:** in November 1923, 1 dollar was worth about **4.2 trillion marks**. On 15 November 1923 the **Rentenmark** was issued: 1 Rentenmark = 1 trillion old marks. - **Zimbabwe, 2008:** in November 2008 monthly inflation was estimated at about **79.6 billion per cent** (Hanke & Kwok). It is often confused with the even larger annual figure. - **Bulgaria, 1997:** monthly inflation of **243 % in February 1997** (IMF) — Module 2, Chapter 7. 🧔 **Adult** What the three cases have in common: - the state finances its spending with new money; - trust in the [currency](https://pecuvo.eu/en/glossary/currency/) collapses; - people flee to foreign currency and goods. The way out is always **a new anchor of trust**: - in Germany — the Rentenmark, backed (at least on paper) by land and property; - in Bulgaria — the [currency board](https://pecuvo.eu/en/glossary/currency-board/); - in Zimbabwe — foreign currencies. Hyperinflation does not come "out of nowhere". It is the result of decisions and of lost trust. **Myth → truth** - Myth: "Hyperinflation is a natural disaster." - Truth: it has clear causes and clear ways out — discipline and trust. **Who profits?** Debtors (their debts melt away) and those who hold foreign currency or goods. Savers lose — sometimes a lifetime's savings. **Scene for 3D:** three rooms — Berlin 1923, Harare 2008, Sofia 1997. In each, the price of bread in the shop window ticks like a clock. The child pulls the "new anchor" lever and the clock stops. **→ Continue at the source** - The Bundestag — 100 years of Weimar, hyperinflation: https://www.bundestag.de/parlament/geschichte/100-jahre-weimar/hyperinflation-970722 - Johns Hopkins — "What hyperinflation looks like": https://magazine.jhu.edu/2009/08/27/what-hyperinflation-looks-like **Sources** - ✔ Bundestag (4.2 trillion marks to the dollar in November 1923) — the address above. - ✔ The Rentenmark, 15.11.1923, 1 : 1 trillion (Wikipedia; Börsen-Zeitung) — https://www.boersen-zeitung.de/konjunktur-politik/vor-90-jahren-das-ende-der-deutschen-hyperinflation · ✔ the decree on the German Rentenbank is of 15.10.1923 (RGBl. I S. 963), the first Rentenmark notes were issued on 15.11.1923, and the rate of 1 trillion (paper) marks = 1 Rentenmark applied from the end of November 1923 (Geigant, "Das Wunder der Rentenmark", Kredit und Kapital 37(3), 2004, 418–431, DOI 10.3790/ccm.37.3.418, CC BY 4.0, opened 21.10.2026). - ✔ Hanke & Kwok (Zimbabwe) — JHU, the address above. - ✔ IMF, PIN 97/15 (Bulgaria) — see Module 2. --- ## The iron principle of the module > **Every loan is money that appears today and disappears when you repay it — with interest. Borrow from your future self only if that future self would agree.** - 👧 Child: "If I borrow now, what will I have to give back, and when?" - 🧑 Teenager: "[Buy now, pay later](https://pecuvo.eu/en/glossary/buy-now-pay-later/)" is also credit. How much will you pay in total? - 🧔 Adult: what will the thing you are borrowing for give back to you? More than it costs with the interest (Module 7 — the APR)? **Your step in Pecuvo:** record every loan as a "debt" account and set a "repayment" goal. See how many months it stays in your life and how much interest it costs. ## Check yourself (3 questions per level) - 👧 1. Who makes banknotes? 2. What does the bank write in its notebook when it makes a loan? 3. What is inflation? - 🧑 1. What happens to the money when you repay a loan? 2. Which two myths does the Bank of England reject? 3. Why is the ECB's target "symmetric"? - 🧔 1. What limits banks' lending? 2. Why did the huge reserves after 2008 not produce huge lending? 3. What do Germany 1923, Zimbabwe 2008 and Bulgaria 1997 have in common? [Lesson sheet for teachers — printable](https://pecuvo.eu/en/teachers/the-mechanics-of-money/)