Unit 6 The financial sector: Debt, money, and financial markets

6.8 Money creation in a modern economy

In this section, we combine insights from the earlier parts of the unit to answer one of the most intriguing questions about the economy today: where does money come from? It is not like commodity money, which is a good that exists and is valued for other reasons. There are two ways that a dollar or euro or pound or rupee in your bank account may have begun its life. It was created either:

• by a bank when it made a loan to a customer, which leads to an increase in bank money, or
• by the central bank when it bought a government bond that was previously owned by a public entity (such as a household, firm, or pension fund), which leads to an increase in base money.

We go through each method in turn relating it to the earlier discussion of banks, the central bank, and the government.

Banks create bank deposits (and therefore money) when they make loans

We have already noted that most of the money in an economy is not currency—whether dollar bills or euro notes—but bank deposits (or bank money, as we call it). This likely corresponds to your own experience where you have a few notes and coins in your pocket, but higher balances in your current account that are accessible from the bank app on your phone. What may seem puzzling is that this money comes into existence when commercial banks make loans.

In Section 6.5, we asked: how can Marco and Julia use bank money as a means of exchange at the supermarket? But at that stage, we had not introduced either the central bank or the government. We now have the ingredients to explain how banks create money and what constrains how much they create.

Suppose that a commercial bank, Alpha Bank, decides to make a loan of $1,000 to a company that wishes to purchase a new computer. The bank approves the loan and credits the company with $1,000 in its current account. This action simultaneously produces an asset for the bank (the loan) and a liability (the deposit of $1,000 in the company’s bank account). The company, A, now has ‘the money’ to spend on the computer at Company B. Crucially, in order to make the loan, the bank did not require that, in advance, bank customers had deposited more money at the bank. The causal chain was from the loan to the creation of $1,000 of deposit money. Company A has borrowed the extra $1,000 because it wants to buy the computer.

Let’s analyse what happens next. If Companies A and B both have accounts at the same bank, the deposit of $1,000 leaves the account of Company A and is credited to Company B’s account.

In this simple case, that is the end of the story. The loan is ‘self-financing’ for the bank: there is no change in its net worth, since its assets and liabilities have increased by equal amounts. It also expects to make a profit on the loan.

But the supply of bank money has increased. Alpha Bank has created money out of thin air by making the loan, as shown in Figure 6.12a.

If Companies A and B have accounts at different banks, Alpha Bank and Beta Bank, respectively, the story is more complicated and involves the banks’ reserve accounts at the central bank, but there will still be the same net increase in bank money in aggregate.

Figure 6.12b illustrates this. We now need to examine the balance sheets of the two commercial banks and that of the central bank. The deposit of $1,000 leaves Alpha Bank and goes to Beta Bank. This means that Alpha Bank’s reserve account falls by $1,000 and Beta’s rises by $1,000, while those of the banking system as a whole are unchanged. But there is a higher level of debt in the economy and this enables new economic activity to occur (in this case, through company A’s use of the new computer). And, in aggregate, new bank money has again been created, because the total deposit liabilities of the two banks have increased. Alpha Bank’s liabilities remain unchanged, but Beta Bank’s deposit liabilities have increased, so total bank money has increased.

If this leaves Alpha Bank short of reserves and Beta Bank with too much in its reserve account at the central bank, one response may be for Alpha Bank to borrow reserves from Beta Bank. This happens through the interbank market, where banks borrow and lend reserves to clear their balances and manage their reserves. Alpha Bank will usually pay an interest rate very close to the policy interest rate on the loan.

You may be wondering if a bank can make as many loans and therefore create as much money as it likes, producing money willy-nilly as it does so.

There are three constraints on the amount of loans banks will make (and therefore, on the amount of money they create).

• Demand for loans. The first constraint is that there must be a demand for bank loans from households and firms on the terms the bank is willing to offer. The bank must expect to make a profit on the loan by setting the lending interest rate (taking into account the risk of default) higher than the policy rate at which it can borrow (for example, in the interbank market in the example of Alpha Bank).

The central bank’s monetary policy will directly affect the amount of lending by banks because it will affect the demand for loans. A higher policy rate will be passed on by banks in a higher lending rate, which will dampen the demand for loans from households and firms. Therefore if the central bank tightens monetary policy in order to reduce aggregate demand to achieve its inflation target, fewer loans will be made and there will be less economic activity as a result.

• Capital adequacy requirements. The second constraint is that a bank is required by the government to have enough equity (net worth), relative to its assets, to meet regulatory requirements. When Alpha Bank makes its new loan, Figure 6.12a shows, this does not change its net worth. But its assets and liabilities have both increased. So its capital adequacy, measured as the ratio of its equity—or net worth—to its total assets has fallen.

If this is now below the level required by the regulator, it will either have to sell some assets and use the proceeds to reduce its liabilities (effectively reversing the initial loan to Company A) or it will need to raise more capital from investors (existing owners of the bank or new investors) to enable it to operate as a larger bank. Unit 8 explains what happens when a bank’s net worth is negative, meaning that it is insolvent.

• Reserve requirements. The third constraint also comes from regulation—this time, the minimum reserve requirements imposed by the central bank. Banks have to have enough reserves to be able to respond to depositors’ requests for withdrawals of their deposits. If a bank does not have enough reserves to meet the minimum requirement, it will borrow reserves in the interbank market.

Central banks create bank deposits when they buy bonds

Whenever the central bank buys bonds or any other asset from the non-bank public, this results in an increase in reserves and a new deposit in the banking system. We have already discussed this process in the context of explaining quantitative easing in Section 6.7. In the pre-QE world, central banks operated monetary policy by keeping excess reserves close to zero (read Extension 6.7 for the details)—and as a result, this was not an important method of creating bank deposits.