Money creation
Overview
 
In economics, money creation is the process by which the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

 of a country or a monetary region (such as the Eurozone
Eurozone
The eurozone , officially called the euro area, is an economic and monetary union of seventeen European Union member states that have adopted the euro as their common currency and sole legal tender...

) is increased due to some reason. There are two principal stages of money creation. First, the central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

 introduces new money into the economy (termed 'expansionary monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

') by purchasing financial asset
Financial asset
A financial asset is an intangible asset that derives value because of a contractual claim. Examples include bank deposits, bonds, and stocks. Financial assets are usually more liquid than tangible assets, such as land or real estate, and are traded on financial markets....

s or lending money to financial institutions. Second, the new money introduced by the central bank is multiplied by commercial banks through fractional reserve banking; this expands the amount of broad money
Broad money
In economics, broad money is a measure of the money supply that includes more than just physical money such as currency and coins . It generally includes demand deposits at commercial banks, and any monies held in easily accessible accounts...

 (i.e.
Encyclopedia
In economics, money creation is the process by which the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

 of a country or a monetary region (such as the Eurozone
Eurozone
The eurozone , officially called the euro area, is an economic and monetary union of seventeen European Union member states that have adopted the euro as their common currency and sole legal tender...

) is increased due to some reason. There are two principal stages of money creation. First, the central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

 introduces new money into the economy (termed 'expansionary monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

') by purchasing financial asset
Financial asset
A financial asset is an intangible asset that derives value because of a contractual claim. Examples include bank deposits, bonds, and stocks. Financial assets are usually more liquid than tangible assets, such as land or real estate, and are traded on financial markets....

s or lending money to financial institutions. Second, the new money introduced by the central bank is multiplied by commercial banks through fractional reserve banking; this expands the amount of broad money
Broad money
In economics, broad money is a measure of the money supply that includes more than just physical money such as currency and coins . It generally includes demand deposits at commercial banks, and any monies held in easily accessible accounts...

 (i.e. cash plus demand deposits) in the economy so that it is a multiple (known as the money multiplier
Money multiplier
In monetary economics, a money multiplier is one of various closely related ratios of commercial bank money to central bank money under a fractional-reserve banking system. Most often, it measures the maximum amount of commercial bank money that can be created by a given unit of central bank money...

) of the amount originally created by the central bank.

Central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

s monitor the amount of money in the economy by measuring monetary aggregates such as M2. The effect of monetary policy on the money supply is indicated by comparing these measurements on various dates. For example, in the United States, money supply measured as M2 grew from $6407.3bn in January 2005, to $8318.9bn in January 2009.

Money creation by the central bank

Within almost all modern nations, special institutions exist (such as the Federal Reserve System
Federal Reserve System
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907...

 in the United States, the European Central Bank
European Central Bank
The European Central Bank is the institution of the European Union that administers the monetary policy of the 17 EU Eurozone member states. It is thus one of the world's most important central banks. The bank was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt,...

 (ECB), and the People's Bank of China
People's Bank of China
The People's Bank of China is the central bank of the People's Republic of China with the power to control monetary policy and regulate financial institutions in mainland China...

) which have the task of executing the monetary policy and often acting independently of the executive
Executive (government)
Executive branch of Government is the part of government that has sole authority and responsibility for the daily administration of the state bureaucracy. The division of power into separate branches of government is central to the idea of the separation of powers.In many countries, the term...

. In general, these institutions are called central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

s and often have other responsibilities such as supervising the smooth operation of the financial system. There are several monetary policy tools available to a central bank to expand the money supply of a country: decreasing interest rates by fiat; increasing the monetary base
Monetary base
In economics, the monetary base is a term relating to the money supply , the amount of money in the economy...

; and decreasing reserve requirement
Reserve requirement
The reserve requirement is a central bank regulation that sets the minimum reserves each commercial bank must hold of customer deposits and notes...

s. All have the effect of expanding the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

.

The primary tool of monetary policy is open market operation
Open market operation
Open market operations is the buying and selling of government bonds on the open market by a central bank. It is the primary means of implementing monetary policy by a central bank. The usual aim of open market operations is to control the short term interest rate and the supply of base money in...

s. This entails managing the quantity of money in circulation through the buying and selling of various financial assets, such as treasury bills, government bonds, or foreign currencies. Purchases of these assets result in currency entering market circulation (while sales of these assets remove money from circulation).

Usually, the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency, the price of gold
Gold
Gold is a chemical element with the symbol Au and an atomic number of 79. Gold is a dense, soft, shiny, malleable and ductile metal. Pure gold has a bright yellow color and luster traditionally considered attractive, which it maintains without oxidizing in air or water. Chemically, gold is a...

, or indices such as Consumer Price Index
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...

. For example, in the case of the USA the Federal Reserve targets the federal funds rate
Federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...

, the rate at which member banks lend to one another overnight. The other primary means of conducting monetary policy include: (i) Discount window
Discount window
The discount window is an instrument of monetary policy that allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions...

 lending (as lender of last resort
Lender of last resort
A lender of last resort is an institution willing to extend credit when no one else will. The term refers especially to a reserve financial institution, most often the central bank of a country, intended to avoid bankruptcy of banks or other institutions deemed systemically important or 'too big to...

); (ii) Fractional deposit lending (changes in the reserve requirement); (iii) Moral suasion (cajoling certain market players to achieve specified outcomes); (iv) "Open mouth operations" (talking monetary policy with the market). The conduct and effects of monetary policy and the regulation of the banking system are of central concern to monetary economics.

Quantitative easing

Quantitative easing involves the creation of a significant amount of new base money by a central bank by the buying of assets that it usually does not buy. Usually, a central bank will conduct open market operations by buying short-term government bonds or foreign currency. However, during a financial crisis
Financial crisis
The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these...

, the central bank may buy other types of financial assets as well. The central bank may buy long-term government bonds, company bonds, asset backed securities, stocks, or even extend commercial loans. The intent is to stimulate the economy by increasing liquidity and promoting bank lending, even when interest rates cannot be pushed any lower.

Quantitative easing increases reserves in the banking system (i.e. deposits of commercial banks at the central bank), giving depository institutions the ability to make new loans. Quantitative easing is usually used when lowering the discount rate
Discount rate
The discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....

 is no longer effective because interest rates are already close to or at zero. In such a case, normal monetary policy cannot further lower interest rates, and the economy is in a liquidity trap
Liquidity trap
A liquidity trap is a situation described in Keynesian economics in which injections of cash into an economy by a central bank fail to lower interest rates and hence to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as...

.

Physical currency

In modern economies, relatively little of the money supply is in physical currency. For example, in December 2010 in the U.S., of the $8853.4 billion in broad money supply (M2), only $915.7 billion (about 10%) consisted of physical coins and paper money. The manufacturing of new physical money is usually the responsibility of the central bank, or sometimes, the government's treasury
Treasury
A treasury is either*A government department related to finance and taxation.*A place where currency or precious items is/are kept....

.

Contrary to popular belief, money creation in a modern economy does not directly involve the manufacturing of new physical money, such as paper currency or metal coin
Coin
A coin is a piece of hard material that is standardized in weight, is produced in large quantities in order to facilitate trade, and primarily can be used as a legal tender token for commerce in the designated country, region, or territory....

s. Instead, when the central bank expands the money supply through open market operations (e.g. by purchasing government bonds), it credits the accounts that commercial banks hold at the central bank (termed high powered money). Commercial banks may draw on these accounts to withdraw physical money from the central bank. Commercial banks may also return soiled or spoiled currency to the central bank in exchange for new currency.

Money creation through the fractional reserve system

Through fractional-reserve banking
Fractional-reserve banking
Fractional-reserve banking is a form of banking where banks maintain reserves that are only a fraction of the customer's deposits. Funds deposited into a bank are mostly lent out, and a bank keeps only a fraction of the quantity of deposits as reserves...

, the modern banking system expands the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

 of a country beyond the amount initially created by the central bank. There are two types of money in a fractional-reserve banking system, currency
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...

 originally issued by the central bank, and bank deposits at commercial banks:
  1. central bank money (all money created by the central bank regardless of its form, e.g. banknotes, coins, electronic money)
  2. commercial bank money (money created in the banking system through borrowing and lending) - sometimes referred to as checkbook money


When a commercial bank loan is extended, new commercial bank money is created. As a loan is paid back, more commercial bank money disappears from existence than was created (assuming an interest rate above zero). Since loans are continually being issued in a normally functioning economy, the amount of broad money in the economy remains relatively stable. Because of this money creation process by the commercial banks, the money supply of a country is usually a multiple larger than the money issued by the central bank; that multiple is determined by the reserve ratio or other financial ratios (primarily the capital adequacy ratio
Capital adequacy ratio
Capital adequacy ratio , also called Capital to Risk Assets Ratio , is a ratio of a bank's capital to its risk...

 that limits the overall credit creation of a bank) set by the relevant banking regulators in the jurisdiction.

Re-lending

An early table, featuring reinvestment from one period to the next and a geometric series, is found in the tableau économique
Tableau économique
The Tableau économique or Economic Table is an economic model first described in François Quesnay in 1759, which lay the foundation of the Physiocrats’ economic theories....

 of the Physiocrats
Physiocrats
Physiocracy is an economic theory developed by the Physiocrats, a group of economists who believed that the wealth of nations was derived solely from the value of "land agriculture" or "land development." Their theories originated in France and were most popular during the second half of the 18th...

, which is credited as the "first precise formulation" of such interdependent systems and the origin of multiplier theory
Multiplier (economics)
In economics, the fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. More generally, the exogenous spending multiplier is the ratio of a change in national income to any autonomous change in spending In economics, the fiscal...

.

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 – such a factor is called a multiplier
Multiplier (economics)
In economics, the fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. More generally, the exogenous spending multiplier is the ratio of a change in national income to any autonomous change in spending In economics, the fiscal...

.
As a formula, if the reserve ratio is R, then the money multiplier m is the reciprocal
Multiplicative inverse
In mathematics, a multiplicative inverse or reciprocal for a number x, denoted by 1/x or x−1, is a number which when multiplied by x yields the multiplicative identity, 1. The multiplicative inverse of a fraction a/b is b/a. For the multiplicative inverse of a real number, divide 1 by the...

, and is the maximum amount of money commercial banks can legally create for a given quantity of reserves.

In the re-lending model, this is alternatively calculated as a geometric series under repeated lending of a geometrically decreasing quantity of money: reserves lead loans. In endogenous money models, loans lead reserves, and it is not interpreted as a geometric series. In practice, because banks often have access to lines of credit, and the money market, and can use day time loans from central banks, there is often no requirement for a pre-existing deposit for the bank to create a loan and have it paid to another bank.

The money multiplier is of fundamental importance in monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

: if banks lend out close to the maximum allowed, then the broad money supply is approximately central bank money times the multiplier, and central banks may finely control broad money supply by controlling central bank money, the money multiplier linking these quantities; this was the case in the United States from 1959 through September 2008.

If, conversely, banks accumulate excess reserves
Excess reserves
In banking, excess reserves are bank reserves in excess of the reserve requirement set by a central bank. They are reserves of cash more than the required amounts. Holding excess reserves is generally considered costly and uneconomical as no interest is earned on the excess amount...

, as occurred in such financial crises as the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...

 and the Financial crisis of 2007–2010 – in the United States since October 2008, then this equality breaks down, and central bank money creation may not result in commercial bank money creation, instead remaining as unlent (excess) reserves. However, the central bank may shrink commercial bank money by shrinking central bank money, since reserves are required – thus fractional-reserve money creation is likened to a string, since the central bank can always pull money out by restricting central bank money, hence reserves, but cannot always push money out by expanding central bank money, since this may result in excess reserves, a situation referred to as "pushing on a string".

Alternative theories

The above gives the mainstream economics
Mainstream economics
Mainstream economics is a loose term used to refer to widely-accepted economics as taught in prominent universities and in contrast to heterodox economics...

 theory of money creation. There are also a number of alternative heterodox theories
Heterodox economics
"Heterodox economics" refers to approaches or to schools of economic thought that are considered outside of "mainstream economics". Mainstream economists sometimes assert that it has little or no influence on the vast majority of academic economists in the English speaking world. "Mainstream...

 of how money is created. Most notably post-Keynesian economics
Post-Keynesian economics
Post Keynesian economics is a school of economic thought with its origins in The General Theory of John Maynard Keynes, although its subsequent development was influenced to a large degree by Michał Kalecki, Joan Robinson, Nicholas Kaldor and Paul Davidson...

 emphasizes endogenous money
Endogenous money
In economics, endogenous money refers to the theory that money comes into existence driven by the requirements of the real economy and that banking system reserves expand or contract as needed to accommodate loan demand at prevailing interest rates. It forms part of Post-Keynesian economics...

 – that money is created by the internal workings of the financial system, rather than by external forces, such as policy actions of the central bank.

Heterodox theories of money creation include:
  • Chartalism
    Chartalism
    Chartalism is a descriptive economic theory that details the procedures and consequences of using government-issued tokens as the unit of money. The name derives from the Latin charta, in the sense of a token or ticket...

    , which holds that money is created by government deficit spending
    Deficit spending
    Deficit spending is the amount by which a government, private company, or individual's spending exceeds income over a particular period of time, also called simply "deficit," or "budget deficit," the opposite of budget surplus....

    , and emphasizes (and advocates) fiat money
    Fiat money
    Fiat money is money that has value only because of government regulation or law. The term derives from the Latin fiat, meaning "let it be done", as such money is established by government decree. Where fiat money is used as currency, the term fiat currency is used.Fiat money originated in 11th...

    .
  • Circuitist money theory, held by some post-Keynesians, which argues that money is created endogenously by the banking system, rather than exogenously by central bank lending. Further, they argue that money is not neutral – a credit money
    Credit money
    Credit money is any claim against a physical or legal person that can be used for the purchase of goods and services. Examples of credit money include personal IOUs, and in general any financial instrument or bank money market account certificate, which is not immediately repayable in specie, on...

     system is fundamentally different from a barter
    Barter
    Barter is a method of exchange by which goods or services are directly exchanged for other goods or services without using a medium of exchange, such as money. It is usually bilateral, but may be multilateral, and usually exists parallel to monetary systems in most developed countries, though to a...

     system, and money and banks must be an integral part of economic models.
  • Credit Theory of Money
    Credit money
    Credit money is any claim against a physical or legal person that can be used for the purchase of goods and services. Examples of credit money include personal IOUs, and in general any financial instrument or bank money market account certificate, which is not immediately repayable in specie, on...

    . This approach was founded by Joseph Schumpeter
    Joseph Schumpeter
    Joseph Alois Schumpeter was an Austrian-Hungarian-American economist and political scientist. He popularized the term "creative destruction" in economics.-Life:...

    . Credit theory asserts the central role of banks as creators and allocators of money supply, and distinguishes between 'productive credit creation' (allowing non-inflationary economic growth
    Economic growth
    In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...

     even at full employment
    Full employment
    In macroeconomics, full employment is a condition of the national economy, where all or nearly all persons willing and able to work at the prevailing wages and working conditions are able to do so....

    , in the presence of technological progress) and 'unproductive credit creation' (resulting in inflation
    Inflation
    In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

     of either the consumer- or asset-price
    Asset price inflation
    Asset price inflation is an economic phenomenon denoting a rise in price of assets, as opposed to ordinary goods and services. Typical assets are financial instruments such as bonds, shares, and their derivatives, as well as real estate and other capital goods.-Price inflation and assets...

     variety).

See also

  • Fractional-reserve banking
    Fractional-reserve banking
    Fractional-reserve banking is a form of banking where banks maintain reserves that are only a fraction of the customer's deposits. Funds deposited into a bank are mostly lent out, and a bank keeps only a fraction of the quantity of deposits as reserves...

  • Central bank
    Central bank
    A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

  • Federal Reserve
  • Fiat currency
  • Quantitative easing
    Quantitative easing
    Quantitative easing is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective. A central bank buys financial assets to inject a pre-determined quantity of money into the economy...

  • Inflation
    Inflation
    In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

  • Money
    Money
    Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...

  • Money supply
    Money supply
    In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

  • National bank
    National bank
    In banking, the term national bank carries several meanings:* especially in developing countries, a bank owned by the state* an ordinary private bank which operates nationally...

  • Open market operation
    Open market operation
    Open market operations is the buying and selling of government bonds on the open market by a central bank. It is the primary means of implementing monetary policy by a central bank. The usual aim of open market operations is to control the short term interest rate and the supply of base money in...

    s
  • Reserve requirement
    Reserve requirement
    The reserve requirement is a central bank regulation that sets the minimum reserves each commercial bank must hold of customer deposits and notes...

    s
  • Chartalism
    Chartalism
    Chartalism is a descriptive economic theory that details the procedures and consequences of using government-issued tokens as the unit of money. The name derives from the Latin charta, in the sense of a token or ticket...


External links

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