Notes on Money Creation

Abstract

Many texts which cover money creation regard the reserve requirement (RR) as being at the very centre of the process, and many still regard the process as starting with a bank receiving a new deposit (and placing the required reserves with the central bank, lending out the rest, which is reflected in the banking system as a new deposit; then the required reserves based on this deposit are placed with the central bank ... and so on until the process ends with the factor new deposit x 1 / RR ratio). There are countries which do not have a RR, and money is still created in these countries, and this is so because money is bank deposits (in the main; the other, small part being notes and coins – N&C) and these are created when banks make new loans. The amount of required reserves is just one of the many factors which impact on bank liquidity, and the latter is manipulated by central banks in order to make the central bank’s key lending rate to banks (repo rate, discount rate, base rate, bank rate ...) effective (or purposefully ineffective in exceptional circumstances such as under a quantitative easing policy). As regards money creation starting with a new deposit, this is not possible (there is one exception: N&C), because no bank can create central bank money; only the central bank is able to. Money (deposit) creation is the outcome of new bank loans (to the private sector or government; marketable or non-marketable) and/or net additions to foreign assets by banks. It is misleading to speak of a money “supply”.

Keywords: money, central banking, banking, monetary policy

JEL Classification: A22, E42, E51, E52, G21