Money creation
From Wikipedia, the free encyclopedia
Money creation is the process by which the money supply of a country is increased. There are several ways that a government, in coordination with the country's commercial banks, can increase or decrease the money supply of a country. If a country follows a fractional-reserve banking regime, as virtually all countries do, not all of the money in circulation needs to be backed by other currencies, physical assets such as gold, or government assets. Instead, the country's currency is backed by the economic potential of the country and is based on government fiat, or decree. This perceived potential puts a theoretical limit on the amount of money a country can prudently create.
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[edit] Money Multiplier
The most common mechanism used to generate money is typically called the money multiplier. It measures the amount by which the commercial banking system increases the money supply. To control the amount of money created by the system, central banks place strict reserve ratios on the commercial banks. For example, some central banks set the proportion of primary deposits that commercial banks may not lend out. This is called the reserve ratio. In the USA this ratio is 10%, in other countries there is no reserve ratio eg. the UK. The reserve ratio is to prevent banks from 1) having a shortage in money when a large demand of deposits is withdrawn 2) limited the amount of money that will be generated. The reserve ratio is determined by the Fed (Federal Reserve) and can be altered.
This system works as follows.
For example, let's assume that a primary deposit ie. cash of $100,000 is made into bank A. If the cash reserve ratio is 10%, then $10,000 must be kept on hand by the bank ($10,000 is 10% of $100,000) and up to $90,000 of new loans can be issued by the bank. When the $90,000 worth of loans are paid off, this sum is added to the reserves of the bank and a further $81,000 ($81,000 is 10% of $90,000) can then be loaned by the bank out of those accounts. It is important to understand that money is not destroyed when a loan is paid off, it is simply removed from circulation and placed in the bank's reserves. If the bank does not make new loans then deflation occurs, if it makes loans in excess of the original $90,000 then inflation occurs.
[edit] An example of the creation of new money
The following steps describe one way that new money can be created. It is an example from the US.
- The government issues a Treasury security. This is simply an IOU, a promise to pay the holder a specified sum of money on a particular date. In this example, let's say the government issues $1,000,000 worth of bonds.
- The Federal Reserve prints a check, in the amount of $1,000,000 and makes it payable to the government. This check is the proceeds from the sale of the bonds.
- The $1,000,000 of bonds is recorded as an asset by the Fed. (money owed to the central bank is called an "asset" by the bank) It is assumed the government, with its power to tax, will make good on its debt (this is why the people buying the bonds from the fed consider it a risk-free investment). The Fed can sell these bonds which are a liability of the government. Individual investors, pension funds, mutual funds, insurance agencies, banks, foreign government central banks, can all buy the bonds, effectively loaning money to the treasury. They do this to invest their money and receive interest in return.
- The government deposits the check in its own account. The government hires employees and buys things with the $1,000,000, and it does so by writing government checks. These government checks are then deposited in commercial banks. For the sake of simplicity, assume it all goes into one commercial bank, which has a zero balance to begin with.
- The commercial bank now claims $1,000,000 in new liabilities (the amount on deposit in a bank is called a "liability" by the bank, because the bank has to pay interest to it, amongst other things). In the US, the law allows the bank to makes loans so longs as it retains a 10% cash reserve. This lending of money that it has on deposit is the precise point at which new money is created, because the depositor still has his money, and the person getting the loan now has money too. If the $1,000,000 is held by the bank as notes then it can lend $900,000 to borrowers.
- $900,000 is loaned for various purposes eg. to buy a house. These loans are in the form of money transfer. The bank transfers the money to the buyer's attorney who transfers it to the seller, who deposits it right back into the bank. Note however, in real life that money would only come from the bank temporarily, which then would issue its own bonds or use a company like Fannie Mae to issue its own bonds, so that again investors can actually lend the money while the bank is simply a middleman, called a "servicer".
- The commercial bank now claims $900,000 in new liabilities. This money is put into reserves, and 90% of that, or $810,000 is lent out. As soon as the $810,000 is deposited back into the bank, the cycle repeats and repeats until there are no more borrowers.
- The total amount lent out to borrowers is $900,000. Add that to the $100,000 that it still has on deposit and the total is $1,000,000. Commercial banks make profit by charging fees for transactions, and by charging a higher interest rate to those they lend to, than what they pay for the funds. If the commercial bank charges 6% interest on the $900,000 it will earn $54,000 per year. If the bank making the loan pays 1% interest to the person who put the money on deposit in the first place it will cost them $10,000 per year. With 90% of that money lent out, if the original depositor wants their money back, the bank has to borrow that money from another bank (or maybe from another source), at rate of interest set by the government (the overnight rate, or the federal funds rate in the US). This is called "asset-liability bouncing", and is a delicate balancing act all banks must work on every day.
[edit] A more realistic model of money creation
Of course, the money creation multiplier is more complex than the description given above. We must add to the equation the currency drain ratio (the propensity of the public to hold cash rather than deposit it in the banking system), the clearing house drain (the loss of deposits from the system due to interactions between banks), and the safety reserve ratio (excess reserves beyond the legal requirement that commercial banks voluntarily hold—usually a very small amount). Also, most jurisdictions require different levels of reserves for different types of deposits. Foreign currency deposits, domestic time deposits, and government deposits often have different cash reserve ratios.
Whatever the reserve ratio ends up being, after all things considered, the bottom line is that the banking system lends out far more than the amount of money that it takes in, and collects interest on those loans from the public.
[edit] See also
[edit] External links
- Reserve Requirements - Fedpoints - Federal Reserve Bank of New York
- - Seignorage and inflation tax
- Mechanisms of Money Creation
