Element 5: money creation
Money creation is an integral part of the financial system, and a significant part of the investment environment in terms of new financial instrument (debt) creation, inflation and interest rates. Interest rates are important for many reasons, including being a target / reflection of monetary policy actions and the valuation of financial instrument (debt and shares) and income-property assets.
Money is anything that is generally accepted as a means of payment. In the distant past money has been many different objects, but stuck in our financial psyches are gold and silver coins. Today, money has two components:
- central bank notes and coins (N&C) and
- bank deposits (BD)
held by the local non-bank private sector (NBPS). The outstanding amount of these (measured monthly in most countries) is therefore the amount of money in circulation (AMIC or just M, also called the money stock26). There are many different measures of money; for the sake of simplicity we use M3, which encompasses all deposits of the NBPS plus its holdings of notes and coins (but from hereon we call it M):
One of the oldest theories in economics is the quantity theory of money of Irving Fisher. In slightly amended form it can be expressed as:
where A denotes change over a period, M = money, V = velocity of circulation of M, P = price level, RGDP = GDP in real terms (i.e. after adjusting for P). It will also be evident that P x RGDP = nominal GDP (NGDP).
Given that V is stable in the long-term, AM translates approximately into ARGDP and AP. In a particular country27, for example, over the past 40 years (roughly):
It is argued that an increase in RGDP cannot take place without an increase in M, and that if M growth is higher than the economy's ability to adjust to the increased demand underlying the change in M, inflation results and growth suffers. In other words, if the growth rate in M is kept to a level consistent with the economy's ability to adjust to the increased demand for goods and services, growth will increase with little impact on P. Thus, monetary policy endeavours to "control" the increase in M to a level consistent with the economy's ability to accommodate increased demand.
What makes up GDP? It is:
C + I = GDE
GDE + X - M = GDP (expenditure on)
where C = consumption expenditure of the private and government sectors, I = investment of the private and government sectors, X = exports, I = imports. It may also be seen as follows:
In many countries C + I = about 70-80% of GDP. How does this fit with money creation? It fits with how money is created. New money = a new bank deposit held by the NBPS (we'll ignore N&C because it is a minor part of M), is created by a bank making a new loan to the NBPS or government. Allow us to present an example.
Company B borrows LCC100 million from a bank through the issue to it of LCC100 million securities (debt instruments such as bonds) with the purpose of purchasing LCC100 million goods from Company L. The bank credits Company B's current account with LCC100 million and Company B pays Company L LCC100 million by internet transfer (i.e. electronic funds transfer - EFT). Company L thus becomes a surplus economic unit (new bank deposit), while Company B becomes a deficit economic unit (bank loan via the issue of bonds to the bank).
Figure 13: money creation
As shown in Figure 13, the banking sector has a new asset (+LCC100 million bonds of Company B = a new loan) and a new deposit liability (+LCC100 million deposits of Company L = new money). Thus, M has increased by LCC100 million and the balance sheet cause of change (BSCoC) in M is the loan by the bank (in the form of the purchase of new bonds issued by Company B and purchased by it). The purchase by the bank of bonds is new credit (loan) creation.
Money was created by balance sheet entries, but, and this is crucial knowledge, underlying it was a "demand" for bank credit (loan), and underlying the demand for credit was an economic activity = a demand for goods / services. If the "goods" are a new factory to be built, investment (I) increases; if the "goods" are consumption goods, C increases. It was made possible by money creation.
In the light of this revelation, what is monetary policy? It is about controlling the growth rate in M creation. As we saw, underlying money creation is the increased demand for goods and services (AC + I). How does the central bank (CB) do this? It implements monetary policy by creating a permanent liquidity shortage (LS). This means that it forces, via open market operations (OMO), the banks to borrow from it on an overnight but permanent basis an amount of money (called reserves - R) at the CB's Key Interest Rate (KIR) (also called repo rate, basis rate, discount rate, and so on). This KIR directly influences the interbank lending rate, the call deposit and other deposit rates of the banks, and, via the bank margin (the margin that the banks endeavour to earn between what they pay for deposits and what they earn on assets = credit extended), bank lending rates. The bank lending rate best known is the prime rate (PR); it is a benchmark rate, i.e. some borrowers will pay, for example, PR - 2% while others will pay PR + 1%.
Figure 14: KIR & prime rate (month-ends over 50 years)
The ultimate aim of the policy is to influence the growth rate in bank lending, i.e. the demand for credit. As you now know, additional bank lending is the counterpart of money growth and underlying bank credit growth is increased demand for goods and services (AC + I). It will be evident that purpose is to harmonize the additional demand for goods and services with the economy's ability to satisfy the additional demand.
Figure 14 shows the relationship between the banks' PR and the KIR over a period of almost 50 years for a particular country. It will be seen that in this case a change in the KIR is immediate translated into an equal change in PR. This can only be achieved if the CB has control over bank liquidity, and makes the KIR effective by engineering a permanent LS.
Element 6: price discovery
The prices of debt (= interest rates, from which prices are derived) and shares (= prices, influenced by interest rates) are discovered in the financial markets, by the interplay of demand and supply. Or are they - when the supply of credit is unlimited (in the sense that credit is supplied if the individual borrower is creditworthy or the corporate project is viable)?
Given such a monetary system, it is evident that a referee (a CB) is required and that interest rates cannot be "free to find their own levels". The reason is clear: because the CB uses interest rates to influence the growth rate in the demand for loans / credit and therefore in M. Thus, the CB in essence "sets" the lower point of the yield curve29 (see Figure 14) and this point becomes the reference point for all interest rates. Even rates for 20 to 30-year investments are affected by the short-term rates.
Figure 14: short-term banking rates & yield curve for government securities
A yield curve is a snapshot" of interest rates and is differentiated from a time series of interest rates, which is a specific rate/s / prices over a period of time. Figure 15 is an example of the latter [in this case rates (ytm) over a period of 50 years].
Interest rates are also a major input into the valuation of shares as we shall see later. While interest rates and share prices are fundamentally tied to the KIR, in the share market the outcome of supply and demand (share prices) can be different, and substantially so, from the fair value prices (FVP) dictated by interest rates and company profits. This vital issue later is taken further later.
Allied participants in the financial system
From the above discussion it will be evident that there are a number of allied participants on the financial system. By this we mean participants other than the principals (those who have financial liabilities or assets or both). As we now know, the principals are:
- Financial intermediaries.
Figure 15: 3-year and 10-year bond rates
The allied participants, who play a major role in terms of facilitating the lending and borrowing process (the primary market) and the secondary markets, are the financial exchanges and their members. Also we need to mention the fund managers, who are actively involved in sophisticated financial market research and therefore play a major role in price discovery, and the regulators of the financial markets. Thus, the allied non-principal participants in the financial markets are:
- Financial exchanges.
- Rating agencies.
- Fund managers.