Money Creation

The process of money creation by commercial banks

Commercial banks bring together savers and borrowers. Through this process they also actually create money from nothing. This is called credit creation. Looking at the diagram to the left, we can understand how this process works. For example, let´s say we have a saver who deposits $1000 into a bank. The commercial bank is required by the central bank to deposit 10% of the $1000 with the central bank due to the minimum reserve requirement (which is to ensure banks have enough liquidity). This leaves the bank with $900 with which they can lend out to people looking to borrow.

As a result, commercial bank creates a loan for $900. The original $1000 deposit has contributed $900 to economic activity and spending. The $900 of spending will create an income of $900, which will be deposited back into a commercial bank. With this deposit of $900, 10% will go to the central bank as part of the MMR so $90 goes to the central bank and this leaves the commercial bank $810 to lend. And the cycle will continue. This is called the money multiplier and we can calculate it by:

Money Multiplier = 1 / Minimum Reserve Rate

So in our example above:

Money Multiplier = 1 / 0.1 = 10

So to calculate how much the initial $1000 deposit will increase the money supply by:

Increase in Money Supply = (initial deposit x money multiplier) - initial deposit.

= (1000 x 10) - 1000

= $10,000 - 1000 = $9000

When calculating the increase in the money supply, it is important to remember that we need to subtract the initial deposit as this already existed in the money supply before the deposit and is therefore no created. If the central bank wishes to slow the growth of the money supply, they can increase the minimum reserve rate (MMR), which will create a lower multiplier. For our example above, lets say the MMR was raised from 10% to 25%.

Money Multiplier = 1 / Minimum Reserve Rate

Money Multiplier = 1 / 0.25 = 4

Increase in Money Supply = (initial deposit x money multiplier) - initial deposit.

= (1000 x 4) - 1000

= $4000 - $1000 = $3000

We can see that a higher minimum reserve rate has caused a lower money multiplier, therefore slowing the growth of the money supply.

Tools of Monetary Policy - Open Market Operations (OMO)

Open Market Operations involves the central bank buying and selling government bonds and other government financial assets in order to increase or decrease the money supply in the economy. As these financial assets are backed by governments, they are usually regarded safer and lower risk.

If the economy is experiencing high levels of inflation, the central bank may increase the sale of government bonds in order to remove excess money supply from the circular flow of income and this can increase the interest rate. Hence the higher interest rates will encourage spending and reduce borrowing, lowering the overall levels of aggregate demand in the economy.

On the other hand, if an economy is experiencing a recession, the central bank may buy government bonds from private individuals, in order to increase the money supply in the economy. This can lower the interest rate in the economy, thus may encourage households and firms to borrow more and save less, therefore can increase the overall levels of aggregate demand.

Tools of Monetary Policy - Minimum Reserve Requirements

Minimum Reserve Requirements (MRR) refer to the minimum amount a commercial bank are required to leave with the central bank. Most central banks require commercial bank to leave a % of their deposits in order to ensure commercial banks have some liquidity to deal with a sudden shocks or events. For example, Bank Runs. These happen when individuals rush to withdraw money from their accounts and savings, such as those seen during the financial crisis of 2007. If the bank does not have enough liquidity due to lending all consumers deposits, this can cause the bank to go bankrupt. Therefore, central banks require a MRR from commercial banks to protect consumers deposits.

The MRR can also be used to increase or decrease the money supply in the economy. If the government wants to increase the money supply (and therefore lower interest rates) they can lower the MRR %, therefore freeing up money for commercial banks to lend.

On the other hand, if the central bank wants to reduce the money supply, (therefore increasing the interest rate) they can increase the MRR%, therefore reducing the money commercial banks have to lend.

Tools of Monetary Policy - Changes in central bank minimum lending rate

The Central Bank Minimum Lending Rate (also known as base rate) is the minimum rate the central bank will charge on loans to commercial banks. Therefore, if the central bank wants to increase the money supply (expansionary monetary policy), it may lower its base rate. This in turn can lower the cost of borrowing for commercial banks, translating into a lower interest rates on loans, mortgages and other credit products from commercial banks.

On the other hand, if the central bank wishes to decrease the money supply (contractionary monetary policy), it can increase the minimum lending rate which in turn, can increase the cost of borrowing for commercial banks, translating into a higher interest rate on loans, mortgages and other credit products from the commercial banks. The higher interest rates may also increase the amount of savings, again therefore reducing the overall money supply in the economy.

Tools of Monetary Policy - Quantitative Easing

Quantitative easing is essentially the central bank creating money and using this money to purchase corporate bonds. A bond is essentially an IOU from either firms (corporate bonds) or government bonds. The sellers of the bonds promise to pay back the value of the debt with interest by a "maturity" date in the future (this could be 2,5,10 years for example).

When the central bank creates money and uses this to purchase either corporate bonds from firms or government bonds already owned by financial institutions. As a result, the amount of money and liquidity for these financial institutions increases, improving their financial position and increasing their lending or purchase of other assets. The improved liquidity ensures money continues to flow around the financial sector, increasing the money supply and therefore keeping interest rates low. As certain assets yields decrease (such as government bonds), firms may be likely to invest in higher yielding assets such as stocks/shares, providing non financial firms with an more access to fiance, possibly increasing business confidence and investment into the economy.

An increase in the money supply may also cause a depreciation in a countries currency, improving export competitiveness and therefore boosting exports and injections into the circular flow of income.

*It is important to note that this "printing" of money in QE does not lead to hyperinflation if it is used during large recessions and deflationary gaps. The increase in the money supply helps the economic activity increase back to its full potential by using up spare capacity, instead of creating shortages.

Demand and Supply of Money

In the above diagrams, we can see how the interest rate is determined. Firstly, we have the demand for money (Dm) and this shows the quantity of money demanded at every given interest rate and represents the desire to hold money for consumption etc and not save. At higher interest rates, the desire to hold money will be less as the rate of return for savings is higher and cost of borrowing is higher. On the other hand, at a lower interest rate, the incentive to save is lower and the incentive to borrow is higher, therefore the demand for money will be greater. We also have the supply of money, which is perfectly inelastic at a fixed amount at any given point in time. It shows the amount of money circulating in an economy at any given point.

In the first diagram, we can see the interest rate would equal r1. If the interest rate was lower than r1, there would be an excess of demand (shortage of money) thus the interest rate would increase back to r1, eliminating the shortage. Similarly, if it was above r1, this would create an excess of supply (surplus of money), thus decreasing the interest rate to r1 until the Qdm =Qsm.

Therefore, a change in either the demand or supply of money can cause an increase or decrease in the interest rate. For example, in the second diagram, lets say the central bank wants to increase the interest rate to reduce inflation. Using one of the tools mentioned above, the central bank can reduce the money supply from Sm1 to Sm2, thus raising the interest rate and decreasing the Qdm from Q1 to Q2 as holding cash becomes less desirable and saving becomes more desirable.

On the other hand, lets say the economy has entered a recession and the central bank wants to increase the money supply from Sm1 to Sm2 using one of the tools discussed earlier to encourage AD. Doing so will lower the interest rate from r1 to r2 and therefore increase the Dm from Q1 to Q3, as holding cash becomes more desirable.

It is important to note that when we are looking at monetary policy, we are discussing tools the government can use to intervene to control the money supply. The central bank does not control the Demand for money directly.

In reality, there is no one equilibrium interest rate in the economy. Instead there is a number of interest rates within different markets that exist within an economy (e.g. short term borrowing, overdrafts, loans, mortgages) all of which carry varying levels of risk and time periods.

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