Money creation: sources & fallacies

Learning outcomes

After studying this text the learner should / should be able to:

1. Describe the balance sheets of the banks and the central bank, and the measurement of money from these.

2. Elucidate the money identity and the sources of money creation.

3. Discuss the fallacies surrounding money creation.

Introduction

We have discussed the financial system and the money market, which is at the very centre of the financial system. The banking sector is at the very centre of the money market. The banking sector is essentially constituted of the private sector banks and the central bank. These are the institutions which need to be analyzed in order to measure money and the sources of money creation.

Money is bank notes and coins (issued by the central bank) and bank deposits held by the NBPS. Money creation is the outcome of new bank loans to the private and government sectors, as well as the activities in the foreign exchange market - in terms of buying and/or selling activities which end with bank / central bank balance sheet changes.

There are many fallacies surrounding money creation, including the genesis being the receipt by a bank of a new deposit (the error is not identifying where it comes from), and money creation being tied strictly to the reserve requirement (RR) (some countries do not have a RR). This section is arranged as follows:

• Measuring money.

• Money identity: sources of money creation.

• Money creation: the fallacies.

Measuring money

You know that the stock of money is made up of bank notes and coins and bank deposits in possession of the NBPS. We have two questions in this regard: how do central banks calculate the money stock and what term of bank deposit qualifies as money?

As regards the latter, central banks across the world have various definitions of money, and they range from M1 to M5. They all include bank notes and coins held by the NBPS; where they differ is in the cut-off point of the term to maturity (ttm) of NBPS deposits, and the higher numbers add in other near-money assets. For the sake of simplicity we will use one of the measures: M3. It includes notes and coins (N&C) in the hands of the NBPS and all NBPS deposits with banks, and we justify this on the basis that the vast majority of deposits with banks are short-term in nature.

How does one calculate the NBPS's holdings of N&C? Take a look at the balance sheets of the central bank (called CB from now on) and the banks shown in Balance Sheets 1-2. You will see that the bank notes and coins held by the NBPS can be derived from the two balance sheets:

Total in issue (in the CB's balance sheet = item A)

Less: N&C held by the banks (item C in the banks' collective balance sheet). Therefore the stock of N&C held by the NBPS:

BALANCE SHEET 1: CENTRAL BANK (LCC BILLIONS)

Assets

D. Foreign assets

1 000

Liabilities

A. Notes and coins

1 000

E. Loans to government

1 100

B. Deposits

1. Government

900

F. Loans to banks (borrowed reserves - BR) at the KIR

Total

400

2 500

2. Banks' reserve accounts (TR) C. Foreign loans

Total

500 100

BALANCE SHEET 2: BANKS (LCC BILLIONS)

Assets

C. Notes and coins

100

Liabilities

A. Deposits of NBPS

5 000

D. Reserves with CB (TR)

500

F. Loans to government

1 000

B. Loans from CB (BR)

400

3 800

G. Loans to NBPS

Total

5 400

Total

5 400

You will also note that the banks have two types of liabilities (see Balance Sheet 2). Item A (BD of the NBPS) is money. Thus, M3 is made up of (see Figure 1):

Central banks calculate M3, as well as its counterparts (elucidated later), from the consolidated balance sheet of the banks and the CB. In most countries there are also other "monetary institutions" (such as rural banks, building societies, mutual banks, land banks and so on) ; they are also consolidated with the central bank's and the banks' balance sheets. The consolidated balance sheet appears as in Balance Sheet 3: called the consolidated balance sheet of them asking sector (MBS).

what is money?

Figure 1: what is money?

BALANCE SHEET 3: MBS (LCC BILLIONS)

Assets

D. Foreign assets

1 000

Liabilities

A. Notes and coins of NBPS

900

E. Loans to government

2 100

B. Deposits

1. Government

900 5 000

2. NBPS

F. Loans to NBPS

Total

3 800 6 900

C. Foreign loans

Total

100

6 900

How is a consolidated balance sheet arrived at? It nets out all the interbank claims. For ease of understanding the relevant items have been highlighted in Balance Sheets 4-5. Note that:

• CB loans to banks (LCC 400 billion) in Balance Sheet 4 are netted off against CB loans (LCC 400 billion) in Balance Sheet 5.

• Bank reserves (LCC 500 billion, found in both balance sheets) are netted off.

• N&C: LCC 1 000 billion less LCC 100 billion = LCC 900 billion (see item A in the consolidated balance sheet.

BALANCE SHEET 4: CENTRAL BANK (LCC BILLIONS)

Assets

Liabilities

D. Foreign assets

1 000

A. Notes and coins

1 000

E. Loans to government

F. Loans to banks (borrowed reserves - BR) at

the KIR

1 100

400

B. Deposits

1. Government

2. Banks' reserve accounts (TR)

C. Foreign loans

900 500

100

Total

2 500

Total

2 500

BALANCE SHEET 5: BANKS (LCC BILLIONS)

Assets

Liabilities

C. Notes and coins

D. Reserves with CB (TR)

100

500

A. Deposits of NBPS

5 000

F. Loans to government

G. Loans to NBPS

1 000

3 800

B. Loans from CB (BR)

400

Total

5 400

Total

5 400

From the consolidated balance sheet of the MBS (Balance Sheet 3), the money stock is easily identified (they have been highlighted): item A and item B2:

Of the two components of money we know that N&C is the minor party; in most countries the proportion of N&C in M3 is as low as 2%. We also know that central banks (as the sole issuers of notes and coins (in most cases) do not use N&C to create new money; they merely react to the demand for N&C, for which deposits are used as payment).

We also know that new money is created by bank lending (domestic and foreign). These sources of money creation are also found in the consolidated balance sheet (balance Sheet 3). Thus, we have the tools for an analysis of money creation. Note that what we are about to show is done by all central banks the world over on a monthly basis.

 
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