Money creation

Money creation is the process by which money is produced or issued. There are two different ways to create money:

physically manufacturing a new monetary unit, such as paper currency or metal coins
loaning out a physical monetary unit multiple times through fractional-reserve lending

Coins are produced by manufacturing metal in a factory called a mint.

Banknotes and bank account balances are financial securities issued by a bank.

Similarly, money destruction, i.e., the reverse of money creation, can occur in two different ways, depending on how the money was created. The destruction of physically created 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.

Money creation by mints

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.

Under nationalized minting with a right to exchange

Nationalized 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.

Under nationalized 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). central bank does not transact business with private individual they are the banker's bank, they act as agent of the government. 1. they issue currency to the public 2. they are establish by parliament 3. their main aim of establishment is not profit making 4. they do give advice to the government 5. they don't accept deposits from individuals 6. they don't transact business with private individuals

Money creation through the fractional reserve system

Fractional-reserve banking creates money whenever a new loan is created. In short, there are two types of money in a fractional-reserve banking system^[1]^[2]:

central bank money (physical currency)
commercial bank money (money created through loans) - sometimes referred to as checkbook money^[3]

When a loan is supplied with central bank money, new commercial bank money is created. As a loan is paid back, the commercial bank money disappears from existence. The table below displays how central bank money is used to produce commercial bank money.

Table:^[4] Fractional-Reserve Lending Cycled 10 times with a 20 percent reserve rate (sources: The Principle of Multiple Deposit Creation^[5], Federal Reserve Bank of New York^[6], Bank for International Settlements^[1])
individual bank	amount deposited	amount loaned out	reserves
A	100	80	20
B	80	64	16
C	64	51.20	12.80
D	51.20	40.96	10.24
E	40.96	32.77	8.19
F	32.77	26.21	6.55
G	26.21	20.97	5.24
H	20.97	16.78	4.19
I	16.78	13.42	3.36
J	13.42	10.74	2.68
K	10.74
			total reserves:
			89.26
	total amount deposited:	total amount loaned out:	total reserves + last amount deposited:
	457.05	357.05	100

	commercial bank money created + central bank money:	commercial bank money created:	central bank money:
	457.05	357.05	100

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. 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. As this process continues, more commercial bank money is created. For more information on how this system works, see Fractional-reserve banking.

Money multiplier

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.

Formula

The money multiplier, m, is the inverse of the reserve requirement, R^[7]:

m={\frac {1}{R}}

Example

For example, with the reserve ratio of 20 percent, this reserve ratio, R, can also be expressed as a fraction:

R={\tfrac {1}{5}}

So then the money multiplier, m, will be calculated as:

m=1/{\tfrac {1}{5}}=5

This number is multiplied by the ~~initial deposit~~ excess reserves to show the maximum amount of money it can be expanded to^[8].

An example of the creation of new money in the USA

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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 worth of bonds.
The Federal Reserve prints a check, in the amount of $1,000 and makes it payable to the government (in practice, the Fed cannot purchase securities directly from the Treasury). This check is the proceeds from the sale of the bonds.
The $1,000 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 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 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 ^[9], and the person getting the loan now has money too. If the $1,000 is held by the bank as notes then it can lend $900 to borrowers.
$900 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 in new liabilities. This money is put into reserves, and 90% of that, or $810 is lent out. As soon as the $810 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 + $810 + $729 ... = $9,000. Assuming that people don't keep significant quantities of cash, total amount of deposits in the bank is $10,000. Total money supply is $10,000. Total amount of debt in the economy is $9,000. Cumulative net worth of all individuals in the country is $1,000 (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 $900 it will earn $54 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 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 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 in order to increase money supply by $10,000. 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.

External links

References

^ ^a ^b Bank for International Settlements - The Role of Central Bank Money in Payment Systems. See page 9, titled, "The coexistence of central and commercial bank monies: multiple issuers, one currency": http://www.bis.org/publ/cpss55.pdf A quick quote in reference to the 2 different types of money is listed on page 3. It is the first sentence of the document:
"Contemporary monetary systems are based on the mutually reinforcing roles of central bank money and commercial bank monies."
^ European Central Bank - Domestic payments in Euroland: commercial and central bank money: http://www.ecb.int/press/key/date/2000/html/sp001109_2.en.html One quote from the article referencing the two types of money:
"At the beginning of the 20th almost the totality of retail payments were made in central bank money. Over time, this monopoly came to be shared with commercial banks, when deposits and their transfer via checks and giros became widely accepted. Banknotes and commercial bank money became fully interchangeable payment media that customers could use according to their needs. While transaction costs in commercial bank money were shrinking, cashless payment instruments became increasingly used, at the expense of banknotes"
^ Chicago Fed - Our Central Bank: http://www.chicagofed.org/consumer_information/the_fed_our_central_bank.cfm
the reference is found in the "Money Manager" section:
"the Fed works to control money at its source by affecting the ability of financial institutions to "create" checkbook money through loans or investments. The control lever that the Fed uses in this process is the "reserves" that banks and thrifts must hold."
^ Table created with the OpenOffice.org Calc spreadsheet program using data and information from the references listed.
^ Federal Reserve Education - How does the Fed Create Money? http://www.federalreserveeducation.org/fed101_html/policy/money_print.htm
See the link to "The Principle of Multiple Deposit Creation" pdf document towards bottom of page.
^ An explanation of how it works from the New York Regional Reserve Bank of the US Federal Reserve system. Scroll down to the "Reserve Requirements and Money Creation" section. Here is what it says:
"Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51.20+...=$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity."
The link to this page is: http://www.newyorkfed.org/aboutthefed/fedpoint/fed45.html
^ http://www.mhhe.com/economics/mcconnell15e/graphics/mcconnell15eco/common/dothemath/moneymultiplier.html
^ Mankiw, N. Gregory (2001), Principles of Macroeconomics
^ Disputed, see discussion

Template:Central Bank

[bis-1] Bank for International Settlements - The Role of Central Bank Money in Payment Systems. See page 9, titled, "The coexistence of central and commercial bank monies: multiple issuers, one currency": http://www.bis.org/publ/cpss55.pdf A quick quote in reference to the 2 different types of money is listed on page 3. It is the first sentence of the document:
"Contemporary monetary systems are based on the mutually reinforcing roles of central bank money and commercial bank monies."

[ecb-2] European Central Bank - Domestic payments in Euroland: commercial and central bank money: http://www.ecb.int/press/key/date/2000/html/sp001109_2.en.html One quote from the article referencing the two types of money:
"At the beginning of the 20th almost the totality of retail payments were made in central bank money. Over time, this monopoly came to be shared with commercial banks, when deposits and their transfer via checks and giros became widely accepted. Banknotes and commercial bank money became fully interchangeable payment media that customers could use according to their needs. While transaction costs in commercial bank money were shrinking, cashless payment instruments became increasingly used, at the expense of banknotes"

[3] Chicago Fed - Our Central Bank: http://www.chicagofed.org/consumer_information/the_fed_our_central_bank.cfm
the reference is found in the "Money Manager" section:
"the Fed works to control money at its source by affecting the ability of financial institutions to "create" checkbook money through loans or investments. The control lever that the Fed uses in this process is the "reserves" that banks and thrifts must hold."

[4] Table created with the OpenOffice.org Calc spreadsheet program using data and information from the references listed.

[mdc-5] Federal Reserve Education - How does the Fed Create Money? http://www.federalreserveeducation.org/fed101_html/policy/money_print.htm
See the link to "The Principle of Multiple Deposit Creation" pdf document towards bottom of page.

[nyfed-6] An explanation of how it works from the New York Regional Reserve Bank of the US Federal Reserve system. Scroll down to the "Reserve Requirements and Money Creation" section. Here is what it says:
"Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51.20+...=$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity."
The link to this page is: http://www.newyorkfed.org/aboutthefed/fedpoint/fed45.html

[7] ttp://www.mhhe.com/economics/mcconnell15e/graphics/mcconnell15eco/common/dothemath/moneymultiplier.html

[8] Mankiw, N. Gregory (2001), Principles of Macroeconomics

[disputed1-9] Disputed, see discussion

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