Money creation is the process by which new money is produced or issued. There are three ways to create money: by manufacturing paper currency or metal coins, through fractional reserve banking and lending by the banking system, and by government policies such as quantitative easing. The practices and regulation of production, issue and redemption of money are of central concern to monetary economics (e.g. money supply, monetarism), and affect the operation of financial markets and the purchasing power of money.

Central banks measure the money supply, which shows the amount of money in existence at a given time. An unknown portion of the new money created is indicated by comparing these measurements on various dates. For example in the US, one of the various money supply measurements, called M2, grew from $286.6bn in January of 1959 to $8,327bn in May 2009.^[1]

The destruction of currency may occur when coins are scrapped to recover their precious metal content, which can be motivated by the value of the metal coming to exceed the face value of the coin, or when the issuer redeems the securities.

[edit] Money creation by mints

Money created by manufacturing a new monetary unit, such as paper currency or metal coins, is most often a responsibility of a government's treasury. In modern economies, relatively little of the money supply is in currency (i.e. coins and banknotes); most is created by lending or quantitative easing (see below) using fractional reserve banking. In the U.S., only about 2% to 3% of the total money supply consists of physical coins and paper money^[2].

[edit] Under competitive minting

Competitive minting means that the business of manufacturing coins is open to many competing manufacturers. The mints buy bullion on the bullion market, and manufacture it into coins that they use to pay for the bullion and their other production costs, and to provide a profit.

Analysis of supply and demand cannot proceed in the normal way because by definition, the money price of money is fixed at unity. Instead, metal producers need money to pay their expenses and to realize their profits in money, and so their demand for money is expressed by their willingness to produce and sell uncoined metal at a discount to its value as coin. This discount is the gross profit margin of manufacturing metal into coin, and the greater this is, the more metal the mints will find economical to manufacture into coin.

[edit] Under nationalized minting with a right to exchange

Nationalized minting means that the government has monopolized the business of minting coins, and the government operates mints that produce a national system of coinage. Under a metallic or bimetallic standard with a national mint, individuals normally have a right to bring precious metal to the national mint and to have it coined at a fixed discount. This discount is called seigniorage.

Basic economic analysis of this arrangement is that it makes the supply of coin elastic at the fixed price, however this fixed price is effectively a price control, and price control theory implies that the supply of coin would be more elastic (responsive) under competitive supply and no price controls.

[edit] Under nationalized minting with no right to exchange

Where there is no legal right to take metal to the national mint and to have it coined into a particular coin, the supply of the coin depends on government or mint policy. This can result in arbitrary debasement of coinage, where the government mint re-manufactures coin with a lower metallic value as a way to raise revenue. However it also enables some more complex coinage arrangements such as the composite legal tender system where gold coin was unlimited legal tender (produced under a right of exchange arrangement as above) and where silver coins are limited legal tender, and have a substantially reduced metallic value below their legal value, but are effectively redeemable at the mint for their legal value in gold coins. This makes the silver coins 'token' coins, and a form of financial asset (and a financial liability to the mint).

[edit] Money creation through the fractional reserve system

There are two types of money in a fractional-reserve banking system, currency originally issued by the central bank, and demand deposits at commercial banks. By the working of the modern banking system, banks expand the money supply of a country whenever a new loan is created. ^[3][4]:

1. central bank money (all money created by the central bank regardless of its form (banknotes, coins, electronic money through loans to private banks))
2. commercial bank money (money created in the banking system through borrowing and lending) - sometimes referred to as checkbook money^[5]

When a commercial bank loan is extended, new commercial bank money is created. As a loan is paid back, the commercial bank money disappears from existence.

[edit] Re-lending

The mainstream economics theory of monetary creation is that commercial bank money is created by commercial banks re-lending central bank money: the central bank (an institution that can be characterised as a partnership between the government and a private coorporation ) lends money to another commercial bank, which re-loans part of it, due to fractional reserves, and this portion is in turn itself re-lent (it is re-re-lent central bank money). This theory is disputed by some schools of heterodox economics, termed endogenous money, which instead argue that money is created endogenously by demand for credit and by commercial bank-initiated lending, rather than exogenously by central bank lending.

The table below displays how central bank money is used to produce commercial bank money via successive re-lending in this theory.

Although no new money was physically created in addition to the initial $100 deposit, new commercial bank money is created through loans. The 2 boxes marked in red show the location of the original $100 deposit throughout the entire process. The total reserves plus the last deposit (or last loan, whichever is last) will always equal the original amount, which in this case is $100. As this process continues, more commercial bank money is created. For more information on how this system works, see Fractional-reserve banking.

An earlier form of such a 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.^[9]

[edit] Money multiplier

The expansion of $100 through fractional-reserve lending under the re-lending model of money creation, at varying rates. Each curve approaches a limit. This limit is the value that the money multiplier calculates.

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, m = 1 / RR, 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.

The money multiplier is of fundamental important 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 2007–2009 – 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.^[10] 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".

[edit] Money creation through quantitative easing

Quantitative easing is the creation of a significant amount of new base money (usually electronically) by a central bank. The intent is to stimulate the economy by promoting bank lending, even when interest rates cannot be pushed any lower. As usual, the central bank creates base money by buying securities. This creates reserves for the banking system (e.g., electronic bank deposits at the central bank), giving depository institutions such as banks the ability to make new loans. The securities can be government bonds, commercial loans, asset backed securities, or even stocks. Quantitative easing is usually used when lowering official interest rates is no longer effective because they are already close to or at zero. (See the article on the liquidity trap.)

[edit] Alternative theories

The above gives the mainstream economics theory of money creation. In heterodox economics, there are a number of alternative theories of how money is created, and generally emphasize endogenous money – that money is created by internal workings of an economy, rather than external forces – under whose rubric they thus fall. These theories include:

• Chartalism, which holds that money is created by government deficit spending, and emphasizes (and advocates) fiat money.
• Circuitist money theory, held by some post-Keynesians, which argues that money is created endogenously by the banking system, rather than exogenously by central bank lending. Further, they argue that money is not neutral – a credit money system is fundamentally different from a barter money system, and money and banks must be an integral part of economic models.
• Credit Theory of Money This approach was founded by Joseph Schumpeter ^[11] A major proponent, who correctly warned about the pending Japanese banking crisis, ^[12] as well as the British banking crisis ^[13], is Southampton University Professor of International Banking, Richard Werner. His approach is characterised by the inductive research methodology (building theories not on axioms and assumptions, but empirical facts), the recognition of pervasive disequilibrium and hence quantity-rationing, the central role of banks as creators and allocators of the supply-determined money supply, and the disaggregation of credit into 'productive' credit creation (allowing non-inflationary 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).^[14] Werner also points out that today many countries' central banks or financial regulators do not impose reserve requirements on banks, such as is the case in the United Kingdom. In this case, the textbook representation of fractional reserve banking becomes inapplicable. This, according to Werner, demonstrates that each bank has the power to create credit (and hence money); it is not a sequential process of banks lending their deposits, as textbooks say.

[edit] See also

Numismatics portal

• Fractional-reserve banking
• Central bank
• Federal Reserve
• Fiat currency
• Quantitative easing
• Inflation
• Money
• Money supply
• National bank
• Open market operations
• Reserve requirements
• Chartalism

[edit] External links

• Federalreserveeducation.org - The Principle of Multiple Deposit Creation
• Reserve Requirements - Fedpoints - Federal Reserve Bank of New York
• Bank for International Settlements - The Role of Central Bank Money in Payment Systems

[edit] References