Organisations and the financial system
Organisations and the financial system

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Organisations and the financial system

1 An overview of financing Small and Medium Enterprises

Why do organisations need finance? Given the structure of the current socio-economic system, anyone with a goal needs some form of funding, even to perform basic day-to-day activities. Just think about the pocket money that children get in order to fund their first small expenses, or the various door-to-door fund-raising activities carried out by non-profit organisations. Of course, just as a child growing into adulthood requires more elaborate sources of finance to sustain increasingly complex objectives, organisations, too, must evaluate ways in which they can finance their goals.

Raising finance performs three main roles:

  1. It provides the money necessary to start up a business (e.g. to secure premises and/or equipment).
  2. It provides businesses with the funds required to fulfil their payment obligations and ensure the smooth running of their daily activities (e.g. payments to suppliers or staff wages).
  3. It equips businesses with the resources necessary to carry out expansion plans (e.g. through long-term investments).

Although in this section you will focus on different sources of finance suitable to various forms of business organisations, most of the sources of finance discussed should be understood as potentially available to every type of organisation, including those in the public sector. Some of the types of financing discussed are also available to not-for-profit organisations, although you will not cover this aspect in detail.

Before starting to look at the various sources of finance available to business organisations, it is worth trying to answer a basic but rather challenging question: where does money come from?

Activity 1  Where does money come from?

Timing: Allow around 20 minutes for this activity

Organisations need money to function properly. Therefore, it is important to understand the primary source of money, as it does not just fall from the sky. In this activity you will share your ideas on money creation before watching a short video from the Bank of England.

Part 1

Where do you think the money circulating in economic systems comes from? Write down your answer in the box below.

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Part 2

A safe bet in answering this kind of question is to ask well-renowned experts on the topic, for example the research team of the Bank of England. Watch the following video on money creation in the modern economy. Once you have finished watching the video, use the box below to write notes on how money is created in the financial system. Was your original answer correct? If so, was there a particular aspect of money creation that you were not previously aware of?

Download this video clip.Video player: author="al22273" timestamp="20200824T124154+0100"
Skip transcript: Video 1 The Bank of England on money creation in the modern economy

Transcript: Video 1 The Bank of England on money creation in the modern economy

Ryland, your article is about how money gets created. We're surrounded here by gold in the vaults of the Bank of England. And historically in the gold standard, the amount of gold would have been related to the stock of money in the economy. Things are very different now. In the modern economy, where does money come from?
Well, let's start off with narrow or central bank money. As the name suggests, central bank money is determined by the Bank of England and consists of notes and reserves. And in normal times at least, notes and reserves are determined by the amount of notes that people want to hold or need for their transactions and the amount of notes and reserves that banks want to hold given the level of interest rates in the economy. It is not chosen or fixed by the central bank as is sometimes described in some economics textbooks.
Your article focuses on broad money. What determines how much of that there is?
Well, broad money, which in many ways is a better measure of the amount of money circulating in the economy, includes all the bank deposits of households and companies. And one of the key points of the article is that banks create additional broad money whenever they make a loan.
Now while this is nothing new, it is sometimes overlooked as the main way in which money is created and it runs contrary to the view sometimes put forward that banks can only lend out deposits that they already have. In fact, loans create deposits - not the other way around.
Now your article explains in more detail how lending creates money. It also explains how there are limits to how much banks are likely to create new money as a result of lending. These could be profitability considerations of the banks themselves through to how households and companies react in aggregate to having increased deposits as a result of higher lending.
That's right.
So if banks create money through lending, what then is the role of the monetary policy of the central bank in this story?
Well, you mentioned some of the limits to how much banks will lend in practice. Well, monetary policy provides the ultimate limit. Now in normal times-- say, before the Great Recession-- monetary policies is set through interest rates, and that determines the loan rates that are faced by borrowers in the economy and the amount of interest that banks pay out to depositors. And this directly affects the amount of lending that goes on in the economy and the amount of broad money that's created as a result.
End transcript: Video 1 The Bank of England on money creation in the modern economy
Video 1 The Bank of England on money creation in the modern economy
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The banking system is at the heart of the creation of money. In fact, almost all the money in the economy is directly created by banks, in the form of bank deposits, created in the exact moment banks concede loans.

In the words of the Bank of England:

Commercial [i.e. high-street] banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created.

(McLeay, Radia and Thomas, 2014 p. 16, bold in the original)

If you would like to read more about how money is created, you can find details of the article cited in this video, ‘Money creation in the modern economy’, in the References section.


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