Money creation

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.[2] 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: The total of all physical currency including coinage. Using the United States dollar as an example, M0 = Federal Reserve notes + US notes + coins. It is not relevant whether the currency is held inside or outside of the private banking system as reserves.
• M1: The total amount of M0 (cash/coin) outside of the private banking system plus the amount of demand deposits, travelers checks and other checkable deposits
• M2: M1 + most savings accounts, money market accounts, retail money market mutual funds, and small denomination time deposits (certificates of deposit of under $100,000).

The money supply is understood to increase through activities by government authorities,[note 3] by the central bank of the nation,[note 4] and by commercial banks.[3]

When commercial banks lend money, they expand the amount of bank deposits.[18] The banking system can expand the money supply of a country beyond the amount created by the central bank, creating most of the broad money in a process called the multiplier effect.[18]

Banks are limited in the total amount they can lend by their capital adequacy ratios and, in countries that impose required reserve ratios, also by these. Reserve requirements oblige commercial banks to keep a minimum, predetermined, percentage of their deposits at an account at the central bank. Many countries in the world, including the United States, Australia, Canada and New Zealand, do not impose minimum reserve requirements on banks. This does not allow commercial banks to lend without limit, however, since there is still, aside from other considerations, the capital adequacy ratio.

The maximum ratio of loans to deposits is the required-reserve ratio RRR, which is determined by the central bank, as

${\displaystyle {\mathit {RRR}}={\frac {R}{D}}}$

where R are reserves and D are deposits.

Whereas central banks can directly control the issuance of physical currency, the question to what extent they can control broad monetary aggregates like M2 by also indirectly controlling the money creation of commercial banks is more controversial.[19] According to the money multiplier theory, which is often cited in macroeconomics textbooks, the central bank controls the money multiplier because it can impose reserve requirements, and consequently via this mechanism also governs the amount of money created by commercial banks.[19][20] Most central banks in developed countries, however, have ceased to rely on this theory and stopped shaping their monetary policy through required reserves.[19] Benjamin Friedman explains in his chapter on the money supply in The New Palgrave Dictionary of Economics that the money multiplier representation is a short-hand simplification of a more complex equilibrium of supply and demand in the markets for both reserves (outside money) and inside money. Friedman adds that the simplification will work well or badly "depending on the strength of the relevant interest elasticities and the extent of variation in interest rates and the many other factors involved".[17] David Romer notes in his graduate textbook "Advanced Macroeconomics" that it is difficult for central banks to control broad monetary aggregates like M2.[21]^{: 607–608}

Monetarist theory, which was prominent during the 1970s and 1980s, argued that the central bank should concentrate on controlling the money supply through its monetary operations.[22] The strategy did not work well for the central banks like the Federal Reserve who tried it, however, and it was abandoned after some years, central banks turning to steer interest rates to obtain their monetary policy goals rather than holding the quantity of base money fixed in order to steer money growth.[23]^{: 464–465} Interest rates influence commercial bank issuance of credit indirectly, so the ceiling implied by the money multiplier does not impose a limit on money creation in practice.[24] By setting interest rates, central-bank operations will affect, but not control the money supply.[18][note 9]

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[25] and because banks have been able to build up additional reserves when they were needed.[26] Many economists and bankers now believe that the amount of money in circulation is limited only by the demand for loans, not by reserve requirements.[27][28][18]

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.[26] 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".[25] The exact mechanism behind the creation of commercial bank money has been a controversial issue. In 2014, a study titled "Can banks individually create money out of nothing? — The theories and the empirical evidence" empirically tested the manner in which this type of money is created by monitoring a cooperating bank's internal records:[29]

This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, "out of thin air".

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).[30]

The model of bank lending stimulated through central-bank operations (such as "monetary easing") has been rejected by Neo-Keynesian[note 10][31] and Post-Keynesian analysis[32][33] as well as central banks.[34][35][note 11] 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.[36]

In accordance to "credit mechanics" bank money expansion or destruction (or not changing) depends on payment flows.

Bank of England tells us in 2019: "Most of the money in the economy is created by banks when they provide loans."[37], but not every provided loan is heightening bank money amount. It depends on payment flows after given loans.[38] (see table by Decker/Goodhart [2021] beside).

• Asmundson, Irena; Oner, Ceyda (September 2012). "What Is Money?" (PDF). Finance & Development. IMF. Retrieved 8 March 2018.
• Federal Reserve historical statistics (11 June 2009) Archived June 5, 2009, at the Wayback Machine
• Hegeland, Hugo (1970) [1954]. Multiplier Theory (7 ed.). Harvard University Press. ISBN 978-0678001622.
• Mankiw, N. Gregory (2012). Macroeconomics (8th ed.). Worth. pp. 81–107. ISBN 978-1429240024.
• Werner, Richard A. (December 2014). "Can banks individually create money out of nothing? — The theories and the empirical evidence". International Review of Financial Analysis. 36: 1–19. doi:10.1016/j.irfa.2014.07.015.

• "The Role of Central Bank Money in Payment Systems", Bank for International Settlements, August 2003
• Mitchell, William (2009) "Deficit spending 101: Part 1"; "Part 2"; "Part 3"