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Money creation and the misconceptions

By Shakeeb Saqlain | March 23, 2014

Where does money come from? During the 19th Century the answer to this question was relatively simple: money was backed by gold, so the amount of money that the Treasury would print or mint was limited to the amount of gold held in the gold reserves.

Today, with the Gold Standard a distant memory, the process of money creation has been shrouded with misconceptions. Economic literature and textbooks note that money creation begins with the bank receiving the deposit, without stating the source of the deposit:

University of Nebraska (2012):

Each time a bank receives a deposit, it sets aside some of it to meet reserve requirements and may lend an amount equal to the remaining excess reserves. These loans take the form of new checking accounts for the borrower which increases the checkbook portion of the money supply. When the borrower spends the loan, he or she writes a check on the new checking account ...

McEchearn (2009:657):

Each time a bank gets a fresh deposit, 10 percent goes to required reserves. The rest becomes excess reserves, which fuel new loans ... The borrower writes a check, which the recipient deposits in a checking account, thereby generating excess reserves to support still more new loans.


The reality is different, though. Instead of banks receiving deposits from people’s savings and then lending these to individuals and businesses, it is bank lending that produces deposits. This is the view in a recent paper by the Bank of England, called "Money Creation in the Modern Economy":
 

In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through 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. The reality of how money is created today differs from the description found in some economics textbooks:

• Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
• In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.

Although commercial banks create money through lending, they cannot do so freely without limit. Banks are limited in how much they can lend if they are to remain profitable in a competitive banking system. Prudential regulation also acts as a constraint on banks’ activities in order to maintain the resilience of the financial system. And the households and companies who receive the money created by new lending may take actions that affect the stock of money — they could quickly ‘destroy’ money by using it to repay their existing debt, for instance.


Why is this discussion important? Although we have known much of the above for a long time, it is nonetheless rare for this debate to be held publicly by a central bank, with key misconceptions about how money is created discussed openly. Furthermore, the release of this report provides another opporunity to debate the merits and effectiveness of the Quantitative Easing (QE) programs. The QE programs have come under the microscope for failing to deal with the underlying structural problems and potentially creating greater fragility in the financial markets.

 

References

1. Money Creation Misconceptions: It Begins with a New Deposit

2. Money Creation in the Modern Economy

3. How Does QE Work and What Does It Really Do?

 

 


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