Money creation - Wikipedia, the free encyclopedia

Money creation - Wikipedia, the free encyclopedia: Three ways to create money are; by manufacturing paper currency or metal coins, through debt and lending, and by government policies such as quantitative easing.

Money creation through the fractional reserve system

Main article: Fractional-reserve banking

Further information: Money supply

To avoid confusion, keep in mind that a "central bank" is not technically a federal institution - it is a private bank, not unlike other private banks, except for the fact that it has the right to control the initial issuance of debt-backed monies to a central government. Almost all nations have central banks, and almost all of the world's money supply is controlled not by governments, but by private bankers. 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. central bank money (M0 or MB = all money created by the central bank regardless of its form (banknotes, coins, electronic money through loans to private banks))
   
2. commercial bank money (M1 - M3 = money created in the banking system through borrowing and lending) - sometimes referred to as checkbook money^[5]

When a commercial bank loan is extended, new commercial bank money is created. As a loan is paid back, the commercial bank money disappears from existence.

Re-lending

The mainstream economics theory of monetary creation is that commercial bank money is created by commercial banks re-lending central bank money: the central bank (a privately-owned institution) lends money to another commercial bank, which re-loans part of it, due to fractional reserves, and this portion is in turn itself re-lent (it is re-re-lent central bank money). This theory is disputed by some schools of heterodox economics, such as monetary circuit theory.
The table below displays how central bank money is used to produce commercial bank money via successive re-lending in this theory.

Fractional-Reserve Lending Cycled 10 times with a 20 percent reserve rate
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.
An earlier form of such a table, featuring reinvestment from one period to the next and a geometric series, is found in the tableau économique of the Physiocrats, which is credited as the "first precise formulation" of such interdependent systems and the origin of multiplier theory.^[9]

Money multiplier

The expansion of $100M through fractional-reserve lending at varying rates. Each curve approaches a limit. This limit is the value that the money multiplier calculates.

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 – such a factor is called a multiplier.

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 with a common ratio of 1 − R.
To correct for currency drain (a lessening of the impact of monetary policy due to peoples' desire to hold some currency in the form of cash) and for banks' desire to hold reserves in excess of the required amount, the formula

can be used, where Currency Drain is the percentage of money that people want to hold as cash and the Desired Reserve Ratio is the sum of the Required Reserve Ratio and the Excess Reserve Ratio.
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.

Money creation through quantitative easing

Main article: Quantitative easing

Quantitative easing refers to the creation of a significant amount of new money (usually electronically) by a central bank. It is sometimes referred to as "printing money". This money is created to stimulate the economy, in particular to promote lending by banks. The central banks use the created money to buy up large quantities of securities from banks. This appears as deposits and gives the banks new money to lend. These securities could be government bonds, commercial loans, asset backed securities, or even stocks. Quantitative easing is usually used when lowering official interest rates is no longer effective because they are already close to or at zero.

See this graph of the Fed's balance sheet to see a history of what happened.  In March 2008, Bear Sterns collapsed which caused the Fed to do "qualitative easing" in which it reduced the quality of its assets from the safest possible short term government debt to loans to the banking industry.  Then when Lehman Brothers collapsed in September, the Fed engaged in quantitative easing in earnest.   Japan pioneered quantitative easing during their liquidity trap deflation, but unfortunately, it has not brought an economic recovery to Japan.  At best it has kept Japan's banks alive. 

Alternative theories

The above gives the mainstream economics theory of money creation. In heterodox economics, alternative theories of how money is created include:

• Chartalism, which holds that money is created by government deficit spending, and emphasizes (and advocates) fiat money.
• Circuitist money theory, held by some post-Keynesians, which argues that money is created endogenously by the banking system, rather than exogenously by central bank lending. Further, they argue that money is not neutral – a credit money system is fundamentally different from a barter money system, and money and banks must be an integral part of economic models.