Creation of money

From CEOpedia | Management online

Money creation is the process of adding more money into circulation by banks. This process leads to the creation of new cash resources. There is a distinction between primary and secondary creation of money. At present, money creation is handled by the Central Bank and commercial banks.

The essence of the money creation process

The Central Bank has the right to introduce new money into the economy by purchasing financial assets or granting loans to financial institutions. Monitors and controls the amount of money in the economy by measuring monetary aggregates such as M2 or M3 and using appropriate financial instruments. The central bank is responsible for conducting monetary policy and exchange rate policy. Thanks to the fact that there is a partial reserve system, money is also created by commercial banks, among others in the form of granting bank loans to its clients. This money is treated in the same way as cash. There is only one way to increase the nominal value of non-cash money of commercial banks, namely to increase the debt in banks. Each repayment of capital installments is equivalent to a permanent withdrawal of money with the same face value from the economic cycle. Interest on debt is treated as a bank's income and re-entering the economic cycle as its expenses. In crisis situations, the monetary policy is relaxed. This is connected with a significant increase in the monetary base by the central bank, by purchasing assets that it usually does not buy. The central bank generally conducts open market operations through the purchase of short-term government or foreign bonds. During the financial crisis, it may also undertake to buy other types of financial assets. The central bank has the right to purchase shares, long-term government bonds, securities secured by receivables, corporate bonds, and may even grant commercial loans. The intention is to revive economic development by increasing liquidity and promoting lending even when interest rates reach such a low level that further reduction is impossible.

The original creation of money

Primary creation is a process at the central bank, consisting in granting loans to commercial banks and issuing by the central bank cash money. Granting the loan is not an expense for the central bank - he does not use the funds deposited there for this purpose, but creates a new money.

The ways of the original creation of money:

  • granting loans to deposit and credit banks,
  • cash withdrawal by the central bank for the benefit of the budgetary unit (so-called cash supply),
  • issuing of cash signs by the central bank,
  • purchase of foreign currencies and foreign currencies by the central bank.

Types of bank accounts

Speaking of the original creation of money, one should mention the types of bank accounts. We distinguish the following types of bank accounts:

  • Settlement accounts:
    • Current accounts - are essential for business entities. They are influenced by receivables from recipients for goods sold and services rendered, funds are taken from them for the payment of wages, covered liabilities to suppliers, etc.
    • Auxiliary bills - they are used to make settlements through other banks than a bank that maintains a current account or to perform operations for a specific purpose.
  • Term deposit accounts are used to store cash for the period resulting from the contract concluded with the bank. Companies using credit without using loans use them, placing free funds on them. They are encouraged to do so by interest rates higher than on current accounts.
  • Savings accounts are maintained for individuals, for school savings and employee fundraising and loan offices. The proof of concluding a contract for such an account is a savings booklet or other personal document. These accounts may not be used for settlements related to business operations.
  • Trust accounts - are kept on the basis of a separate agreement. The funds come only from third parties who entrust them to the account holder on the basis of a separate trust agreement concluded with him.

Secondary creation of money

Creating new money takes place by granting loans by commercial banks to various business entities. Bank lending is possible due to the resources they own from sources such as:

  • deposits deposited in banks,
  • bank's own funds,
  • loans taken out at the central bank,
  • loans taken on the interbank market.

In the discussed process, the stages are distinguished:

  • creation of the primary contribution - transformation of cash into non-cash money. This change does not affect the amount of money in circulation, because only the form of money has changed.
  • creation of a derivative contribution - a transaction involving the loan to a customer from this part of the contributions, which does not have to be kept in the form of a mandatory reserve. The loan is made available to the customer by opening a bill with his contribution at his disposal (a derivative).
  • During economic stabilization, the banks do not have to keep all the cash deposits in the treasury. Clients make payments and withdrawals alternately and only a relatively small cash reserve is enough to fulfill all their instructions. The rest of the funds may be used by banks granting loans to enterprises or individual persons, earning on this transaction. Borrowed sums return to banks, in the form of bills and can be used to grant another loan.

Deposit creation rate

Deposit Creation Factor informs you how many times you will increase the total of bank deposits as a result of paying the original deposit.

m = 1r where:

m - deposit creation rate, r - mandatory reserve rate.

Surplus reserve The surplus reserve is part of the contributions remaining after the reserve reserves have been paid.

W = RN-R0 where:

RN - size of the surplus reserve W - size of cartridges R0 - the amount of the mandatory reserve

The maximum amount of loans created Knowing the value of the money creation multiplier and the size of the surplus reserve, you can calculate the maximum sum of loans created (K):

RN = K * m

Examples of Creation of money

  • Primary Creation of Money: This refers to the process by which the Central Bank creates money. This is done through the process of "open market operations", which is when the Central Bank buys and sells government securities on the open market. Through this process, the Central Bank is able to inject additional money into the economy.
  • Secondary Creation of Money: This refers to the process by which commercial banks create money. This is done through the process of "fractional reserve banking", which is when banks only keep a fraction of the deposits they receive as reserves. The remaining deposits are lent out, creating new money.
  • Quantitative Easing: This is a form of money creation that is done by Central Banks in order to stimulate economic growth. Through this process, the Central Bank buys government bonds and other financial assets from commercial banks in order to inject money into the economy.

Advantages of Creation of money

Money creation has a number of advantages. These include:

  • Increased liquidity in the economy - Money creation increases the amount of money in circulation, providing more funds for businesses, households and individuals to use. This increased liquidity can help to spur economic growth and support investment.
  • Lower interest rates - Money creation can lead to lower interest rates, which can help to stimulate economic activity. Lower interest rates can make borrowing costs more affordable and encourage businesses and households to take out loans.
  • Greater access to finance - Increased money creation can make credit more accessible, allowing businesses and households to access finance for investment and other activities.
  • Improved economic stability - Money creation can help to manage economic instability, as it can help to offset economic shocks. The increased money supply can help to prevent deflation and manage economic downturns.
  • Increased employment - Money creation can lead to increased employment, as businesses and households are able to access more funds for investment and other activities. This can lead to increased job opportunities and economic growth.

Limitations of Creation of money

  • The amount of money creation is limited by the Central Bank. The Central Bank sets the limits on the amount of money that can be created by the banking system, which is known as the money supply.
  • The money creation process is subject to regulations set by the Central Bank. These regulations ensure that the money creation process is conducted in a safe and efficient manner.
  • The money creation process is also limited by the amount of deposits that are held by banks. Banks can only create a certain amount of money based on the amount of deposits they hold.
  • The Central Bank also sets reserve requirements which limit the amount of money that can be created by commercial banks. Banks must hold a certain amount of their deposits in reserve in order to meet these requirements.
  • Finally, the money creation process is limited by the availability of credit. Banks cannot create money if they do not have enough credit available to lend out.

Other approaches related to Creation of money

The process of money creation involves a variety of approaches and methods, including:

  • Quantitative easing - This is a process used by Central Banks to increase the money supply in the economy by purchasing government bonds and other securities from commercial banks. This increases the amount of money available for lending, and thus boosts economic activity.
  • Credit creation - This is the process by which commercial banks create new money by issuing loans to customers. This new money is created out of thin air and is then used by the customers to purchase goods and services.
  • Currency issuance - This is the process by which the Central Bank creates new money, by issuing new currency notes and coins. This new money is then put into circulation, increasing the money supply.

In summary, money creation is a process of adding more money into circulation by banks. This process involves quantitative easing, credit creation and currency issuance, all of which lead to the creation of new cash resources.

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