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In economics, money creation is the process by which the money supply of a country or a monetary region (such as the Eurozone) is increased. A central bank may introduce new money into the economy (termed 'expansionary monetary policy') by purchasing financial assets or lending money to financial institutions. Commercial bank lending then multiplies this base money through fractional reserve banking, which expands the total of broad money (cash plus demand deposits).
Central banks monitor the amount of money in the economy by measuring monetary aggregates such as M2. The effect of monetary policy on the money supply is indicated by comparing these measurements on various dates. For example, in the United States, money supply measured as M2 grew from $6407.3bn in January 2005, to $8318.9bn in January 2009.
Money creation by the central bank
Monetary policy regulates a country's money supply, the amount of broad currency in circulation. Almost all modern nations have special institutions (such as the United States Federal Reserve System, the European Central Bank (ECB), and the People's Bank of China) for conducting monetary policy, often acting independently of the executive. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system.
The primary tool of monetary policy is open market operations: the central bank buys and sells financial assets such as treasury bills, government bonds, or foreign currencies. Purchases of these assets result in currency entering market circulation, while sales of these assets remove currency. Usually, open market operations aim for a specific short term interest rate. In other instances, they might instead target a specific exchange rate relative to some foreign currency, the price of gold, or indices such as the Consumer Price Index. For example, the US Federal Reserve may target the federal funds rate, the rate at which member banks lend to one another overnight.
Other monetary policy tools to expand the money supply include decreasing interest rates by fiat; increasing the monetary base; and decreasing reserve requirements. Some other means are: discount window lending (as lender of last resort); moral suasion (cajoling the behavior of certain market players); and "open mouth operations" (publicly asserting future monetary policy). The conduct and effects of monetary policy and the regulation of the banking system are of central concern to monetary economics.
Quantitative easing involves the creation of a significant amount of new base money by a central bank by the buying of assets that it usually does not buy. Usually, a central bank will conduct open market operations by buying short-term government bonds or foreign currency. However, during a financial crisis, the central bank may buy other types of financial assets as well. The central bank may buy long-term government bonds, company bonds, asset backed securities, stocks, or even extend commercial loans. The intent is to stimulate the economy by increasing liquidity and promoting bank lending, even when interest rates cannot be pushed any lower.
Quantitative easing increases reserves in the banking system (i.e. deposits of commercial banks at the central bank), giving depository institutions the ability to make new loans. Quantitative easing is usually used when lowering the discount rate is no longer effective because interest rates are already close to or at zero. In such a case, normal monetary policy cannot further lower interest rates, and the economy is in a liquidity trap.
In modern economies, relatively little of the supply of broad money is in physical currency. For example, in December 2010 in the U.S., of the $8853.4 billion in broad money supply (M2), only $915.7 billion (about 10%) consisted of physical coins and paper money. The manufacturing of new physical money is usually the responsibility of the central bank, or sometimes, the government's treasury.
Contrary to popular belief, money creation in a modern economy does not directly involve the manufacturing of new physical money, such as paper currency or metal coins. Instead, when the central bank expands the money supply through open market operations (e.g. by purchasing government bonds), it credits the accounts that commercial banks hold at the central bank (termed high powered money). Commercial banks may draw on these accounts to withdraw physical money from the central bank. Commercial banks may also return soiled or spoiled currency to the central bank in exchange for new currency.
Money creation through the fractional reserve system
Through fractional reserve banking, the modern banking system expands the money supply of a country beyond the amount initially created by the central bank. There are two types of money in a fractional-reserve banking system: currency originally issued by the central bank, and bank deposits at commercial banks:
- central bank money (all money created by the central bank regardless of its form, e.g. banknotes, coins, electronic money)
- commercial bank money (money created in the banking system through borrowing and lending) – sometimes referred to as checkbook money
When a commercial bank loan is extended, new commercial bank money is created. As a loan is paid back, that commercial bank money disappears from existence. Since loans are continually being issued in a normally functioning economy, the amount of broad money in the economy remains relatively stable. Because of this money creation process by the commercial banks, the money supply of a country is usually a multiple larger than the money issued by the central bank; that multiple is determined by the reserve requirements or other financial ratios (primarily the capital adequacy ratio that limits the overall credit creation of a bank) set by the relevant banking regulators in the jurisdiction.
An early table, featuring reinvestment from one period to the next and a geometric series, is found in the tableau économique of the Physiocrats, which is credited as the "first precise formulation" of such interdependent systems and the origin of multiplier theory.
The most common mechanism used to measure this increase in the money supply is typically called the money multiplier. It calculates the maximum amount of money that an initial deposit can be expanded to with a given reserve ratio – such a factor is called a multiplier. As a formula, if the reserve ratio is R, then the money multiplier m is the reciprocal, and is the maximum amount of money commercial banks can legally create for a given quantity of reserves.
In the re-lending model, this is alternatively calculated as a geometric series under repeated lending of a geometrically decreasing quantity of money: reserves lead loans. In endogenous money models, loans lead reserves, and it is not interpreted as a geometric series. In practice, because banks often have access to lines of credit, and the money market, and can use day time loans from central banks, there is often no requirement for a pre-existing deposit for the bank to create a loan and have it paid to another bank.
The money multiplier is of fundamental importance in monetary policy: if banks lend out close to the maximum allowed, then the broad money supply is approximately central bank money times the multiplier, and central banks may finely control broad money supply by controlling central bank money, the money multiplier linking these quantities; this was the case in the United States from 1959 through September 2008.
If, conversely, banks accumulate excess reserves, as occurred in such financial crises as the Great Depression and the Financial crisis of 2007–2008 – in the United States since October 2008, then this equality breaks down, and central bank money creation may not result in commercial bank money creation, instead remaining as unlent (excess) reserves. However, the central bank may shrink commercial bank money by shrinking central bank money, since reserves are required – thus fractional-reserve money creation is likened to a string, since the central bank can always pull money out by restricting central bank money, hence reserves, but cannot always push money out by expanding central bank money, since this may result in excess reserves, a situation referred to as "pushing on a string".
There are also heterodox theories of how money is created. These include:
- Chartalism sees the state as creating money when it spends, and destroying it when it taxes. More importantly, the private banking system is not, in empirical terms, reserve-limited, so its creation of money is an endogenous process, driven by credit demand and lending willingness. This accounts for the power of the state's interest rate policy in governing most of the money supply in normal times. 
- Credit Theory of Money. This approach was founded by Joseph Schumpeter. Credit theory asserts the central role of banks as creators and allocators of 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).
- US Federal Reserve historical statistics June 11, 2009[dead link]
- Federal Reserve Statistic February 17, 2011
- Mankiw, N. Gregory (2002). Macroeconomics (5th ed.). Worth. pp. 81–107.
- Modern Money Mechanics
- Bank for International Settlements – The Role of Central Bank Money in Payment Systems. See page 9, titled, "The coexistence of central and commercial bank monies: multiple issuers, one currency": http://www.bis.org/publ/cpss55.pdf A quick quote in reference to the 2 different types of money is listed on page 3. It is the first sentence of the document: "Contemporary monetary systems are based on the mutually reinforcing roles of central bank money and commercial bank monies."
- European Central Bank – Domestic payments in Euroland: commercial and central bank money: http://www.ecb.int/press/key/date/2000/html/sp001109_2.en.html One quote from the article referencing the two types of money: "At the beginning of the 20th almost the totality of retail payments were made in central bank money. Over time, this monopoly came to be shared with commercial banks, when deposits and their transfer via checks and giros became widely accepted. Banknotes and commercial bank money became fully interchangeable payment media that customers could use according to their needs. While transaction costs in commercial bank money were shrinking, cashless payment instruments became increasingly used, at the expense of banknotes"
- Chicago Fed – Our Central Bank: http://www.chicagofed.org/consumer_information/the_fed_our_central_bank.cfm
- the reference is found in the "Money Manager" section:
- "the Fed works to control money at its source by affecting the ability of financial institutions to "create" checkbook money through loans or investments. The control lever that the Fed uses in this process is the "reserves" that banks and thrifts must hold."
- the reference is found in the "Money Manager" section:
- The multiplier theory, by Hugo Hegeland, 1954, p. 1
- "Disyatat, P. 2010 The bank lending channel revisited.". Bank for International Settlements. "Page 2. the concept of the money multiplier is flawed and uninformative in terms of analyzing the dynamics of bank lending. Page 7 When a loan is granted, banks in the first instance create a new liability that is issued to the borrower. This can be in the form of deposits or a cheque drawn on the bank, which when redeemed, becomes deposits at another bank. A well functioning interbank market overcomes the asynchronous nature of loan and deposit creation across banks. Thus loans drive deposits rather than the other way around."
- "Paul Tucker, Money and credit: Banking and the Macroeconomy". Bank of England. " banks....in the short run.....lever up their balance sheets and expand credit at will....Subject only but crucially to confidence in their soundness, banks extend credit by simply increasing the borrowing customer's current account.....This 'money creation' process is constrained by their need to manage the liquidity risk from the withdrawal of deposits and the drawdown of backup lines to which it exposes them."
- (Samuelson 1948, pp. 353–354): By increasing the volume of their government securities and loans and by lowering Member Bank legal reserve requirements, the Reserve Banks can encourage an increase in the supply of money and bank deposits. They can encourage but, without taking drastic action, they cannot compel. For in the middle of a deep depression just when we want Reserve policy to be most effective, the Member Banks are likely to be timid about buying new investments or making loans. If the Reserve authorities buy government bonds in the open market and thereby swell bank reserves, the banks will not put these funds to work but will simply hold reserves. Result: no 5 for 1, “no nothing,” simply a substitution on the bank’s balance sheet of idle cash for old government bonds.
- Bell, Stephanie. "The Hierarchy of Money". Retrieved 22 February 2012.
- New Economic Perspectives. "MMT primer". Retrieved 12 December 2012.
- See: Werner, Richard A. (2005). New Paradigm in Macroeconomics: Solving the Riddle of Japanese Macroeconomic Performance. New York: Palgrave Macmillan. p. 423. ISBN 978-1403920744. OCLC 56413058.
- See also: Ryan-Collins, Josh; Werner, Richard; Jackson, Andrew (2012). Where Does Money Come From?: A Guide to the UK Monetary & Banking System (2nd ed.). London: New Economics Foundation. p. 178. ISBN 978-1908506238. OCLC 816167522.
- Samuelson, Paul (1948). Economics