2 Money creation in the modern economy PDF

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Macro II

Money Creation in the modern economy

Two misconceptions about money creation Banks act simply as intermediaries, lending out the deposits that savers place with them. When households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment or goods and services. Savings do not increase the the funds available for banks to lend. The Central Bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money (money multiplier). In this view, CBs implement monetary policy by choosing a quantity of reserves. It assumes a constant ratio of broad money to base money which is not the case. CBs today typically implement monetary policy by setting the price of reserves  interest rates. Banks first decide how much to lend depending on the profitable lending opportunities which depends on the interest rate set by the CB. This lending decision determines how many bank deposits are created by the banking system.

Money creation in reality Broad money = measure of the total amount of money held by households and companies in the economy. (bank deposits make 97% of broad money) Those deposits are mainly created by banks themselves At the moment a bank gives a loan, new money is created!

The lending of money has no influence on the BS of the CB.

Both sides of the commercial banking sectors balance sheet increases as new money and loans are created.

Reserves can only be lent between banks but NEVER to consumers as the do not have access to reserve accounts.

The new deposits increase the assets of the consumer. The new loan increases their liabilities

Macro II

Money Creation in the modern economy

Other ways of creating and destroying money -

Taking out a loan  creates money Repay a loan  destroys money (if one pays back its credit card invoice in full it is a sum zero game) Banks buying and selling government bonds  Banks often buy and hold government bonds as they can be sold quickly for CB money, if for example, depositors want to withdraw currency in large amounts. Issuance of long-term debt destroy money because they cannot be exchanged for currency easily and therefore increase the resilience of the bank.

Limits to broad money creation 1. Banks face limits on how much they can lend. - Market forces may constrain lending because banks have to be able to lend profitable - Banks have to mitigate the risks involved with making additional loans - Regulatory policy acts as a constraint on banks activities  avoid threat to financial system 2. Money creation is also constrained by the behavior of money holders (households and businesses) Households and companies who receive newly created money might respond by undertaking actions that immediately destroy it, for example by repaying loans. 3. The ultimate constraint on money creation is monetary policy. By influencing the level of interest rates in the economy, the CBs monetary policy affects how much households and companies want to borrow.

The moment the mortgage loan is made, the households account is credited with new deposits. Once they purchase the home, they pass their new deposit to the seller. the buyer is left with a new asset in form of a house and a new liability in the form of a loan. The seller is left with money in the form of a bank deposit. When the transaction takes place, the new deposit will be transferred to the sellers bank. The buyers bank would then have fewer reserves and more loans relative to the to its deposits before. This is critical to the bank as it may not be able to pay all its outflows. Therefore, banks try to attract or retain additional liabilities to accompany their new loans. By attracting new deposits, the bank can increase its lending without running down its reserves. It could also borrow from other banks. However, the bank needs to make sure it is attracting and retaining some kind of funds in order to keep expanding lending!

Managing the risks associated with making loans: - Make sure to attract stable deposits (no withdrawal of large amounts)  liquidity risk - Make sure the borrowers are able to pay back their loans  credit risk (interest rates for loan include this risk) If banks perceive the risk as lower due to stable economy they might lend more money.

Macro II Money Creation in the modern economy Constraints arising from the response of households and companies  2 possibilities what happens to newly created deposits: - Money may quickly be destroyed if the households or companies use the money to repay debts  usually no effect on economy - The money created by the banks leads to more spending in the economy. Companies and households may have excess money and decide to spend it in goods and services.  Can lead to increased inflationary pressure Monetary policy – the ultimate constraint on money creation - CB want to ensure monetary stability by keeping the consumer price inflation on 2%. - In normal times, the CB implements monetary policy by setting short-term interest rates  interest rate paid on CB reserves held by commercial banks. - The interest rate that commercial banks can obtain on money placed at the central bank influences the rate at which they are willing to lend on similar terms in money markets. - by influencing the price of credit this way, monetary policy affects the creation of broad money. Central banks DO NOT choose a quantity of reserves to bring about the desired short-term interest rate. Rather, they focus on prices – setting interest rates. The demand for base money is therefore more likely a consequence rather than a cause of banks making loans and creating broad money.

QE – creating broad money directly with monetary policy Once short-term interest rates reach the lower bound, it is not possible for the CB to provide further stimulus to the economy by lowering the rate at which reserves remunerated. A possible way of providing further stimulus is through a process of asset purchases (QE). QE involves a shift in the focus of monetary policy to the quantity of money: The CB purchases a quantity of assets, financed by the creation of broad money and a corresponding increase in the amount of CB reserves. The seller of the assets will hold deposits now which will likely exceed the desired ratio so they will rebalance their portfolios by using the deposits to buy higher-yielding assets such as bonds and shares. The CB does not give the bank free money! QE aims to buy assets (government bonds) from non-bank financial companies such as pension funds or insurance companies. The pension fund’s bank credits the pension funds account with 1bio. £.

The CB finances its purchase by crediting reserves to the pension fund’s bank – it gives the commercial bank an IOU

The commercial bank’s balance sheet expands: new deposit liabilities are matched with an asset in the form of new reserves.

Macro II Money Creation in the modern economy Why is this not free money? While banks do earn interest on the newly created reserves, QE also creates an accompanying liability for the bank in the form of the pension funds deposit, which the bank will itself have to pay interest on. QE leaves banks with both a new IOU from the CB but also a new, equally sized IOU to consumers (e.g. pension fund) and the interest rates on both of these depend on Bank Rate. Why are the extra reserves not multiplied up into new loans and broad money? The reserves created (Figure 3, third row) do not play a central role. Banks cannot directly lend out reserves! Reserves are an IOU from the CB to commercial banks. They can use them to make payments to each other but cannot lend them to consumers....