Before analyzing the process of money creation, we must
first review the nature of money and the reason why it exists.
Money exists in order to facilitate the making of transactions---it
saves the labour and capital resources that would have to be used if
barter were the only method of exchange. Money consists of cash-in-pocket,
bank deposits that can be transferred by cheque and, depending on how broadly
we define it, other bank deposits and highly "liquid" assets that
can be quickly converted into cash at prices known in advance. In the
discussion that follows, money will be defined simply as cash-in-hand
plus bank deposits.
In modern economies the money supply is determined by the
government. The government puts money in circulation every time
it buys goods or assets from the private sector and takes it out
of circulation by levying taxes on the private sector and selling
assets to private institutions and individuals. When the government
exchanges money for goods or securities the stock of money
in private hands necessarily goes up. And when it sells assets to the
private sector or levies taxes, the money it receives goes out of circulation.
We must distinguish here between two branches of government---the treasury and
the central bank. The job of the treasury is to budget the government's
expenditures and finance them either by levying taxes or borrowing. Since
every dollar it spends must be raised through taxes or borrowing, the
treasury's actions do not change the money supply.
It is the central bank's job to manage the money supply.
It puts money in circulation by purchasing bonds from the private
sector and takes it out of circulation by selling bonds to the
private sector. These actions are called open market operations.
The central bank also manages the government's deposit accounts
on which cheques are written to pay the government's expenditures---these
deposits typically are in part with the commercial banks and in part with
the central bank itself.
The treasury normally issues bonds to finance some portion
of the government's expenditures. The central bank then buys
in the open market an amount of these sufficient to put in circulation the
appropriate quantity of money. In some cases the central bank may buy bonds
directly from the Treasury, who puts the funds in circulation when it makes
government expenditures with them.
Things are more complicated than this, however, because part
of the money supply consists of deposits in the commercial banks---quite
apart from the amount of cash in circulation, any change in the amount of
these deposits will also change the money supply. We must therefore
investigate the forces causing bank deposits to change.
Commercial banks are profit-making firms who borrow funds
from depositors and lend them out to households and businesses at
rates of interest that are above the interest rates paid on the
deposits. The excess of interest received over interest paid
minus the costs of managing their loans and deposits represents
the banks' profits.
The balance sheet of a typical bank is given in Table 1. From the principles
of double-entry bookkeeping, total assets shown on the left must exactly equal
total liabilities and net worth shown on the right.
Table 1. First City Bank
Assets |
(thousands of $) |
Liabilities |
|
| Cash Reserves |
3,000 |
30,000 |
Deposits |
| Government Bonds | 10,000 |
| Loans |
22,000 |
|
| | |
Net Worth |
|
| | 5,000 |
Equity |
|
|
|
| Total | 35,000 |
35,000 | Total |
Not all the funds the banks obtain from deposits can be
loaned out. Some portion must be kept as cash reserves to meet
any demands of depositors to withdraw cash. Although it is not
shown in the figure, these reserves consist of cash-on-hand plus
deposits with the central bank that can be immediately converted
into cash. Banks will also normally hold some government bonds
and other interest earning assets in addition to their commercial
loans.
Table 2. First City Bank
Assets |
(thousands of $) |
Liabilities |
|
| Cash Reserves |
3,100 |
30,100 |
Deposits |
| Government Bonds | 10,000 |
| Loans |
22,000 |
|
| | |
Net Worth |
|
| | 5,000 |
Equity |
|
|
|
| Total | 35,100 |
35,100 | Total |
Suppose that the central bank buys $100 of bonds from someone in the private
sector who deposits the funds in the commercial bank depicted in Table 1. This
will increase the bank's deposits and its reserves by $100, as shown above in
Table 2. Since the bank only needs, say, $10 of reserves to back the
additional $100 of deposits, it loans out $90. The bank's balance sheet is
then shown in Table 3.
Table 3. First City Bank
Assets |
(thousands of $) |
Liabilities |
|
| Cash Reserves |
3,010 |
30,100 |
Deposits |
| Government Bonds | 10,000 |
| Loans |
22,090 |
|
| | |
Net Worth |
|
| | 5,000 |
Equity |
|
|
|
| Total | 35,100 |
35,100 | Total |
But there is more. The person who took out the loan spends the funds and the
person receiving them deposits the money in her bank, shown in Table 4.
Table 4. Second City Bank
Assets |
(thousands of $) |
Liabilities |
|
| Cash Reserves |
2,000 |
20,000 |
Deposits |
| Government Bonds | 5,000 |
| Loans |
17,000 |
|
| | |
Net Worth |
|
| | 4,000 |
Equity |
|
|
|
| Total | 24,000 |
24,000 | Total |
That bank's reserves and deposits will increase by $90, as shown in Table 5.
The money supply has now increased by $190 as a result of the central
bank's open market operation---deposits have increased by $100 in the first
bank and by $90 in the second. Now the second bank only needs to hold,
say, $9 in reserves to back the additional deposit of $90, so it
will loan out $81, which will be deposited in a third bank. The
money supply is then higher by $100 + $90 + $81 = $271. The
third bank, in turn, will loan out a portion of these $81 and
keep only a fraction as reserves. This loan will be deposited
again, and so on.
Table 5. Second City Bank
Assets |
(thousands of $) |
Liabilities |
|
| Cash Reserves |
2,090 |
20,090 |
Deposits |
| Government Bonds | 5,000 |
| Loans |
17,000 |
|
| | |
Net Worth |
|
| | 4,000 |
Equity |
|
|
|
| Total | 24,090 |
24,090 | Total |
So the ultimate effect of a $100 open market purchase of
bonds by the central bank will be an expansion in the money
supply of some multiple of that amount. A decision on the part of the public
to hold $100 less cash and $100 more deposits will have exactly the same
effect. Deposits and reserves will initially rise by $100 followed by a
multiplier effect as the excess reserves are repeatedly loaned out and
redeposited.
To understand the overall effects of monetary expansions
of the sort outlined above we must distinguish between base Money
or high-powered money and the money supply itself. High-powered
or base money is the cash or reserve base upon which the banking system
can create deposits. It equals the reserves of the banking
system plus the public's cash holdings---the latter potentially can
be deposited in banks and augment reserves. Thus
1. H
= C + R
where H is the stock of base or high-powered money,
C is the stock of currency held by the public and
R is the stock of bank reserves.
The money supply, denoted by M , is defined for our
purposes as cash held by the public plus deposits in banks, denoted
by D
2. M
= C + D
The ratio of the money supply to base or high powered money, denoted by
mm is then equal to
3. mm = M/H
= (C + D) / (C + R)
Dividing both the numerator and denominator of the right-hand side of
Equation 3 by D, we get
4. mm
= (C/D + 1) / (C/D + R/D) =
(c + 1) / (c + f)
where c = C/D is the public's desired ratio of cash
to deposit holdings and f = R/D is the commercial
banking system's desired ratio of reserves to deposits. If the banking
system's desired reserve ratio or the public's desired cash to deposit
ratio falls the money multiplier will increase, as will the money
supply associated with any given stock of base money.
The effects of changes in c and f on
mm can be best seen by plugging some numbers into Equation 4.
Suppose that the private sector's desired currency/deposit ratio is 0.2 and
the banking system's desired reserve/deposit ratio is 0.1. Then
mm
= (c + 1) / (c + f) = 1.2 / 0.3 = 4
resulting in a money supply equal to four times the stock of high-powered
money. Now let the reserve/deposit ratio f rise to 0.2. The
money multiplier falls to
mm
= (c + 1) / (c + f) = 1.2 / 0.4 = 3
and the money supply becomes only three times the stock of base
money. If c then rises to 0.3 the money multiplier becomes
mm
= (c + 1) / (c + f) = 1.3 / 0.5 = 2.6
at which point the money supply will be only 2.6 times the stock
of high-powered money.
The central bank can control the stock of base money by its
open market operations but private sector decisions determine how
big the stock of money associated with this stock of base money
will be. Since
5. M
= mm H = [(c + 1) / (c + f)] H
the central bank, to keep the money supply at a desired level,
must continually adjust H to offset the effects of
changes in c and f on mm and
M .
It is time for another test. Be sure to think up your own answers before
accessing the ones provided.
Question 1
Question 2
Choose Another Topic in the Lesson