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How Central Banks Create Money:
Actually, central banks do not create money directly. Commercial banks create money. For purpose of this discussion, "money" will refer to fiat currency. Dollars, euros, pounds, yen, yuan, etc.
Actually, central banks do not create money directly. Commercial banks create money. For purpose of this discussion, "money" will refer to fiat currency. Dollars, euros, pounds, yen, yuan, etc.
When a commercial bank grants a loan to an individual or a business, it creates money. According to the loan indenture, the borrower assumes a number of legal obligations related to repayment of the loan.
In exchange for these "promises to pay", which constitute a security, the loan contract, issued by the borrower to the commercial bank, the bank credits the borrower's chequing account with a demand deposit.
This cash may be withdrawn in physical currency, or transferred in a payment to another account. If the currency is spent, someone else receives it, and it generally finds its way bank into a commercial bank demand deposit, albeit possibly at another financial institution.
Thus, when a bank grants a loan, it increases the total amount of cash on deposit in the commercial banking system. In a sense, it creates money "out of thin air".
According to double-entry bookkeeping convention, when a loan is granted, a new asset must be offset by a new liability.
For the borrower, the loan, i.e., the security issued by the borrower to the bank, is a liability. The deposit is an asset.
For the borrower, the loan, i.e., the security issued by the borrower to the bank, is a liability. The deposit is an asset.
For the bank, the deposit, which may be withdrawn by the borrower at any time, is a liability. The loan, which is a promise by the borrower to repay the debt, is an asset.
Although a bank creates money when it grants a loan, it is constrained in the total amount of loans it may have outstanding at any given time.
Commercial banks are regulated, either by a financial services regulatory agency of government, or by a central bank.
Commercial banks are regulated, either by a financial services regulatory agency of government, or by a central bank.
The regulator determines the total amount of loans each commercial bank may have outstanding. The mechanism of control is the "reserve ratio".
Just as individuals and businesses maintain deposits in accounts at commercial banks, commercial banks maintain deposits in accounts at the central bank. These are called "bank reserves".
The reserve ratio is defined as the minimum ratio between a commercial bank's reserves and the total amount of its deposit liabilities. For example, if the reserve ratio is set at 10%, then banks must have 10% of their loan book in reserve.
In other words, for every $1 of reserves it maintains at the central bank, it may loan $10. Since each new loan results in the creation of a new demand deposit liability, the commercial bank's loan book is constrained by two things:
1. Its bank reserves
2. The reserve ratio
1. Its bank reserves
2. The reserve ratio
Central banks do not create money. Commercial banks do. But central banks regulate the total amount of money the commercial banks are allowed to create.
The only way commercial banks can create money is by granting loans.
The only way commercial banks can create money is by granting loans.
As maturing loans amortise and are repaid by borrowers to the banks, money is destroyed. As new loans are granted, money is created. The change in the money supply is the net of loans granted and loans repaid.
In view of the above, there are two ways for central banks to increase the "money supply", which is, roughly speaking, the aggregate amount of deposit liabilities, as determined by the total amount of loans outstanding in the banking system.
The first way is to lower the reserve ratio. Then commercial banks may expand their loan books, and money is created.
For example, if the reserve ratio is lowered from 10% to 8%, then the commercial banks, for each $1 of bank reserves, may now loan $12.50, rather than only $10.
For example, if the reserve ratio is lowered from 10% to 8%, then the commercial banks, for each $1 of bank reserves, may now loan $12.50, rather than only $10.
Hence, they are permitted to make $2.50 in new loans for each dollar of bank reserves.
Conversely, if the central bank lowers the reserve ratio, commercial banks must contract their loan books, and money is destroyed.
Conversely, if the central bank lowers the reserve ratio, commercial banks must contract their loan books, and money is destroyed.
For example, if the central bank raises the reserve ratio from 10% to 12.5%, then for each dollar of reserves, commercial banks may loan only $8. Therefore, they must contract their loan books by $2 per dollar of reserves.
They may do this either by calling existing loans, or granting new loans at a lower rate of issuance than the rate of repayment of outstanding loans.
The second way in which central banks facilitate the creation of money is through "open market operations".
In these operations, central banks purchase securities from commercial banks, usually government bonds.
In these operations, central banks purchase securities from commercial banks, usually government bonds.
In some instances, the central banks may also purchase corporate bonds or shares, or other securities. Whichever financial assets the open market operations target, the effect on the money supply is essentially the same.
For illustrative purposes, let us assume that banks purchase "government" or "sovereign" bonds. But first, how are sovereign bonds created?
Governments collect taxes (revenue) and spend on various programmes (expenses). When a government spends more than it collects in taxes,
Governments collect taxes (revenue) and spend on various programmes (expenses). When a government spends more than it collects in taxes,
the result is a "fiscal deficit". This fiscal deficit is funded by borrowing, via the issuance of government bonds. The mechanism through which these bonds are created is a "bond auction".
In this auction, a commercial bank known as a "primary dealer" purchases newly issued bonds. This primary dealer is typically either an investment bank or a large commercial bank with a capital markets division, accustomed to dealing in securities, and licensed by the state.
Continued in Part 2 of 3... https://twitter.com/valley_llama/status/1299229364769431553
