What is money? An Australian perspective: Part two


Welcome to part two of this series about money in Australia. Part one explored the Bank of England’s (BOEs) definition of money and discussed the first type of money (i.e. currency) in the modern economy. The BOE suggests there are two other types of money.

2. The second type of money is BANK DEPOSITS

What are they?

Remember how the BOE defines modern money to be a special form of IOU? Bank deposits are just that. An IOU from commercial banks to consumers1. They are also special because they are trusted by everyone (to be discussed later). In fact, according to the BOE, bank deposits make up most of the money in the economy.

To verify what the BOE is claiming, I’ve gone back to the RBA’s website here and found something interesting called the money aggregate series. This series not only lists the amount of currency (as we saw in Chart 1) in Australia, but it also lists the amount of other ‘money’ in the economy. For simplicity, the series I’m going to focus on is called M32.

This sounds complicated but it is not. Basically, M3 represents all the banknotes and coins in the economy plus all deposits held at banks and credit unions/building societies (and a few other institutions)(source: RBA).

If I now plot the M3 series on top of the currency data, a different picture unfolds (see chart 2). If we also include all the money held as ‘deposits at banks and ADIs (i.e. M3) then as of January 2019 we have a lot more ‘money’ in the economy than we first thought. Closer to $2.1 trillion!

Chart 2 – Australian Currency + M3 series in Billions$

Importantly, this data appears to substantiate the BOE’s assertion that ‘currency’ only accounts for a fraction of the money held by households and companies in the modern economy. And that – in fact – the bulk of money consists of deposits with banks!

Why do people use them?

From the previous section we saw that most money in the Australian economy is in the form of bank deposits. But why do we use bank deposits? The BOE gives a few suggestions which I will expand on a little here. Specifically, bank deposits are likely used as ‘money’ because of convenience, security, and trust.


Most households and companies would prefer to keep their ‘currency’ (banknotes and coins) deposited in the bank because it saves them lugging around notes and coins. Bank deposits also allow for relatively quick transactions, without the need of transferring large amounts of currency. For example, when making a purchase in a store, the shopper can simply swap their ‘bank deposit’ to the account of the store owner (at the same bank or different bank).


Bank deposits are often the default type of money in a modern economy. This is because we ‘trust’ them and have confidence that others also trust them and accept them as payments for goods and services. A direct deposit is as good as cash right?

In Australia, it is fair to say that most individuals receive their salary or wage directly as bank deposits. However, rather than swapping them into banknotes and coins, many households use them as a store of value and increasingly as the default medium of exchange (e.g. debit Cards, cheques, Bpay, Direct deposit, POLi payments, and paypass). See Davies et al. (2016) and Flannigan and Staib (2017) for more information.


It is typically safer to store your ‘currency’ as bank deposits to protect it from getting lost, damaged, or stolen. Furthermore, in bank deposits are often covered by government gaurantees.

For example, since 2008 Australia has had the financial claims scheme (FCS) which provides protection for deposits in banks, building societies and credit unions up to $250,000 for each account holder.  The FCS is activated by the Australian government if (and only when) a bank (or other deposit taking institution) fails (i.e. becomes insolvent), and aims to provide depositors with prompt access to their deposits. This would help ensure bank depositors remain confident in their deposit.

Interestingly, how the FCS would work if there was ever a bank ‘bail-in’ scenario in Australia is an intriguing question and a topic for another blog3.

How is it created?

I hope it is now relatively obvious that most ‘money’ in the modern economy is in the form of bank deposits. Moreover, these deposits are used as the default type of money (at least this is true in Australia). So here comes the two trillion dollar question. How are bank deposits created?

Initially, this might seem like a trivial question. Of course bank deposits come from people depositing banknotes and coins into the bank right? If this was the whole story, then how do we currently have a little over $2 trillion worth of ‘deposits with banks’ (i.e. M3 in chart 2) in Australia, yet only $73.5 Billion of banknotes and coins in existence? Where do bank deposits come from?

Well, the BOE suggests that bank deposits, unlike currency which is created by the central bank (RBA), are mostly created by commercial banks themselves! The BOE article continues:

“the amount of currency is very small compared to the amount of bank deposits. Far more important for the creation of bank deposits is the act of making new loans by banks. When a bank makes a loan to one of its customers, it simply credits the customer’s account with a higher deposit balance. At that instant, new money is created”(Pg. 8 italics added). 

This is a crucial insight into how money works. In fact, it is so underappreciated and potentially misunderstood that the BOE has published a dedicated article and working paper which go into great detail about money creation and how commercial banks create money by making new loans.

Moreover, there are a number of academic articles that corroborate the BOE view about money creation, not only in terms of theory (see Werner, 2014), but also empirically (see Werner, 2016). This phenomenon of banks creating money has been referred to in the academic literature as the Credit Creation Theory or Financing through Money Creation (FMC) model of banking.

Let me summarise how it works. When a banks makes a loan (e.g. a mortgage), the bank ‘purchases’ the loan contract from the borrower (e.g. household) and records it (on the computer) as an asset on its balance sheet. It is an asset to the bank because the borrower owes the bank the amount of the loan. The bank then simply adds the loan amount to the borrowers account.

This new ‘deposit’ goes down on the bank’s balance sheet as a liability because the bank owes the borrower the amount of the deposit (which is the same size of the initial loan). At this moment, the bank has created new money in the form of a new bank deposit (remember that bank deposits act as money) (source Werner, 2014).

When you think about it. This bank deposit is really just an IOU from the bank to the borrower. The loan is also simply and IOU from the borrower to the bank. The difference with the borrowers IOU however is that it is not widely accepted in the economy. The banks IOU (the deposit) is trusted and widely accepted as a medium of exchange – it is money!

Commercial banks therefore can and do create new money in the form of bank deposits. They do this by making new loans.

3. The third type of money is CENTRAL BANK RESERVES

Commercial banks needs to hold currency (banknotes and coins) to meet customer withdrawals. Banks also need to settle large amounts of transaction with each other during – and at the end of – every day.

Using physical banknotes to carry out these daily settlements would be highly inefficient in the modern world. Commercial Banks are therefore allowed to hold a different type of IOU from the central bank.

In Australia, these are known as exchange settlement balances (ESA) which we touched on earlier (see Baker and Jacobs, 2010). Exchange Settlement balances are simply a record on the RBA’s balances sheet of the amount owed by the RBA to each individual bank or authorised deposit-taking institutions (ADIs).

Similar to how commercial bank deposits are a useful medium of exchange for households and companies, ESA are a useful medium of exchange for banks (and ADIs). In fact, ESA are banks most immediate source of liquidity, and are used to settle transactions between themselves, which in Australia occurs daily on a large scale (Baker and Jacobs, 2010).

To give you a quick example of this. If one commercial bank wants to make a payment to another commercial bank – as they do every day – the banks will notify the RBA who will simply adjust each banks ESA accordingly, without the need of withdrawing and swapping currency.

In Australia, this process occurs for high-value payments (e.g. foreign exchange transaction) under the real-time gross settlement (RTGS) system in which payments between banks are made in real time. The RTGS system utilises the Reserve Bank Information and Transfer System (RITS), which is the underlying technology that makes the real time payments possible.

The net inter-bank obligations resulting from low-value payments (e.g. debit and credit card transaction from Bank A to Bank B) are also settled through RITS, but this settlement occurs at 9.00 am on the day after the transactions were made (Source Gallagher et al 2010).

New Payments Platform

As of February 2018 a new system of fast payments has been ‘live’ to the public in Australia. This New Payments Platform (NPP) allows immediate 24/7 payments across customers accounts at different financial institutions. The NPP works in conjunction with new infrastructure at the RBA called the Fast Settlement Service (FSS).

The FSS provides for the ‘fast’ settlement of NPP transaction between different financial institutions across their ESA at the RBA. In combination, the NPP and FSS has brought fast payments services to Australians.

One of the first technologies available to the public that takes advantage of the NPP is called Osko. Osko is a service developed by the BPAY Group and allows fast payments 24/7 to existing account holders in a number of financial institutions.


So what is money?

The Bank of England (the second oldest central bank in the world) suggests that money is just a special kind of IOU that is trusted and accepted as a medium of exchange in the economy.

Specifically, this money comes in different forms including currency (banknotes and coins), central bank reserves, and most notably bank deposits. In fact, most of the money in the modern economy takes the form of bank deposits.

Moreover, these bank deposits are created by commercial banks when they make new loans.

Is money any different in Australia? Probably not. Just looking at the RBA’s money aggregate data shows that currency makes up only a tiny fraction of Australia’s money supply.

In fact, the majority of the money supply is in deposits with banks (look at chart 2 if not convinced). To me this is quite obvious. What is less obvious is the mechanics of how these bank deposits are created.

This article has hinted that they are created by banks making loans, but what is the actual process?

To find out more, you can read my article called ‘Where does money come from?’. Or take a look at the BOE article called ‘Money creation in the modern economy‘.

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  1. See my article called Who owns the money in your bank account?.
  2. In Australia, M3 is defined as currency, plus deposits with banks, plus all other deposits at banks (including certificates of deposits) from the private non-ADI sector, plus ‘Deposits with non-bank ADIs (Authorised deposit-taking institution.
  3. A bank ‘bail-in’ is a way ‘to restructure the liabilities of a distressed financial institution (i.e. bank) by writing down its unsecured debt and/or converting it to equity’ (source IMF). This could mean the ‘write down’ or conversion (i.e. freezing) of bank deposits because the ‘money’ we deposit in the bank is technically an ‘unsecured loan’ to the bank. In New Zealand they have a bank bail-in regime already in place which appears to specifically include deposits (see the Open Bank Resolution), however it it much less clear if the same regime exists in Australia.

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