Money creation
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Money creation is the process by which money is produced or issued. There are 2 different ways to create money:
- physically manufacturing a new monetary unit, such as metal coins
- issuing banknotes or demand deposits.
Coins are produced by manufacturing metal in a factory called a mint.
Banknotes and bank account balances are financial securities issued by a bank.
The reverse of money creation, i.e. money destruction, can occur in 2 different ways, depending on how the money was created. The destruction of money occurs when coins are scrapped to recover their precious metal content, or when the issuer redeems the securities. The destruction of money created through loans occurs as the loans are paid back.
The practices and regulation of production, issue and redemption of money is of central concern to monetary economics, and affect the operation of financial markets and the purchasing power of money.
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[edit] Money Creation By Mints
[edit] Under Competitive Minting
Competitive minting means that the business of manufacturing coins is open to many competing manufacturers. The mints buy bullion on the bullion market, and manufacture it into coins that they use to pay for the bullion and their other production costs, and to provide a profit.
Analysis of supply and demand cannot proceed in the normal way because by definition, the money price of money is fixed at unity. Instead, metal producers need money to pay their expenses and to realise their profits in money, and so their demand for money is expressed by their willingness to produce and sell uncoined metal at a discount to its value as coin. This discount is the gross profit margin of manufacturing metal into coin, and the greater this is, the more metal the mints will find economical to manufacture into coin.
[edit] Under Nationalised Minting with a Right to Exchange
Nationalised minting means that the government has monopolised the business of minting coins, and the government operates mints that produce a national system of coinage. Under a metallic or bimetallic standard with a national mint, individuals normally have a right to bring precious metal to the national mint and to have it coined at a fixed discount. This discount is called seigniorage.
Basic economic analysis of this arrangement is that it makes the supply of coin elastic at the fixed price, however this fixed price is effectively a price control, and price control theory implies that the supply of coin would be more elastic (responsive) under competitive supply and no price controls.
[edit] Under Nationalised Minting with no Right to Exchange
Where there is no legal right to take metal to the national mint and to have it coined into a particular coin, the supply of the coin depends on government or mint policy. This can result in arbitrary debasement of coinage, where the government mint re-manufactures coin with a lower metallic value as a way to raise revenue. However it also enables some more complex coinage arrangements such as the composite legal tender system where gold coin was unlimited legal tender (produced under a right of exchange arrangement as above) and where silver coins are limited legal tender, and have a substantially reduced metallic value below their legal value, but are effectively redeemable at the mint for their legal value in gold coins. This makes the silver coins 'token' coins, and a form of financial asset (and a financial liability to the mint).
[edit] Money Creation Through the Fractional Reserve System
[edit] How the fractional reserve system can turn $1,000 into $4,570.50
In this example, an initial deposit of $1,000 is lent out 10 times at a fractional reserve rate of 20%. In an attempt to simplify an explanation of how it works, a different bank is used for each deposit. In the real world, sometimes when a bank gives out a loan, that same money ends up right back in the same bank so it then has more money to lend out.
| Table 1: $1,000 of actual money loaned out 10 times with a 20 percent reserve rate | |||
|---|---|---|---|
| Individual Bank | amount deposited at bank | amount loaned out | amount left in bank (reserves) |
| A | $1,000.00 | $800.00 | $200.00 |
| B | $800.00 | $640.00 | $160.00 |
| C | $640.00 | $512.00 | $128.00 |
| D | $512.00 | $409.60 | $102.40 |
| E | $409.60 | $327.68 | $81.92 |
| F | $327.68 | $262.14 | $65.54 |
| G | $262.14 | $209.72 | $52.43 |
| H | $209.72 | $167.77 | $41.94 |
| I | $167.77 | $134.22 | $33.55 |
| J | $134.22 | $107.37 | $26.84 |
| K | $107.37 | ||
| total reserves: | |||
| $892.63 | |||
| total deposits: | total amount loaned out: | total reserves + last amount deposited | |
| $4,570.50 | $3,570.50 | $1,000.00 | |
Notice how no new money was physically created. Only the $1,000 from the initial deposit was used. New money is created virtually through loans. The 2 boxes marked in red show where the original $1,000 is throughout the entire process. The total reserves plus the last deposit will always equal the original amount, which in this case is $1,000. As this process continues, more new money is created.
Also notice how when a loan is paid back, money is erased from existence. This is how the money supply is expanded and contracted through a fractional reserve lending system.
[edit] Money Multiplier
Under central banking with mandatory minimum reserve ratios for commercial banks, where the reserves must be central bank banknotes or balances with the central bank, the central bank can control the stock of money by controlling its own issues and the mandatory minimum reserve ratio.
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 reserve ratios on the commercial banks which set the proportion of primary deposits the banks must hold as qualifying reserves.
The reserve ratio is to prevent banks from:
- having a shortage of cash when large deposits are withdrawn.
- generating too much money
This system works as follows.
For example, the central bank issues banknotes or account balances by buying financial assets and paying for them by tendering its own banknotes or crediting the seller's account with the central bank. This creates money that the commercial banks can use as reserves to meet the minimum reserve requirement. The commercial banks can therefore expand their issue of banknotes and/or account balances by the amount of additional reserves divided by the minimum reserve ratio.
For example, suppose the central bank buys $1 000 000 in government bonds from a commercial bank. The commercial bank now has $1 000 000 more reserves, and if the minimum reserve ratio is 10% it can now accept an additional $10 000 000 in deposits from customers on current accounts.
The money creation process is affected by the currency drain ratio (the propensity of the public to hold banknotes rather than deposit it with a commercial bank), and the safety reserve ratio (excess reserves beyond the legal requirement that commercial banks voluntarily hold—usually a very small amount).
[edit] Deposit Multiplier Example
It is sometimes said that banks make tremendous profits through the deposit multiplier effect. One should however keep in mind that for every additional fraction of deposit banks not only have additional income from extra advances but also extra expenses as extra deposits are their liabilities. For example, a reserve of $1,000,000 will allow banks to make almost $9,000,000 of advances. They will receive income on 9x the reserves, but also pay interest on 10x the same reserves as well.
Assuming a 10% reserve ratio requirement, 4% on deposits and 6% from advances (loans), net interest income is ultimately tending towards 14% of the reserves, which is 9x the 2% spread between interest received minus interest paid, minus the 4% interest paid on the deposits which make up the reserves itself.
[edit] Types of money in the fractional reserve system
[edit] Banknotes
Banks that issue banknotes are called banks of issue. A banknote is a promissory note issued by a banker payable to bearer on demand. Banknotes are issued in exchange for money, and are repayable in money. Banknotes are used as money because they are negotiable by mere delivery, and are repayable on demand.
[edit] Bank account balances
Banks accept deposits on current account that are repayable by cheque. This enables the balances to be paid to third party at the customer's order by the use of cheques and other payment instruments. Bank account balances are issued in exchange for money deposited or received by the banker on behalf of a customer.
[edit] An example of the creation of new money in the USA
The following steps describe one way that new money can be created in the USA.
- 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 goods 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 a "liability" of the bank). In the US, the law allows the bank to make loans so long 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 that can be lent out to borrowers in this manner is $900,000 + $810,000 + $729,000 ... = $9,000,000. Assuming that people don't keep significant quantities of cash, total amount of deposits in the bank is $10,000,000. Total money supply is $10,000,000. Total amount of debt in the economy is $9,000,000. Cumulative net worth of all individuals in the country is $1,000,000 (equal to the amount of money created by the Fed).
- 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 $9,000,000 it will earn $540,000 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 $100,000 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.
In the example above, federal government runs a deficit of $1,000,000 in order to increase money supply by $10,000,000. This is not necessary. In principle, Federal Reserve may buy Treasury securities directly from any one of primary dealers.
The same process also runs backwards - Federal Reserve may sell Treasury securities it holds as assets to primary dealers, taking money out of circulation and reducing money supply.
[edit] See also
| Numismatics Portal |
- Fractional Reserve Banking
- Central bank
- Federal Reserve
- Fiat currency
- Inflation
- Money
- Money supply
- National bank
- Open market operations
- Reserve requirements
[edit] External links
- Reserve Requirements - Fedpoints - Federal Reserve Bank of New York
- - Seignorage and inflation tax
- Clearing and Currency Drains Article
- Mechanisms of Money Creation
- How banks create money: deposit creation multiplier example.
[edit] References
fr:Création monétaire ja:信用創造 vi:Số nhân tiền tệ zh:货币扩张
