Money creation: fallacies

Introduction

Before we begin, another reminder of the reserve requirement (RR) ratio (r), and the amount of reserves calculated (R or TR), is required. Most countries have an r. This is a statutory requirement in terms of which banks are required to hold on deposit with the CB an amount of funds (required reserves - RR). The RR is a proportion of the amount of deposits the banks have (we assume 10%). Thus if the banks have LCC 100 billion in deposits they are obliged to have LCC 10 billion on deposit with the CB.

A number of critical notes are required here:

• Although rare, there are some countries that do not have a RR.

• In some countries the banks have two accounts:

- Required reserves accounts in which the RR are held.

- Settlement account (SA) (over which interbank settlements take place).

• In other countries the banks have just one account: a "settlement" or "reserves" account in which the RR and ER are held and over which interbank settlement takes place. We assume one account called "reserve account".

• Central banks do not pay interest on the banks' RR or ER; this is usually the case, but there are exceptions.

• Because of the latter, the banks have no reason to hold excess reserves (ER) with the CB.

• In many countries N&C rank as RR; therefore if the RR is LCC 100 million and the banks have N&C in portfolio (teller tills, ATMs, etc) to the extent of LCC 30 million, only LCC 70 million is required to be held in the reserve accounts.

• In some countries N&C do not rank as reserves.

• Banks' N&C and their reserve balances (where applicable) are referred to as central bank money (CBM).

• No bank can create CBM; only the CB can do so - by buying assets from the banks (under repo) or making loans to the banks (against collateral of eligible assets = government securities usually).

• Many CBs accommodate the banking system by means of repos (buying assets for a period); as these repos amount to loans, we refer to all CB accommodation as loans.

• When the CB makes a loan to a bank (= provides borrowed reserves - BR) it does so at an "administratively" determined rate (by the MPC): the KIR.

A bank receives a deposit...

We begin with the most misguided pedagogy on money creation. In a nutshell it says that money creation begins with a bank receiving a deposit. It is postulated that if a bank receives a deposit of LCC 100 million, it is obliged to place LCC 10 million (reminder: r = 10%) with the CB (RR). Once this is executed it can lend out LCC 90 million (see Balance Sheets 35-36).

BALANCE SHEET 35: BANK A (LCC MILLIONS)

Assets

Liabilities

Reserves with CB (TR) (RR +10)

Loans

+10 +90

Deposits

+ 100

BALANCE SHEET 36: CENTRAL BANK (LCC MILLIONS)

Assets

Liabilities

Bank reserves (TR) (RR +10)

+10

Total

+10

When the loan of LCC 90 million is made, this amount ends up as a deposit with the bank (we assume there is one bank126). The bank places 10% (= LCC 9 million) with the CB and lends out the rest (= LCC 81 million) (see Balance Sheets 37-38 = a continuance of Balance Sheets 35-36).

BALANCE SHEET 37: BANK A (LCC MILLIONS)

Assets

Reserves with CB (TR)

(RR +10 & +9)

Loans

Loans

+ 19

+90

+81

Deposits

Deposits

+ 100

+90

Total +190 Total +190

BALANCE SHEET 38: CENTRAL BANK (LCC MILLIONS)

Assets

Liabilities

Bank reserves (TR) (RR +10 & +9)

+ 19

Total

+19

This process continues until the full original deposit amount of LCC 100 million is "used up", i.e. is equal to the RR amount, which may be expressed as:

In other words, the money creation process continues until a total of LCC 1 000 deposits have been created (including the original deposit), and this was possible because the original deposit of LCC 100 million could be used as RR = compliance with the reserve requirement. Balance Sheets 39-40 illustrate this.

BALANCE S

NK A (LCC MILLIONS)

Assets

Liabilities

Reserves with CB (TR) (RR +100)

Loans

+ 100

+900

Deposits

+ 1 000

Total

+1 000

Total

BALANCE SHEET 40: CENTRAL BANK (LCC MILLIONS)

Assets

Liabilities

Bank reserves (TR) (RR +100)

+ 100

Total

This is the so-called money multiplier, and it is expressed as the reciprocal of r:

Thus, for every LCC 10 in new bank deposits, the total money stock increase is LCC 100. This is unadulterated nonsense and it is so for the following reasons:

• Where does the original deposit come from? One cannot just suck a deposit out of the air. Some balance sheet would have changed in the direction of deposits +LCC 100 million, but what other balance sheet item change compensates for this?

• As we have shown, no bank can create CBM, i.e. it is not possible for a bank to place any amount with the CB, without the CB buying an asset / reducing a liability.

• Note that, because of the flawed starting point in the "explanation", the balance sheet of the CB does not balance. So "something" is incorrect, and it is that the CB did not buy an asset or reduce a liability in order to create reserves (CBM) for the bank.

It is quite evident that the deposit originated from a new bank loan, as we expounded above. A final note to this section: it was assumed that there is only one bank; introducing more banks does not alter the principle.

 
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