Money creation
From Wikipedia, the free encyclopedia
Money creation is the process by which money is produced or issued. There are three different ways to create money:
- manufacturing a new monetary unit, such as paper currency or metal coins (money creation)
- loaning out a physical monetary unit multiple times through fractional-reserve lending (credit creation)
- buying of government securities or other financial instruments by central bank through Open market operations (electronic creation)
Coins are produced by manufacturing metal in a factory called a mint.
Banknotes and bank account balances are financial securities issued by a bank.
Similarly, money destruction, i.e., the reverse of money creation, can occur in two different ways, depending on how the money was created. The destruction of physically created money occurs when coins are scrapped to recover their precious metal content, which can be incentivized by the value of the metal coming to exceed the face value of the coin, or when the issuer redeems the securities. The destruction of money created through loans occurs as the loans are paid back (deleveraging)[citation needed].
The practices and regulation of production, issue and redemption of money is of central concern to monetary economics (e.g. money supply, monetarism), and affect the operation of financial markets and the purchasing power of money.
In modern economies, relatively little of the money supply is in currency (i.e. coins and banknotes); most is created through lending.
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[edit] Money creation by mints
[edit] Under competitive minting
Competitive minting means that the business of manufacturing coins is open to many competing manufacturers. The mints buy bullion on the bullion market, and manufacture it into coins that they use to pay for the bullion and their other production costs, and to provide a profit.
Analysis of supply and demand cannot proceed in the normal way because by definition, the money price of money is fixed at unity. Instead, metal producers need money to pay their expenses and to realize their profits in money, and so their demand for money is expressed by their willingness to produce and sell uncoined metal at a discount to its value as coin. This discount is the gross profit margin of manufacturing metal into coin, and the greater this is, the more metal the mints will find economical to manufacture into coin.
[edit] Under nationalized minting with a right to exchange
Nationalized minting means that the government has monopolized the business of minting coins, and the government operates mints that produce a national system of coinage. Under a metallic or bimetallic standard with a national mint, individuals normally have a right to bring precious metal to the national mint and to have it coined at a fixed discount. This discount is called seigniorage.
Basic economic analysis of this arrangement is that it makes the supply of coin elastic at the fixed price, however this fixed price is effectively a price control, and price control theory implies that the supply of coin would be more elastic (responsive) under competitive supply and no price controls.
[edit] Under nationalized minting with no right to exchange
Where there is no legal right to take metal to the national mint and to have it coined into a particular coin, the supply of the coin depends on government or mint policy. This can result in arbitrary debasement of coinage, where the government mint re-manufactures coin with a lower metallic value as a way to raise revenue. However it also enables some more complex coinage arrangements such as the composite legal tender system where gold coin was unlimited legal tender (produced under a right of exchange arrangement as above) and where silver coins are limited legal tender, and have a substantially reduced metallic value below their legal value, but are effectively redeemable at the mint for their legal value in gold coins. This makes the silver coins 'token' coins, and a form of financial asset (and a financial liability to the mint).
[edit] Money creation through the fractional reserve system
Fractional-reserve banking creates money whenever a new loan is created. In short, there are two types of money in a fractional-reserve banking system, the two types being legally equivalent [1][2]:
-
- central bank money (all money created by the central bank regardless of its form (banknotes, coins, electronic money through loans to private banks))
- commercial bank money (money created in the banking system through borrowing and lending) - sometimes referred to as checkbook money[3]
When a loan is supplied with central bank money, new commercial bank money is created. As a loan is paid back, the commercial bank money disappears from existence. The table below displays how central bank money is used to produce commercial bank money.
| Table:[4] Fractional-Reserve Lending Cycled 10 times with a 20 percent reserve rate (sources: The Principle of Multiple Deposit Creation[5], Federal Reserve Bank of New York[6], Bank for International Settlements[1]) | ||||
|---|---|---|---|---|
| individual bank | amount deposited | amount loaned out | reserves | |
| A | 100 | 80 | 20 | |
| B | 80 | 64 | 16 | |
| C | 64 | 51.20 | 12.80 | |
| D | 51.20 | 40.96 | 10.24 | |
| E | 40.96 | 32.77 | 8.19 | |
| F | 32.77 | 26.21 | 6.55 | |
| G | 26.21 | 20.97 | 5.24 | |
| H | 20.97 | 16.78 | 4.19 | |
| I | 16.78 | 13.42 | 3.36 | |
| J | 13.42 | 10.74 | 2.68 | |
| K | 10.74 | |||
| total reserves: | ||||
| 89.26 | ||||
| total amount deposited: | total amount loaned out: | total reserves + last amount deposited: | ||
| 457.05 | 357.05 | 100 | ||
| commercial bank money created + central bank money: | commercial bank money created: | central bank money: | ||
| 457.05 | 357.05 | 100 | ||
Although no new money was physically created in addition to the initial $100 deposit, new commercial bank money is created through loans. The 2 boxes marked in red show the location of the original $100 deposit throughout the entire process. The total reserves plus the last deposit (or last loan, whichever is last) will always equal the original amount, which in this case is $100. As this process continues, more commercial bank money is created. For more information on how this system works, see Fractional-reserve banking.
[edit] Money multiplier
The most common mechanism used to measure this increase in the money supply is typically called the money multiplier. It calculates the maximum amount of money that an initial deposit can be expanded to with a given reserve ratio.
[edit] Formula
The money multiplier, m, is the inverse of the reserve requirement, R:
This formula stems from the fact that the sum of the "amount loaned out" column above can be expressed mathematically as a geometric series[7].
Example
For example, with the reserve ratio of 20 percent, this reserve ratio, R, can also be expressed as a fraction:
So then the money multiplier, m, will be calculated as:
This number is multiplied by the initial deposit to show the maximum amount of money it can be expanded to[8].
[edit] See also
- Fractional-reserve banking
- Central bank
- Federal Reserve
- Fiat currency
- Inflation
- Money
- Money supply
- National bank
- Open market operations
- Reserve requirements
[edit] External links
- federalreserveeducation.org - The Principle of Multiple Deposit Creation
- Reserve Requirements - Fedpoints - Federal Reserve Bank of New York
- - Seignorage and inflation tax
- Schematic diagram to explain the fractional-reserve process
- Bank for International Settlements - The Role of Central Bank Money in Payment Systems
- Murrey Rothbard "The Mystery of Banking"
[edit] References
- ^ a b Bank for International Settlements - The Role of Central Bank Money in Payment Systems. See page 9, titled, "The coexistence of central and commercial bank monies: multiple issuers, one currency": http://www.bis.org/publ/cpss55.pdf A quick quote in reference to the 2 different types of money is listed on page 3. It is the first sentence of the document:
- "Contemporary monetary systems are based on the mutually reinforcing roles of central bank money and commercial bank monies."
- ^ European Central Bank - Domestic payments in Euroland: commercial and central bank money: http://www.ecb.int/press/key/date/2000/html/sp001109_2.en.html One quote from the article referencing the two types of money:
- "At the beginning of the 20th almost the totality of retail payments were made in central bank money. Over time, this monopoly came to be shared with commercial banks, when deposits and their transfer via checks and giros became widely accepted. Banknotes and commercial bank money became fully interchangeable payment media that customers could use according to their needs. While transaction costs in commercial bank money were shrinking, cashless payment instruments became increasingly used, at the expense of banknotes"
- ^ Chicago Fed - Our Central Bank: http://www.chicagofed.org/consumer_information/the_fed_our_central_bank.cfm
- the reference is found in the "Money Manager" section:
- "the Fed works to control money at its source by affecting the ability of financial institutions to "create" checkbook money through loans or investments. The control lever that the Fed uses in this process is the "reserves" that banks and thrifts must hold."
- the reference is found in the "Money Manager" section:
- ^ Table created with the OpenOffice.org Calc spreadsheet program using data and information from the references listed.
- ^ Federal Reserve Education - How does the Fed Create Money? http://www.federalreserveeducation.org/fed101_html/policy/money_print.htm
- See the link to "The Principle of Multiple Deposit Creation" pdf document towards bottom of page.
- ^ An explanation of how it works from the New York Regional Reserve Bank of the US Federal Reserve system. Scroll down to the "Reserve Requirements and Money Creation" section. Here is what it says:
- "Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51.20+...=$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity."
- ^ http://www.mhhe.com/economics/mcconnell15e/graphics/mcconnell15eco/common/dothemath/moneymultiplier.html
- ^ Mankiw, N. Gregory (2001), Principles of Macroeconomics
