The cash reserve requirement

Before the next part of this story can be presented, we need to introduce the cash reserve requirement (RR; it also denotes the amount of required reserves). Most countries have a RR, but some do not, which divorces money creation from it - a tenet of this text which we shall return to. This is a statutory requirement in terms of which banks are required to hold on deposit with the central bank (CB) an amount of funds called cash reserves (R). The amount of RR is a proportion of the amount of deposits the banks have (we assume 10% for the sake of simplicity - we denote this RR percentage as r). Thus if the banks have LCC 100 billion in deposited obliged to have 10 billion on deposit with the CB.

Figure 4: money creation & RR

A number of essential notes are required here:

• As noted, although rare, there are some countries that do not have a RR.

• In some countries the banks have two accounts:

- Reserve account (RA), in which the RR balances are held.

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

• At times banks have reserves in excess of RR, denoted as ER. RR + ER = the total of reserves (denoted as R).

• In some countries the banks have just one CB account: a SA in which R is held and over which interbank settlement takes place.

• Central banks do not pay interest on banks' R. This is usually the case, but there are exceptions14.

• Because of the latter, the banks have no reason to hold ER with the CB; i.e. they endeavour to hold the minimum RR.

• In this discussion we assume there is one account: the SA and that interest is not paid on R.

• In many countries N&C rank as RR; therefore if the RR is LCC 100 million and the banks have N&C in portfolio (in ATMs, teller tills, etc) to the extent of LCC 10 million: only LCC 90 million is required to be held on the SA as RR.

• In some countries N&C cannot be used to satisfy the RR. We assume this in the text.

• Banks' N&C and their CB account balances are referred to as CB money (CBM).

• No bank can create CBM; only the CB can do so - by buying an asset from the bank or making a loan to the bank (against collateral of eligible assets = government securities usually).

• When the CB makes a loan to a bank (= provides borrowed R) it does so at an "administratively" determined rate (set by the Monetary Policy Committee - the MPC): this rate is called by many names such as repo rate, base rate, discount rate, bank rate and so on. We will refer to it at the CB's key interest rate (KIR).

The above will become clearer as we progress. For the moment see figure 4: when banks make loans of LCC 100 million and create deposits of LCC 100 million they are obliged to have LCC 10 million in RR with the CB. This can only be supplied by the CB by making loans to the banks, and this is done at the KIR.

Money creation does not start with a bank receiving a deposit

Introduction

Many text books on money and banking lead the scholar astray with the starting point of money creation being a bank receiving a deposit. They postulate that if a bank receives a deposit of LCC 100 million, it is obliged to place LCC 10 million (r = 10%) with the CB. Once this is executed it can lend out LCC 90 million (see Boxes 6-7).

When the loan of LCC 90 million is made, this amount ends up as a deposit with the bank (again we assume there is one bank15). The bank places 10% (= LCC 9 million) with the CB and lends out the rest (= LCC 81 million) (see Boxes 8-9 = a continuation of Boxes 6-7).

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

New deposit creation = Original deposit of LCC 100 million / r

= LCC 100 million / 0.10

= LCC 1 000 million.

Thus we have a so-called money / credit multiplier and it is expressed as the reciprocal of r; therefore:

Money / credit multiplier = 1 / r.

In this example the multiplier = 1 / 0.10 = 10. So, for every LCC 10 million increase in the original bank deposit the money stock increases by LCC 100 million. It will be evident that if r is 8%: the multiplier = 1 / 0.08 = 12.5, meaning that for every LCC 10 million increase in the original bank deposit the money stock increases by LCC 125 million (assuming a demand for loans exists).

This is misleading, 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. Someone's balance sheet would have changed in the direction of deposits + LCC 100 million, but what other balance sheet item changes compensate for this?

• Note that the CB's balance sheets do not balance

• No bank can create CBM; only the CB can; therefore the transactions shown above cannot happen.