# Money creation

Money creation, or money issuance, is the process by which the money supply of a country, or of an economic or monetary region,[note 1] is increased. In most modern economies, most of the money supply is in the form of bank deposits.[1] Central banks monitor the amount of money in the economy by measuring the so-called monetary aggregates.[note 2]

## Money supply

The term "money supply" commonly denotes the total, safe, financial assets that households and businesses can use to make payments or to hold as short-term investment.[2] The money supply is measured using the so-called "monetary aggregates", defined in accordance to their respective level of liquidity: In the United States, for example, M0 for currency in circulation; M1 for M0 plus transaction deposits at depository institutions, such as drawing accounts at banks; M2 for M1 plus savings deposits, small-denomination time deposits, and retail money-market mutual fund shares.[2]

The money supply is understood to increase through activities by government authorities,[note 3] by the central bank of the nation,[note 4] and by commercial banks.[3]

## Money creation by the central bank

### Central banks

The authority through which monetary policy is conducted is the central bank of the nation. The mandate of a central bank typically includes either one of the three following objectives or a combination of them, in varying order of preference, according to the country or the region: Price stability, i.e. inflation-targeting; the facilitation of maximum employment in the economy; the assurance of moderate, long term, interest rates.[4]

The central bank is the banker of the government[note 5] and provides to the government a range of services at the operational level, such as managing the Treasury's single account, and also acting as its fiscal agent (e.g. by running auctions), its settlement agent, and its bond registrar.[5] A central bank cannot become insolvent in its own currency. However, a central bank can become insolvent in liabilities on foreign currency.[6]

Central banks operate in practically every nation in the world, with few exceptions.[7] There are some groups of countries, for which, through agreement, a single entity acts as their central bank, such as the organization of states of Central Africa, [note 6] which all have a common central bank, the Bank of Central African States, or monetary unions, such as the Eurozone, whereby nations retain their respective central bank yet submit to the policies of the central entity, the ECB. Central banking institutions are generally independent of the government executive.[1]

The central bank's activities directly affect interest rates, through controlling the base rate, and indirectly affect stock prices, the economy's wealth, and the national currency's exchange rate.[4] Monetarists and some Austrians[note 7][8] argue that the central bank should control the money supply, through its monetary operations.[note 8][9][10] Critics of the mainstream view maintain that central-bank operations can affect but not control the money supply.[note 9]

### Open-market operations

Open-market operations (OMOs) concern the purchase and sale of securities in the open market by a central bank. OMOs essentially swap one type of financial assets for another; when the central bank buys bonds held by the banks or the private sector, bank reserves increase while bonds held by the banks or the public decrease. Temporary operations are typically used to address reserve needs that are deemed to be transitory in nature, while permanent operations accommodate the longer-term factors driving the expansion of the central bank's balance sheet; such a primary factor is typically the trend of the money-supply growth in the economy. Among the temporary, open-market operations are repurchase agreements (repos) or reverse repos, while permanent ones involve outright purchases or sales of securities.[11] Each open-market operation by the central bank affects its balance sheet.[11]

### Monetary policy

Monetary policy is the process by which the monetary authority of a country, typically the central bank (or the currency board), manages the level of short-term interest rates[note 10][12] and influences the availability and the cost of credit in the economy,[4] as well as overall economic activity.[13]

Central banks conduct monetary policy usually through open market operations. The purchase of debt, and the resulting increase in bank reserves, is called "monetary easing." An extraordinary process of monetary easing is denoted as "quantitative easing", whose intent is to stimulate the economy by increasing liquidity and promoting bank lending.

## Money creation by government spending

State spending is part of the state's fiscal policy. Deficit spending involves the state spending into the economy more than it receives (in taxes and other payments) within a certain period of time, typically the budget year.[14]

Deficit spending increases the money supply.[15] The extent and the timing of budget deficits is disputed among schools of economic analysis. The mainstream view is that net spending by the public sector is inflationary in so far as it is "financed" by the banking system, including the central bank, and not by the sale of state debt to the public.[16]

The existence itself of budget deficits is generally considered inflationary by mainstream economics,[15] so policies are prescribed for the lowering of the deficit,[note 11] while heterodox economists such as Post-Keynesians treat deficit spending as "simply" a fiscal policy option.[17]

## Role of banks in money creation

When commercial banks lend money, they expand the amount of bank deposits.[18] The banking system can expand the money supply of a country beyond the amount created or targeted by the central bank, creating most of the broad money in a process called the multiplier effect.[18]

Banks are limited in the total amount they can lend by their capital adequacy ratios, and their required reserve ratios. The required-reserves ratio obliges banks to keep a minimum, predetermined, percentage of their deposits at an account at the central bank.[note 12] The theory holds that, in a system of fractional-reserve banking, where banks ordinarily keep only a fraction of their deposits in reserves, an initial bank loan creates more money than it initially lent out.

The maximum ratio of loans to deposits is the required-reserve ratio RRR, which is determined by the central bank, as

${\displaystyle {\mathit {RRR}}={\frac {R}{D}}}$

where R are reserves and D are deposits.

In practice, if the central bank imposes a required reserve ratio (RRR) of 0.10, then each commercial bank is obliged to keep at least 10% of its total deposits as reserves, i.e. in the account it has at the central bank.

The process of money creation can be illustrated with the following United States example:

1. Corporation A deposits $100,000 into Bank of America. 2. Bank of America keeps$10,000 as reserves at the Federal Reserve (the central bank of the United States). To make a profit, Bank of America loans the remaining $90,000 to the federal government. 3. The government spends the$90,000 by buying something from corporation B.
4. B deposits the $90,000 into its account with Wells Fargo. 5. Wells Fargo keeps$9,000 as reserves at the Federal Reserve, and then lends the remaining $81,000 to the government. If this chain continues indefinitely then, in the end, an amount approximating$1,000,000 has gone into circulation and has therefore become part of the total money supply.[19] Furthermore, the Federal Reserve itself can and does lend money to banks as well as to the federal government.[20][failed verification]

There is currently neither an explanation on where the money comes from to pay the interest on all these loans,[citation needed][dubious ] nor is there an explanation as to how the United States Department of the Treasury manages default on said loans (see Lehman Brothers).[citation needed][dubious ] A negative supply of money is predicted to occur in the event that all loans are repaid at the same time.

The ratio of the total money added to the money supply (in this case, $1,000,000) to the total money added originally in the monetary base (in this case,$100,000) is the money multiplier.[note 13] In this context, the money multiplier relates changes in the monetary base,[note 14] which is the sum of bank reserves and issued currency, to changes in the money supply.[15]

If changes in the monetary base cause a change in the money supply, then

${\displaystyle M_{1}={\mathit {MB}}\cdot m\,}$

where M1 is the new money supply, MB is the monetary base, and m is the money multiplier. Therefore, the money multiplier is:[15]

${\displaystyle m={\frac {M_{1}}{\mathit {MB}}}\leq {\frac {1}{\mathit {RRR}}}}$

The central bank can control the money supply, according to this theory, by controlling the monetary base as long as the money multiplier is limited by the required reserve ratio.

## Credit theory of money

The fractional reserve theory where the money supply is limited by the money multiplier has come under increased criticism since the financial crisis of 2007–2008. It has been observed that the bank reserves are not a limiting factor because the central banks supply more reserves than necessary[21] and because banks have been able to build up additional reserves when they were needed.[22] Many economists and bankers now believe that the amount of money in circulation is limited only by the demand for loans, not by reserve requirements.[23][24][18]

When a bank issues a loan of $1,000 to a customer, they debit the customer's loan account with$1,000 and at the same time they credit the customer's deposit account with $1,000, ready for using. The bank now has a new asset of$1,000 and a new liability of $1,000. The bank's accounts are still in balance because the assets and liabilities are increased by the same amount. The bank does not take the$1,000 out of its reserves. It takes it from the pool of client funds, deposited with it, that would be out of circulation, if the bank didn't re-lend it.

In the United States, the 1913 Federal Reserve Act allowed federal banks to purchase short-term securities directly from the Treasury, in order to facilitate its cash-management operations. The Banking Act of 1935 prohibited the central bank from directly purchasing Treasury securities, and permitted their purchase and sale only "in the open market". In 1942, during wartime, Congress amended the Banking Act's provisions to allow purchases of government debt by the federal banks, with the total amount they'd hold "not [to] exceed $5 billion." After the war, the exemption was renewed, with time limitations, until it was allowed to expire in June 1981.[40] ## See also ## Footnotes 1. ^ Such as the Eurozone or ECCAS 2. ^ For example, in the United States, money supply measured as M2 grew from$6.407 trillion in January 2005, to 18.136 trillion in January 2009. See Federal Reserve (2009)
3. ^ "A [state budget] deficit will lead to a direct rise in the money supply if the...Treasury finances the deficit not by borrowing but by drawing down balances it holds at commercial banks or [the central bank]." From Cacy (1975)
4. ^ See "Money multiplier"
5. ^ Formally, the Treasury's banker, or the banker of the respective competent authority, depending on the country, e.g. of the Ministry of Finance
6. ^ Established by Cameroon, Central African Republic, Chad, Republic of Congo, Equatorial Guinea and Gabon
7. ^ "The chief cause of inflation, Hayek wrote, is governmental control of the money supply."
8. ^ "Empirical studies of relations between the monetary base and the total money supply establish a strong basis for believing that central banks can control the money supply."
9. ^ "Another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money. ... Rather than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the price of reserves — that is, interest rates." McLeay (2014)
10. ^ It has been argued that the central bank of a fiscally and monetarily sovereign nation can actually affect, if not dictate, the whole interest spectrum – above which, of course, as it is argued, adjustments are made for their actual conduct of business by commercial banks and the private sector, in accordance to their assessments, objectives, and preferences. E.g.: "Monetary policy – and there we are increasingly certain – cannot only influence the expectations component, but also the term premium. ... Central banks can lower long-term rates by removing duration risk from the market." Cœuré (2017). Also: "There is no evidence that the central bank has any meaningful control over the...spread between the short-term and the long-term rate of interest [but] it is quite clear that the central bank has full control over the long-term rate of interest.
11. ^ And of state debt
12. ^ Many countries in the world, including major economic powers, including Australia, Canada and New Zealand, do not impose minimum cash reserves on banks. This does not allow banks to lend without limit, since there is always, aside from other considerations, the capital adequacy ratio.
13. ^ The origin of the notion of a money multiplier is discussed in Hegeland (1970)
14. ^ Also known as high-powered money
15. ^ "By increasing the volume of their government securities and loans and by lowering Member Bank legal reserve requirements, the Reserve Banks can encourage an increase in the supply of money and bank deposits. Without taking drastic action, they can encourage but they cannot compel. For in the middle of a deep depression just when we want Reserve policy to be most effective, the Member Banks are likely to be timid about buying new investments or making loans. If the Reserve authorities buy government bonds in the open market and thereby swell bank reserves, the banks will not put these funds to work but will simply hold reserves."
16. ^ "In reality, neither are [bank] reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available. ... Banks first decide how much to lend depending on the profitable lending opportunities available to them — which will, crucially, depend on the interest rate set by the [central bank]." McLeay et al. (2014)
17. ^ For example, in December 2010, in the United States, of the $8.853 trillion broad money supply (M2, table 1), only about 10% (or$915.7 billion, table 3) consisted of coins and paper money. See Statistic, FRS
18. ^ At a \$1=¥0.0094 conversion rate

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