Creation of money

Creation of money
See also
Equity instrument Direct paper Credit Facility Interbank market External sources of finance Cash and cash equivalents Fiduciary money Liquidity management Source of financing

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:

1. 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.

1. 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

References

• McLeay, M., Radia, A., & Thomas, R. (2014). Money creation in the modern economy. Bank of England Quarterly Bulletin, Q1.
• Sunderam, A. (2014). Money creation and the shadow banking system. The Review of Financial Studies, 28(4), 939-977.
• Ricks, M. (2011). Regulating money creation after the crisis. Harv. Bus. L. Rev., 1, 75.