Money identity: sources of money creation

Introduction

We replicate the consolidated balance sheet here for ease of reference (see Balance Sheet 6).

BALANCE SHEET 6: MBS (LCC BILLIONS)

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

It is evident that, because the balance sheet balances, items A + B2 must be equal to all the asset items minus the remaining liability items. Therefore:

It will also be evident that we should combine the related asset and liability items, and they are:

• Foreign assets and foreign loans (D - C).

• Loans to government and government deposits (E - B1).

Therefore,

In terms of the numbers in Balance Sheet 6 we have:

In words:

This is the money identity: the "counterparts" of the money stock (the amount of money in circulation) are net foreign assets (NFA), net loans to government (NLG) and loans to the NBPS (LNBPS).

It will be evident that any change in the money stock must be equal to and therefore is "explained" by changes in NFA, NLG and LNBPS (the sources):

This is the money identity: it provides an analysis of the balance sheet sources of changes (BSSoC) in M3. The actual sources are the transactions that underlie the BSSoC, and they are:

• Net foreign assets (NFA):

- Bank and CB dealings in the foreign exchange market. If these institutions do nothing in the forex market, the market clears at a particular exchange rate. If they do, they alter the demand / supply equation of the forex market and create / destroy money, and the market will clear at a different exchange rate.

• Net loans to government (NLG):

- Bank and CB purchases or sales of government securities.

- The movement of NBPS deposits at banks to government (which we assume banks at the CB only), for example when taxes are paid; and the movement of government deposits to the NBPS, when government spends locally.

• Loans to the NBPS (LNBPS):

- The demand for loans by the NBPS which is satisfied by the banks.

In most countries the latter is the overriding source of money creation, whereas in developing countries the first two mentioned play the overriding role. The accompanying chart shows the year-on-year growth rates for M3 and LNBPS over a 40-year period for a particular country. It is quite evident that the overriding BSSoC in M3 was changes in LNBPS.

M3 & LNBPS (yoy %)

Figure 2: M3 & LNBPS (yoy %)

Example: loan from bank

It will be useful to provide a few examples of the sources of changes in M3. It is to be noted that here we do not indicate the effect of changes in bank deposits on the banks' reserve requirements. This is because we do not wish to divert attention from the principles of money creation. The effect of deposit changes on the reserve requirement is introduced at a later stage.

You will recall that when Company A sells goods to Company B and Company B acquires a loan facility from Bank A and utilizes it for the purchase, the relevant balance sheets changes are as indicated in Balance Sheets 7-9 (amount = LCC 100 million).

BALANCE SHEET 7: COMPANY A (LCC MILLIONS)

Assets

Liabilities

Goods

Deposits at Bank A

-100 +100

Total

BALANCE SHEET 8: COMPANY B (LCC MILLIONS)

Assets

Liabilities

Goods

+100

Loan from Bank A

+ 100

Total

+100

BALANCE SHEET 9: BANK A (LCC MILLIONS)

Liabilities

Loan to Company A

+100

Deposits of Company A

+ 100

Seen in the balance sheet of the MBS (see Balance Sheet 10) these transactions should be clearer. On this day (of the balance sheet construction) M3 increased by LCC 100 million and there was one BSSoC in M3: LNBPS increased by LCC 100 million. The real source was the demand for loans which was satisfied by the bank.

BALANCE SHEET 10: MBS (LCC MILLIONS)

Assets

Liabilities

D. Foreign assets

E. Loans to government

F. Loans to NBPS

+100

A. Notes and coins of NBPS

B. Deposits

1. Government

2. NBPS

C. Foreign loans

+100

Total

+100

Total

+100

 
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