Cash: money in its material form, that is, notes and coins. It is issued by the state and is the official legal tender. Cash is a part of the central bank money. Only the exchangeability into cash gives the deposit money its value. Cash is the only type of money that circulates in both money cycles.
Central Bank: the bank of the state and the institution that practically carries out the creation of the state fiat money. The central bank creates money for the financial system on its own initiative and can, in a banking crisis, stabilise it with unlimited credit, acting as the so-called ‘lender of last resort’. But the central bank also creates the new money that is needed for the government’s deficit spending, although in many states the central bank and government won’t collaborate directly but instead use banks as intermediaries. The most important instrument with which the central bank pursues its monetary policy and tries to influence the banks’ money creation activities is the key interest rate.
Central bank money (currency or reserves): the actual national (or supranational) currency. The central bank creates it as cash and as non-cash money in central bank accounts. Government, central bank and banks use only central bank money among one another. The banks’ deposit money gets its value only by being exchangeable into central bank money. Banks always need central bank money: for cash withdrawals to their customers, for settlements and transactions with other banks and for minimum reserves. The banks get it from the central bank at the key interest rate.
Deficit spending (deficit expenditure): the part of the annual government budget, which is not covered by tax revenues of the same amount. Deficit spending leads to money creation by the state and the newly created money ends up as credit on the accounts of households and companies. The deficit spending of all the years sums up to the sovereign debt.
Deposit money (bank money, bank deposits, giral money): the deposits that we citizens have on the assets side of our current and savings accounts. Deposit money is generated by the banks whenever they grant loans to households and companies or buy value from them. For the banks deposit money
represents a debt to their customers, as they have to cash it out or transfer it on their behalf – therefore, it is on the liabilities side of the bank balance sheet. Together with state cash, deposit money is the money that households and companies use for their financial interactions.
Fiat money: money issued by the government that is not covered by any material equivalent, such as gold or silver. Fiat money has been the international norm for money at least since 1971, when the USA abolished the last remnant of the gold standard. It has the advantage that each state can freely create its own money and technically cannot go bankrupt as long as it is indebted exclusively in its own currency.
Government bonds: government promissory notes. They have a term, are denominated in a currency and usually offer an interest rate. Government bonds are very popular with investors as the safest possible investment, and they are indispensable for institutional investors such as insurance companies. Contrary to common belief, government bonds do not serve to raise money for the state (as it has the money creation monopoly and the central bank). Technically, government bonds rather serve to absorb liquidity out of the banking sector, and thus guarantee the effectiveness of the key interest rate. Government bonds which are resold to private individuals shut down demand and thus also have an anti-inflationary effect.
Key interest rate (base rate, prime rate): the interest rate that the central bank charges commercial banks for the central bank money they lend. In the case of a national currency, the interest rate for government bonds is only slightly higher than the key interest rate, as these are as safe as the currency itself. The banks pass on the rate to their private customers with respective risk surcharges. With these mechanisms, the key interest rate influences all interest rates in a currency area. For the central bank it is the most important instrument. When the economy is running hot, with the banks granting more and more loans and inflation is threatening, the key interest rate is raised and acts as a brake. In a recession, lowering the key interest rate is less effective, as even a loan at zero interest is too expensive if demand and profit expectations are lacking.
Public debt (national debt, government debt, sovereign debt): the sum of all annual budget deficits, minus budget surpluses in other years. The public debt also corresponds to the money that the government has created in favour of the private sector over the course of its existence and has not taxed back, and thus (disregarding inflows and outflows of foreign money) mirrors the net savings of the private sector.
Public debt ratio (debt to GDP ratio): the public debt not in absolute terms but in relation to gross domestic product (GDP). This means that the public debt ratio decreases automatically when GDP increases. Even if government debt is rarely actually repaid, the public debt ratio has been able to fall repeatedly in many countries during good economic times, a process also known as “growing out of debt”. On the other hand, the public debt ratio rises automatically when GDP declines – even if no new debt is taken on.
Sectors (private sector/public sector/foreign countries): the private sector is formed by households and companies (including private commercial banks, if not specified otherwise) and it is opposed to the public sector i.e., the federal state. The third sector are the foreign countries (also named ‘rest of the world’). In the analysis of an economy, each economic agent inevitably belongs to one of the three sectors.
Sectoral analysis: Taking into account that in a credit money system every credit balance has inevitably arisen with a debt, by means of the division into sectors one can answer the following question: If a country’s private sector has net savings of 10-billion-euro, and the public sector of the same state has only 4-billion-euro debt – who has the other 6-billion-euro debt? It has to be the foreign countries – as someone has to have it.
