Money creation

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.^[11] 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:

• 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^{[clarification needed]} 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 under $100,000).

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.^[12]

In modern economies, physical currency consists of only a fraction of the broad money supply.^{[note 1]} 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.^[3]

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.^[13] 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.^[14] 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.^[15] In Japan, the nation's central bank "routinely" purchases approximately 70% of state debt issued each month,^[16] and as of Oct 2018, owns approximately 440 trillion yen (approximately $4 trillion)^{[note 2]} or over 40% of all outstanding government bonds.^[17]

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.^[18] 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 (The New York Fed's Open Market Trading Desk) 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. (The correspondent banks, in turn, credit the dealers' bank accounts.) In this way, the open market purchase leads to an increase in reserve balances.^[19]

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 (repurchase) contracts, are short-term (often overnight) 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.

Money multiplier

Historical explanations of money creation often focused on the concept of a money multiplier, where reserve deposits or an underlying commodity such as gold were multiplied by bank lending of those deposits or gold balances to a maximum limit defined by the reserve requirement for money lenders. Thus, the total money supply was a function of the reserve requirement. Many states today, however, have no reserve requirement. The money multiplier has thus largely been abandoned as an explanatory tool for the money creation process.

When commercial banks lend money today, they expand the amount of bank deposits in the economy.^[20] The banking system can expand the money supply of a country far beyond the amount of reserve deposits created by the central bank. This means that, contrary to popular belief, most money is not created by central banks.^[21][22] Some argue that banks are limited in the total amount they can lend by their capital adequacy ratios and, in countries that impose required reserve ratios, by required reserves.

Bank capital, used for calculating the capital adequacy ratio, consists of assets on the bank balance sheet in excess of liabilities, with values further refined by regulation such as the international regulatory framework for banks, Basel III. Banks create capital by creating loans (assets) and destroying bank liabilities, which occurs when loans are repaid. This process increases bank equity, enabling banks to create commercial bank deposit liabilities (money) for their own use. In this way, banks create and manage their own capital levels. Because accounting conventions define the value of any given asset or liability, bank capital is a subjective measure that many argue is open to manipulation and may be a poor method for regulating money creation.

Reserve requirements oblige commercial banks to keep a minimum, predetermined percentage of their deposits in an account at the central bank. Countries with no reserve requirement include the United States, Great Britain, Australia, Canada, and New Zealand, which means no minimum reserve requirement is imposed on banks. The constraining factor on bank lending recognized today is largely the number of available borrowers willing to create loan contracts.