Money creation


Money creation, or money issuance, is the process by which the money supply of a country or economic region is increased. In most modern economies, both central banks and commercial banks create money. Central banks issue money as a liability, typically called reserve deposits, which is available only for use by central bank account holders. These account holders are generally large commercial banks and foreign central banks.
Central banks can increase the quantity of reserve deposits directly by making loans to account holders, purchasing assets from account holders, or by recording an asset and directly increasing liabilities. However, the majority of the money supply that the public uses for conducting transactions is created by the commercial banking system in the form of commercial bank deposits. Bank loans issued by commercial banks expand the quantity of bank deposits.
Money creation occurs when the amount of loans issued by banks increases relative to the repayment and default of existing loans. Governmental authorities, including central banks and other bank regulators, can use various policies—mainly setting short-term interest rates—to influence the amount of bank deposits that commercial banks create.

Monetary policy

The monetary authority of a nation—typically its central bank—influences the economy by creating and destroying liabilities on its balance sheet with the intent to change the supply of money available for conducting transactions and generating income. The policy that defines how the central bank changes its ledger to reduce or increase the amount of money in the economy available for banks to conduct transactions is known as monetary policy.
If the central bank is charged by law with maintaining price or employment levels in the economy, monetary policy may include reducing the money supply during times of high inflation to increase unemployment. The hope is that reducing employment will also reduce spending on goods and services that exhibit increasing prices. Monetary policy directly impacts the availability and cost of commercial bank deposits in the economy, which in turn impacts investment, stock prices, private consumption, demand for money, and overall economic activity. A country's exchange rate influences the value of its net exports.
In most developed countries, central banks conduct their monetary policy within an inflation targeting framework, whereas the monetary policies of most developing countries' central banks target some kind of fixed exchange rate system. Central banks operate in practically every nation in the world, with few exceptions. There are also groups of countries for which a single entity acts as their central bank, such as the organization of states of Central Africa, which have a common central bank, or monetary unions, such as the Eurozone. In the Eurozone, nations retain their respective central banks yet submit to the policies of a central entity, the European Central Bank.
Central banks conduct monetary policy by setting an interest rate paid on central bank deposit liabilities, directly purchasing or selling assets to change the amount of deposits on their balance sheet, or by signaling to the market through speeches and written guidance an intent to change the interest rate on deposits or to purchase or sell assets in the future.
Lowering interest rates by reducing the amount of interest paid on central bank liabilities or purchasing assets like bank loans and government bonds for higher prices is called monetary expansion or monetary easing. In contrast, raising rates by paying more interest on central bank liabilities is known as monetary contraction or tightening. An extraordinary process of monetary easing is denoted as quantitative easing, which involves the central bank purchasing large amounts of assets for high prices over an extended period.

Money supply

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 investments. The money supply is measured using so-called "monetary aggregates," which are defined based on their respective levels of liquidity. In the United States, for example:
In most countries, the central bank, treasury, or other designated state authority is empowered to mint new physical currency, usually taking the form of metal coinage or paper banknotes. While the value of major currencies was once backed by the gold standard, the end of the Bretton Woods system in 1971 led to all major currencies becoming fiat money—backed by a mutual agreement of value rather than a commodity.
Various measures are taken to prevent counterfeiting, including the use of serial numbers on banknotes and the minting of coinage using an alloy at or above its face value. Currency may be demonetized for a variety of reasons, including loss of value over time due to inflation, redenomination of its face value due to hyperinflation, or its replacement as legal tender by another currency. The currency-issuing government agency typically works with commercial banks to distribute freshly minted currency and retrieve worn currency for destruction, enabling the reuse of serial numbers on new banknotes.
In modern economies, physical currency consists of only a fraction of the broad money supply. In the United Kingdom, gross bank deposits outweigh the physical currency issued by the central bank by a factor of more than 30 to 1. The United States, with a currency used substantially in legal and illicit international transactions, has a lower ratio of 8 to 1.

Debt monetization

Debt monetization is a term used to describe central bank money creation for use by government fiscal authorities, such as the U.S. Treasury. In many states, such as Great Britain, all government spending is always financed by central bank money creation. Debt monetization as a concept is often based on a misunderstanding of modern financial systems compared to fixed exchange rate systems like the gold standard.
Historically, in a fixed exchange rate financial system, central bank money creation directly for government spending by the fiscal authority was prohibited by law in many countries. However, in modern financial systems, central banks and fiscal authorities work closely together to manage interest rates and economic stability. This involves the creation and destruction of deposits on the central bank ledger to ensure that transactions can settle so that short-term interest rates do not exceed specified targets.
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 as of Oct 2018, owns approximately 440 trillion yen 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 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 would 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. Today, primary dealers in the United States are required to purchase all Treasuries at auction, and the U.S. central bank will create any quantity of reserve deposits necessary to settle the auction transaction.

Open market operations

Central banks can purchase or sell assets in the market, which is referred to as open market operations. When a central bank purchases assets from market participants, such as commercial banks that hold accounts at the central bank, reserve deposits are credited to the commercial banks' accounts and asset ownership is transferred to the central bank. In this way, the central bank can modulate the amount of reserve deposits in the financial system by exchanging financial assets like bonds for reserve deposits. For example, in the United States, when the Federal Reserve permanently purchases a security, the office responsible for implementing purchases and sales buys eligible securities from primary dealers at prices determined in a competitive auction. The Federal Reserve pays for those securities by crediting the reserve accounts of the correspondent banks of the primary dealers. In this way, the open market purchase leads to an increase in reserve balances.
Conversely, sales of assets by the U.S. central bank reduce reserve balances, which reduces the amount of money available in the financial system for settling transactions between member banks. Central banks also engage in short term contracts to "sell-assets-now, repurchase-later" to manage short-term reserve deposit balances. These contracts, known as repo contracts, are short-term contracts that are continually rolled over until some desired result in the financial system is achieved. Operations conducted by central banks can address either short-term goals on the bank's agenda or long-term factors such as maintaining financial stability or maintaining a floor and/or ceiling around a targeted interest rate for reserve deposits.