Money creation, or money issuance, is the process by which the money supply of a country, or of an economic or monetary region,[note 1] is increased. In most modern economies, most of the money supply is in the form of bank deposits. Central banks monitor the amount of money in the economy by measuring the so-called monetary aggregates.[note 2]
The term "money supply" commonly denotes the total, safe, financial assets that households and businesses can use to make payments or to hold as short-term investment. The money supply is measured using the so-called "monetary aggregates", defined in accordance to their respective level of liquidity: In the United States, for example, M0 for currency in circulation; M1 for M0 plus transaction deposits at depository institutions, such as drawing accounts at banks; M2 for M1 plus savings deposits, small-denomination time deposits, and retail money-market mutual fund shares.
The authority through which monetary policy is conducted is the central bank of the nation. The mandate of a central bank typically includes either one of the three following objectives or a combination of them, in varying order of preference, according to the country or the region: Price stability, i.e. inflation-targeting; the facilitation of maximum employment in the economy; the assurance of moderate, long term, interest rates.
The central bank is the banker of the government[note 4] and provides to the government a range of services at the operational level, such as managing the Treasury's single account, and also acting as its fiscal agent (e.g. by running auctions), its settlement agent, and its bond registrar. A central bank cannot become insolvent in its own currency. However, a central bank can become insolvent in liabilities on foreign currency.
Central banks operate in practically every nation in the world, with few exceptions. There are some groups of countries, for which, through agreement, a single entity acts as their central bank, such as the organization of states of Central Africa, [note 5] which all have a common central bank, the Bank of Central African States, or monetary unions, such as the Eurozone, whereby nations retain their respective central bank yet submit to the policies of the central entity, the ECB. Central banking institutions are generally independent of the government executive.
The central bank's activities directly affect interest rates, through controlling the base rate, and indirectly affect stock prices, the economy's wealth, and the national currency's exchange rate.Monetarists and some Austrians[note 6] argue that the central bank should control the money supply, through its monetary operations.[note 7] Critics of the mainstream view maintain that central-bank operations can affect but not control the money supply.[note 8]
Open-market operations (OMOs) concern the purchase and sale of securities in the open market by a central bank. OMOs essentially swap one type of financial assets for another; when the central bank buys bonds held by the banks or the private sector, bank reserves increase while bonds held by the banks or the public decrease. Temporary operations are typically used to address reserve needs that are deemed to be transitory in nature, while permanent operations accommodate the longer-term factors driving the expansion of the central bank's balance sheet; such a primary factor is typically the trend of the money-supply growth in the economy. Among the temporary, open-market operations are repurchase agreements (repos) or reverse repos, while permanent ones involve outright purchases or sales of securities. Each open-market operation by the central bank affects its balance sheet.
Monetary policy is the process by which the monetary authority of a country, typically the central bank (or the currency board), manages the level of short-term interest rates[note 9] and influences the availability and the cost of credit in the economy, as well as overall economic activity.
Central banks conduct monetary policy usually through open market operations. The purchase of debt, and the resulting increase in bank reserves, is called "monetary easing." An extraordinary process of monetary easing is denoted as "quantitative easing", whose intent is to stimulate the economy by increasing liquidity and promoting bank lending.
State spending is part of the state's fiscal policy. Deficit spending involves the state spending into the economy more than it receives (in taxes and other payments) within a certain period of time, typically the budget year.
Deficit spending increases the money supply. The extent and the timing of budget deficits is disputed among schools of economic analysis. The mainstream view is that net spending by the public sector is inflationary in so far as it is "financed" by the banking system, including the central bank, and not by the sale of state debt to the public.
The existence itself of budget deficits is generally considered inflationary by mainstream economics, so policies are prescribed for the lowering of the deficit,[note 10] while heterodox economists such as Post-Keynesians treat deficit spending as "simply" a fiscal policy option.
When commercial banks lend out money, they are expanding the amount of bank deposits. The modern banking system can expand the money supply of a country beyond the amount created or targeted by the central bank, creating most of the broad money in the system through fractional-reserve banking.
Banks are limited in the total amount they can loan by their capital adequacy ratios, and their required reserve ratios. The required-reserves ratio obliges the bank to keep a minimum, predetermined, percentage of their deposits at an account at the central bank.[note 11] The theory holds that, in a system of fractional-reserve banking, where banks ordinarily keep only a fraction of their deposits in reserves, an initial bank loan creates more money than is initially lent out.
The maximum ratio of loans to deposits is the required-reserve ratio , which is determined by the central bank, as
where are reserves and are deposits.
In practice, if the central bank imposes a required reserve ratio () of 0.10, then each commercial bank is obliged to keep at least 10% of its total deposits as reserves, i.e. in the account it has at the central bank.
The process of money creation can be illustrated with the following example in the United States: Corporation A deposits $100,000 into Bank of America. Bank of America keeps $10,000 as reserves at the Federal Reserve. To make a profit, Bank of America loans the remaining $90,000 to the federal government. The government spends the $90,000 by buying something from corporation B. B deposits the $90,000 into its account with Wells Fargo. Wells Fargo keeps $9,000 as reserves at the Federal Reserve, and then lends the remaining $81,000 to the government. If this chain continues indefinitely then, in the end, an amount approximating $1,000,000 has gone into circulation and has therefore become part of the total money supply. Furthermore, the Federal Reserve itself can and does lend money to banks as well as to the federal government. There is currently neither an explanation on where the money comes from to pay the interest on all these loans, nor is there an explanation as to how the United States Department of the Treasury manages default on said loans (see Lehman Brothers). A negative supply of money is predicted to occur in the event that all loans are repaid at the same time.
The ratio of the total money added to the money supply (in this case, $1,000,000) to the total money added originally in the monetary base (in this case, $100,000) is the money multiplier.[note 12] In this context, the money multiplier relates changes in the monetary base,[note 13] which is the sum of bank reserves and issued currency, to changes in the money supply.
If changes in the monetary base cause a change in the money supply, then
where is the new money supply, is the monetary base, and is the money multiplier. Therefore, the money multiplier is
The central bank can control the money supply, according to this theory, by controlling the monetary base as long as the money multiplier is limited by the required reserve ratio.
The fractional reserve theory where the money supply is limited by the money multiplier has come under increased criticism since the financial crisis of 2007-2008. It has been observed that the bank reserves are not a limiting factor because the central banks supply more reserves than necessary and because banks have been able to build up additional reserves when they were needed. Many economists and bankers now realize that the amount of money in circulation is limited only by the demand for loans, not by reserve requirements.
When a bank issues a loan of $1000 to a customer, they debit the customer's loan account with $1000 and at the same time they credit the customer's deposit account with $1000, ready for using. The bank now has a new asset of $1000 and a new liability of $1000. The bank's accounts are still in balance because the assets and liabilities are increased by the same amount. The bank's balance sheet is simply expanded with the amount of $1000. The bank does not take the $1000 out of its reserves. The $1000 are new circulating money that did not exist prior to the transaction.
A study of banking software demonstrates that the bank does nothing else than adding an amount to the two accounts when they issue a loan. The observation that there appears to be no limit to the amount of credit money that banks can bring into circulation in this way has given rise to the often-heard expression that "Banks are creating money out of thin air".
The amount of money that is created in this way when a loan is issued is equal to the principal of the loan, but the money needed for paying the compound interest of the loan has not been created. As a consequence of this process, the amount of debt in the world exceeds the total money supply. Critics of the current banking system are calling for monetary reform for this reason.
The credit theory of money, initiated by Joseph Schumpeter, asserts the central role of banks as creators and allocators of the money supply, and distinguishes between "productive credit creation" (allowing non-inflationary economic growth even at full employment, in the presence of technological progress) and "unproductive credit creation" (resulting in inflation of either the consumer- or asset-price variety).
The model of bank lending stimulated through central-bank operations (such as "monetary easing") has been rejected by Neo-Keynesian [note 14] and Post-Keynesian analysis as well as central banks.[note 15] The major argument offered by dissident analysis is that any bank balance-sheet expansion (e.g. through a new loan) that leaves the bank short of the required reserves may affect the return it can expect on the loan, because of the extra cost the bank will undertake to return within the ratios limits - but this does not and "will never impede the bank's capacity to give the loan in the first place." Banks first lend and then cover their reserve ratios: The decision whether or not to lend is generally independent of their reserves with the central bank or their deposits from customers; banks are not lending out deposits or reserves, anyway. Banks lend on the basis of lending criteria, such as the status of the customer's business, the loan's prospects, and/or the overall economic situation.
The central bank, or other competent, state authorities (such as the Treasury), are typically empowered to create new, physical currency, i.e. paper notes and coins, in order to meet the needs of commercial banks for cash withdrawals, and to replace worn and/or destroyed currency. The process does not increase the money supply, as such; the term "printing [new] money" is considered a misnomer.
"Monetary financing", also "debt monetization", occurs when the country's central bank purchases government debt. It is considered by mainstream analysis to cause inflation, and often hyperinflation. IMF's former chief economist Olivier Blanchard states that
governments do not create money; the central bank does. But with the central bank's cooperation, the government can in effect finance itself by money creation. It can issue bonds and ask the central bank to buy them. The central bank then pays the government with money it creates, and the government in turn uses that money to finance the deficit. This process is called debt monetization.
the central bank does not have the option to monetize any of the outstanding government debt or newly issued government debt...[A]s long as the central bank has a mandate to maintain a short-term interest rate target, the size of its purchases and sales of government debt are not discretionary. The central bank's lack of control over the quantity of reserves underscores the impossibility of debt monetization. The central bank is unable to monetize the government debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to any support rate that it might have in place for excess reserves.
Monetary financing used to be standard monetary policy in many countries, such as Canada or France, while in others it was and still is prohibited. In the Eurozone, Article 123 of the Lisbon Treaty explicitly prohibits the European Central Bank from financing public institutions and state governments. In Japan, the nation's central bank "routinely" purchases approximately 70% of state debt issued each month, and owns, as of Oct 2018, approximately 440 trillion JP¥ (approx. $4trillion)[note 17] or over 40% of all outstanding government bonds.
In the United States, the 1913 Federal Reserve Act allowed federal banks to purchase short-term securities directly from the Treasury, in order to facilitate its cash-management operations. The Banking Act of 1935 prohibited the central bank from directly purchasing Treasury securities, and permitted their purchase and sale only "in the open market". In 1942, during wartime, Congress amended the Banking Act's provisions to allow purchases of government debt by the federal banks, with the total amount they'd hold "not [to] exceed $5 billion." After the war, the exemption was renewed, with time limitations, until it was allowed to expire in June 1981.