CREATION OF MONEY

Creation of Money

Money creation refers to the process by which the money supply in an economy is increased. It typically involves the activities of central banks and commercial banks. There are two primary mechanisms for money creation:

1. Central Bank Money Creation
2. Commercial Bank Money Creation

Central Bank Money Creation

The central bank, such as the Federal Reserve in the United States, is responsible for creating the base money supply, which includes physical currency (banknotes and coins) and reserves held by commercial banks at the central bank.

Tools of Central Bank Money Creation:

1. Open Market Operations (OMOs):
   • The central bank buys or sells government securities in the open market.
   • When the central bank buys securities, it pays with new money, increasing the money supply.
   • When it sells securities, it takes money out of circulation, decreasing the money supply.
2. Discount Rate:
   • The interest rate charged by central banks on loans to commercial banks.
   • Lowering the discount rate makes borrowing cheaper for commercial banks, encouraging them to lend more, thereby increasing the money supply.
   • Raising the discount rate makes borrowing more expensive, reducing the money supply.
3. Reserve Requirements:
   • The percentage of deposits that commercial banks must hold as reserves.
   • Lowering reserve requirements frees up funds for banks to lend, increasing the money supply.
   • Raising reserve requirements reduces the funds available for lending, decreasing the money supply.

Example of Central Bank Money Creation

Suppose the central bank conducts an open market operation by purchasing $1 billion in government securities. The central bank credits the accounts of the sellers with $1 billion, which increases the amount of money in circulation. This initial injection of funds increases the base money supply and sets the stage for further money creation by commercial banks.

Commercial Bank Money Creation

Commercial banks create money through the process of accepting deposits and making loans. This process is often referred to as the fractional reserve banking system.

Mechanism of Money Creation by Commercial Banks

1. Deposits and Reserves:
   • When a customer deposits money into a bank, the bank keeps a fraction of the deposit as reserves (as required by the central bank) and can lend out the rest.
2. Lending and Money Multiplier:
   • The money lent out by the bank is deposited into other banks, which keep a fraction as reserves and lend out the rest.
   • This process repeats, creating a money multiplier effect where the total money supply increases by a multiple of the original deposit.

Example of Commercial Bank Money Creation

Let’s use a simplified example to illustrate this process:

1. Initial Deposit:
   • John deposits $1,000 into Bank A.
   • Assume the reserve requirement is 10%.
2. Bank A’s Actions:
   • Bank A keeps $100 as reserves (10% of $1,000) and lends out $900.
3. Second Deposit:
   • Jane borrows $900 from Bank A and deposits it into Bank B.
4. Bank B’s Actions:
   • Bank B keeps $90 as reserves (10% of $900) and lends out $810.
5. Third Deposit:
   • The borrower deposits $810 into Bank C.
6. Bank C’s Actions:
   • Bank C keeps $81 as reserves (10% of $810) and lends out $729.

This process continues, creating new deposits and loans. The initial $1,000 deposit can ultimately create a total money supply of:

Total Money Supply=Initial Deposit×1Reserve Requirement\text{Total Money Supply} = \text{Initial Deposit} \times \frac{1}{\text{Reserve Requirement}}Total Money Supply=Initial Deposit×Reserve Requirement1​

Using the 10% reserve requirement:

Total Money Supply =1,000×0.101​=1,000×10=10,000

So, the initial $1,000 deposit has the potential to increase the total money supply by $10,000 through the lending activities of banks.

Conclusion

Money creation is a critical process in the functioning of modern economies. It involves the activities of both central banks and commercial banks:

1. Central Banks:
   • Control the base money supply through tools like open market operations, discount rates, and reserve requirements.
2. Commercial Banks:
   • Create additional money through the fractional reserve banking system by accepting deposits and making loans.

The combined effect of these activities determines the overall money supply in the economy, influencing economic activity, inflation, and financial stability. Understanding money creation helps in comprehending how monetary policy affects the economy and how banks contribute to the expansion of the money supply.