Money creation: Difference between revisions

In economics, money creation is the process by which the money supply of a country is expanded. There are two principal stages of money creation. First, the central bank of a country can introduce or issue new money into the economy (termed 'expansionary monetary policy'). A central bank usually injects new money into the economy by purchasing financial assets. Second, the new money introduced by the central bank is multiplied by commercial banks through fractional reserve banking, expanding the amount of broad money (i.e. cash plus demand deposits) in the economy.

Central banks monitor the amount of money in the economy by measuring monetary aggregates such as M2. The effect of monetary policy on the money supply is indicated by comparing these measurements on various dates. For example in the US, M2 grew from $6407.3bn in January 2005 to $8318.9bn in January 2009.^[1]

The conduct and effects of monetary policy and the regulation of the banking system are of central concern to monetary economics.

Within almost all modern nations, special institutions (such as the Federal Reserve System in the United States, the Bank of England, the European Central Bank, the People's Bank of China, and the Bank of Japan) exist which have the task of executing the monetary policy and often acting independently of the executive. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system. There are several monetary policy tools available to a central bank to expand the money supply of a country: decreasing interest rates by fiat; increasing the monetary base; and decreasing reserve requirements. All have the effect of expanding the money supply.

The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various financial assets, such as treasury bills, government bonds, or foreign currencies. Purchases of these assets result in currency entering market circulation (while sales of these assets remove money from circulation).

Usually, the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency, the price of gold, or indices such as Consumer Price Index. For example, in the case of the USA the Federal Reserve targets the federal funds rate, the rate at which member banks lend to one another overnight. The other primary means of conducting monetary policy include: (i) Discount window lending (as lender of last resort); (ii) Fractional deposit lending (changes in the reserve requirement); (iii) Moral suasion (cajoling certain market players to achieve specified outcomes); (iv) "Open mouth operations" (talking monetary policy with the market).

Quantitative easing involves the creation of a significant amount of new base money by a central bank by the buying of assets that it usually does not buy. Usually, a central bank will conduct open market operations by buying short-term government bonds or foreign currency. However, during a financial crisis, the central bank may buy other types of financial assets as well. The central bank may buy long-term government bonds, company bonds, asset backed securities, stocks, or even extend commercial loans. The intent is to stimulate the economy by increasing liquidity and promoting bank lending, even when interest rates cannot be pushed any lower.

Quantitative easing increases reserves in the banking system (i.e. deposits of commercial banks at the central bank), giving depository institutions the ability to make new loans. Quantitative easing is usually used when lowering the discount rate is no longer effective because they are already close to or at zero. In such a case, normal monetary policy cannot further lower interest rates, and the economy is in a liquidity trap.

In modern economies, relatively little of the money supply is in physical currency, in the U.S., only about 2% to 3% of the total money supply consists of physical coins and paper money.^[2]. The manufacturing of new physical money is usually the responsibility of the central bank, or sometimes, the government's treasury.

Contrary to popular belief, money creation in a modern economy does not directly involve the manufacturing of new physical money, such as paper currency or metal coins. Instead, when the central bank expands the money supply through open market operations (e.g. by purchasing government bonds), it credits the accounts that commercial banks hold at the central bank (termed high powered money). Commercial banks may draw on these accounts to withdraw physical money from the central bank. Commercial banks may also return soiled or spoiled currency to the central bank in exchange for new currency.^[3]

There are two types of money in a fractional-reserve banking system, currency originally issued by the central bank, and demand deposits at commercial banks. By the working of the modern banking system, banks expand the money supply of a country whenever a new loan is created.^[4][5]:

1. central bank money (all money created by the central bank regardless of its form (banknotes, coins, electronic money through loans to private banks))
2. commercial bank money (money created in the banking system through borrowing and lending) - sometimes referred to as checkbook money^[6]

When a commercial bank loan is extended, new commercial bank money is created. As a loan is paid back, the commercial bank money disappears from existence. Since loans are continually being issued in a normally functioning economy, the amount of broad money in the economy remain relatively stable. Because of this money creation process by the commercial banks, the money supply of a country is usually a multiple larger than the money issued by the central bank; that multiple is primarily determined by the reserve ratio set by the relevant banking regulators in the jurisdiction.

Commercial bank money is created by commercial banks lending and re-lending money created by the central bank. The table below, copied from the money multiplier, displays how bank money is used to produce commercial bank money via successive re-lending.

Although no new money was physically created in addition to the initial 100 deposit, new commercial bank money is created through loans. The 2 boxes marked in red show the location of the original 100 deposit throughout the entire process of this example. The total reserves plus the last deposit (or last loan, whichever is last) will always equal the original amount, which in this case is 100 in series like this. As this process continues, more commercial bank money is created. For more information on how this system works, see Fractional-reserve banking.

Other mathematical expansion series will produce different results by choosing different reserve rates and reserve ratios, as seen in the graph below. An earlier form of such a table, featuring reinvestment from one period to the next and a geometric series, is found in the tableau économique of the Physiocrats, which is credited as the "first precise formulation" of such interdependent systems and the origin of multiplier theory.^[10]

The reserve rate is computed by dividing the reserve by the deposit and the reserve ratio is computed by dividing the reserve by the money loaned out. In this example, in step A, 20 divided by 100 produces a reserve rate of 20% and 20 divided by 80 produces a reserve ratio of 25%.

The reserve ratio is unrelated to the reserve rate. Put another way, the reserve ratio has nothing to do with how much of the original deposit can be used as reserves. The whole original deposit could be used as new reserves and thus be used to expand the money supply. The money multiplier is multiplied by the initial deposit to show the maximum amount of money it can be expanded to.^[11] In step A, the maximal amount that can be loaned is 400; based on the 100 initial deposit, a 25% reserve ratio, and a 100% reserve rate. The maximal amount that can be loaned in step B is 1600 based on 400 being created in step A. In each step, the money the banks create then becomes new deposits which can be expanded as well.

Based on the mathematical series of the equation in the next section applied to the example above, if the maximum amount was loaned in each step then on step K the maximum amount of commercial bank money that could theoretically be loaned into existence is 419430400.

The most common mechanism used to measure this increase in the money supply is typically called the money multiplier. It calculates the maximum amount of money that an initial deposit can be expanded to with a given reserve ratio – such a factor is called a multiplier. As a formula, if the reserve ratio is R, then the money multiplier m is the reciprocal, ${\displaystyle m=1/R,}$ and is the maximum amount of money commercial banks can legally create for a given quantity of reserves.

In the re-lending model, this is alternatively calculated as a geometric series under repeated lending of a geometrically decreasing quantity of money: reserves lead loans. In endogenous money models, loans lead reserves, and it is not interpreted as a geometric series.

The money multiplier is of fundamental importance in monetary policy: if banks lend out close to the maximum allowed, then the broad money supply is approximately central bank money times the multiplier, and central banks may finely control broad money supply by controlling central bank money, the money multiplier linking these quantities; this was the case in the United States from 1959 through September 2008.

If, conversely, banks accumulate excess reserves, as occurred in such financial crises as the Great Depression and the Financial crisis of 2007–2010 – in the United States since October 2008, then this equality breaks down, and central bank money creation may not result in commercial bank money creation, instead remaining as unlent (excess) reserves.^[12] However, the central bank may shrink commercial bank money by shrinking central bank money, since reserves are required – thus fractional-reserve money creation is likened to a string, since the central bank can always pull money out by restricting central bank money, hence reserves, but cannot always push money out by expanding central bank money, since this may result in excess reserves, a situation referred to as "pushing on a string".

The above gives the mainstream economics theory of money creation. In heterodox economics, there are a number of alternative theories of how money is created, and generally emphasize endogenous money – that money is created by internal workings of an economy, rather than external forces – under whose rubric they thus fall. These theories include:

• Chartalism, which holds that money is created by government deficit spending, and emphasizes (and advocates) fiat money.
• Circuitist money theory, held by some post-Keynesians, which argues that money is created endogenously by the banking system, rather than exogenously by central bank lending. Further, they argue that money is not neutral – a credit money system is fundamentally different from a barter system, and money and banks must be an integral part of economic models.
• Credit Theory of Money. This approach was founded by Joseph Schumpeter.^[13] Credit theory asserts the central role of banks as creators and allocators of money supply, and distinguishes between 'productive credit creation' (allowing non-inflationary economic growth even at full employment, in the presence of technological progress) and 'unproductive credit creation' (resulting in inflation of either the consumer- or asset-price variety).^[14]

• Fractional-reserve banking
• Central bank
• Federal Reserve
• Fiat currency
• Quantitative easing
• Inflation
• Money
• Money supply
• National bank
• Open market operations
• Reserve requirements
• Chartalism

• Federalreserveeducation.org - The Principle of Multiple Deposit Creation
• Reserve Requirements - Fedpoints - Federal Reserve Bank of New York
• Bank for International Settlements - The Role of Central Bank Money in Payment Systems