Banks are a riddle wrapped up in an enigma. We all kind of know that they do stuff with money we don’t understand, while the last crisis left a feeling of deep mistrust and confusion. We try to shed a bit of light onto the banking system. Why were banks invented, why did they cause the last crisis and are there alternatives?

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Banking Explained – Money and Credit

Banking plays a crucial role in the modern economy, providing individuals and businesses with access to financial services such as loans, savings accounts, and payment transfers. However, understanding the intricate workings of banking, particularly money and credit, can be quite daunting. This article aims to simplify these concepts and provide a comprehensive introduction to the world of banking.

Firstly, let’s delve into the foundation of banking: money. Money is a medium of exchange used to facilitate transactions and store value. Traditionally, money has taken physical forms such as coins and banknotes. However, with advancements in technology, most transactions now occur digitally. Nevertheless, the underlying principle remains the same: money represents a claim on goods, services, or other forms of wealth.

In modern banking, money is primarily created through a process called fractional reserve banking. When you deposit money into a bank, only a fraction of this deposit is kept in reserve as cash reserves, while the rest is used to extend loans and earn interest. This process allows banks to create new money, essentially multiplying the initial deposit. For example, if you deposit $100 into your account, the bank can lend out $90 while keeping $10 as reserves. Consequently, the total money supply increases by $90, contributing to economic growth.

Now, let’s turn our attention to credit, a fundamental component of banking. Credit refers to the borrowing and lending of money, enabling individuals and businesses to access funds they may not possess temporarily. Banks provide credit in various forms, the most common being loans and credit cards.

When you apply for a loan, the bank evaluates your creditworthiness based on factors such as your credit history, income, and existing debts. If approved, you receive the requested funds with a contractual agreement to repay the principal amount along with interest over a specified period. Loans can be used for diverse purposes, such as purchasing a house, funding education, or expanding a business.

Credit cards, on the other hand, provide a convenient line of credit for everyday purchases. When you use a credit card, you essentially borrow money from the issuing bank, with an obligation to repay the outstanding balance before the billing cycle ends. If you fail to repay the full amount, the bank charges interest on the remaining balance. Additionally, credit cards often offer rewards and benefits, making them a popular payment option for many.

The functioning of credit is crucial for economic growth. By facilitating borrowing, banks stimulate investment, entrepreneurship, and consumer spending. However, an excessive reliance on credit can also lead to financial instability, as seen during economic downturns or credit bubbles.

Furthermore, credit and money are interconnected. When you take out a loan, new money is created in the form of a bank deposit. Conversely, when you repay the loan, money is effectively destroyed. This dynamic interaction between credit and money supply impacts the overall economy, influencing interest rates, inflation, and economic activity.

In summary, banking is an intricate system built on the foundations of money and credit. Money, as a medium of exchange, allows for transactions and wealth storage, while credit enables individuals and businesses to access funds beyond their immediate means. Understanding these concepts is crucial in navigating the world of finance and making informed decisions regarding loans, savings, and investments.