The Bitcoin Standard: The Decentralized Alternative to Central Banking

by Saifedean Ammous

A fundamental fact to understand about the modern financial system is that banks create money whenever they engage in lending. In a fractional reserve banking system similar to the one present all over the world today, banks not only lend the savings of their customers, but also their demand deposits. In other words, the depositor can call on the money at any time while a large percentage of that money has been issued as a loan to a borrower. By giving the money to the borrower while keeping it available to the depositor, the bank effectively creates new money and that results in an increase in the money supply. This underlies the relationship between money supply and interest rates: when interest rates drop, there is an increase in lending, which leads to an increase in money creation and a rise in the money supply. On the other hand, a rise in interest rates causes a reduction in lending and contraction in the money supply, or at least a reduction in the rate of its growth.