How Money is Created in the Modern Economy

Money is essential for our everyday lives. We use it to buy goods and services, to pay taxes and bills, and to save for the future.

But where does the money come from?

How is it created and destroyed?

And who controls the amount of money in the economy?

In this blog post, we will explore these questions and more. We will explain how the majority of money in the modern economy is created by commercial banks making loans, and how this process differs from some popular misconceptions. We will also discuss the limits and constraints on money creation, and the role of monetary policy in ensuring that money growth is consistent with low and stable inflation.

Signup to FinFormed here

This blog was inspired by the article "Money Creation in the Modern Economy" By Michael McLeay, Amar Radia and Ryland Thomas and published by the Bank of England

Read my other posts here: Conventional Finance - FinFormed, Islamic Finance - FinFormed, Takaful - FinFormed, Career - FinFormed and Randow Writings - FinFormed

What is Money?

Before we dive into how money is created, we need to define what money is. Money is anything that is widely accepted as a means of payment for goods and services and as a store of value. Money can take different forms, such as:

• Currency: This includes banknotes and coins, which are mostly issued by the central bank. Currency is the most tangible and familiar form of money, but it only makes up a small fraction of the total money supply (maybe around 3% in the country).
• Bank deposits: These are the balances that households and companies hold in their bank accounts. Bank deposits are created by commercial banks when they make loans, and they can be transferred electronically or converted into currency. Bank deposits make up the vast majority of the money supply (maybe around 97%).
• Central bank reserves: These are the balances that commercial banks hold at the central bank. Central bank reserves are used to settle payments between banks and to meet the demand for currency from the public. Central bank reserves are also created by the central bank, either by supplying them on demand in exchange for other assets, or by purchasing assets directly through quantitative easing (QE).

There are different ways of measuring the amount of money in the economy, depending on which types of money are included. The most common measures are:

• Narrow money: This includes currency and sight deposits (accounts that can be withdrawn immediately without penalty). Narrow money is the most liquid and transactional form of money, and it is closely related to spending in the economy.
• Broad money: This includes currency, sight deposits, and other types of deposits, such as fixed-term deposits and savings accounts. Broad money is a broader measure of money that reflects the total amount of money held by households and companies in the economy.
• Base money: This includes currency and central bank reserves. Base money is the most basic and fundamental form of money, sometimes referred to as the monetary base or high-powered money.

There is a general relationship between money and spending, but it is not always stable or predictable. This is because money creation depends on various factors, such as the behaviour of banks, households, and companies, and the monetary policy of the central bank.

How is Money Created by Commercial Banks?

The reality of how money is created today differs from the description found in some economics textbooks, where money is assumed to be created by the central bank through a fixed multiplier of reserves. In fact, in the modern economy, most money is created by commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

This description of money creation contrasts with the notion that banks can only lend out pre-existing money, or that they can lend out their reserves. Bank deposits are simply a record of how much the bank itself owes its customers. So they are a liability of the bank, not an asset that could be lent out. Reserves can only be lent between banks, since consumers do not have access to reserves accounts at the Bank of England.

What are the Limits and Constraints on Money Creation?

Although commercial banks create money through their lending behaviour, they cannot in practice do so without limit. In particular, the price of loans — that is, the interest rate (plus any fees) charged by banks — determines the amount that households and companies will want to borrow. A number of factors influence the price of new lending, not least the monetary policy of the central bank, which affects the level of various interest rates in the economy. The limits to money creation by the banking system were discussed in a paper by Nobel Prize-winning economist James Tobin and this topic has recently been the subject of debate among a number of economic commentators and bloggers.

In the modern economy there are three main sets of constraints that restrict the amount of money that banks can create:

• Banks themselves face limits on how much they can lend. In particular:
  • Market forces constrain lending because individual banks have to be able to lend profitably in a competitive market.
  • Lending is also constrained because banks have to take steps to mitigate the risks associated with making additional loans.
  • Regulatory policy acts as a constraint on banks’ activities in order to mitigate a build-up of risks that could pose a threat to the stability of the financial system.
• Money creation is also constrained by the behaviour of the money holders — households and businesses. Households and companies who receive the newly created money might respond by undertaking transactions that immediately destroy it, for example by repaying outstanding loans.
• The ultimate constraint on money creation is monetary policy. By influencing the level of interest rates in the economy, the central bank’s monetary policy affects how much households and companies want to borrow. This occurs both directly, through influencing the loan rates charged by banks, but also indirectly through the overall effect of monetary policy on economic activity in the economy. As a result, the central bank is able to ensure that money growth is consistent with its objective of low and stable inflation.

How Does Monetary Policy Affect Money Creation?

The ultimate constraint on money creation is monetary policy. By influencing the level of interest rates in the economy, the central bank’s monetary policy affects how much households and companies want to borrow. This occurs both directly, through influencing the loan rates charged by banks, but also indirectly through the overall effect of monetary policy on economic activity in the economy. As a result, the central bank is able to ensure that money growth is consistent with its objective of low and stable inflation.

The central bank implements monetary policy by setting the policy rate, or Bank Rate, which influences the interest rates charged on loans and paid on savings throughout the economy. A reduction in Bank Rate reduces the cost of borrowing and the return on savings, which encourages spending and investment, and thus increases the amount of money created. Conversely, an increase in Bank Rate increases the cost of borrowing and the return on savings, which discourages spending and investment, and thus reduces the amount of money created.

In addition to influencing the price of money, the central bank also influences the quantity of money directly through its operations in the financial markets. The most important of these operations is open market operations, where the Bank buys or sells assets, such as government bonds, in exchange for central bank reserves. When the Bank buys assets, it creates new reserves, which increases the amount of base money and can lead to more lending and deposit creation by banks. When the Bank sells assets, it destroys reserves, which reduces the amount of base money and can lead to less lending and deposit creation by banks.

Since the financial crisis, the central bank has also used a new tool of monetary policy, known as quantitative easing (QE), to increase the amount of money in the economy. QE involves the Bank buying large amounts of financial assets, such as government bonds and corporate bonds, from non-bank financial companies, such as insurance companies and pension funds, in exchange for new central bank reserves. The companies selling the assets to the Bank can use the new reserves to buy other assets, such as shares and property, which can increase their prices and stimulate spending in the economy. QE can also reduce the cost of borrowing and increase the amount of lending and deposit creation by banks.

Conclusion

Money creation in the modern economy is a complex process, involving many actors and many types of money. The majority of money in the economy is created by commercial banks making loans, but this process is constrained by various factors, including the monetary policy of the central bank. Understanding how money is created is essential for understanding many important issues in economics, including the causes of inflation, the role of banks in the economy, and the effects of monetary policy.

Here are the key points we’ve covered:

• Money is created by commercial banks when they make loans, and is destroyed when loans are repaid.
• The amount of money that banks can create is not unlimited. Banks have to be able to lend profitably in a competitive market, and manage the risks associated with making loans. They are also constrained by regulatory policy, including capital and liquidity requirements.
• The ultimate constraint on money creation is monetary policy. By influencing the level of interest rates in the economy, the central bank’s monetary policy affects how much households and companies want to borrow, and thus the amount of money creation.
• The central also influences the quantity of money directly through its operations in the financial markets, including open market operations and quantitative easing.

P.S. What other financial topics would you like us to cover? Let us know in the comments below! We’re here to help you understand the complex world of finance in a simple and engaging way.

Disclaimer: The views expressed in this blog are not necessarily those of the blog writer and his affiliations and are for informational purposes only.

Subscribe on LinkedIn

Follow us on social media @Linkedin

If you found this blog post insightful, don’t forget to subscribe to our website for more updates on Finance. Your subscription will help us continue to bring you the latest insights into the world of finance. And if you think this post could benefit others, please feel free to share it. Let’s spread the knowledge together!