Money Creation

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The money supply is the volume of currency in circulation at a T time. These are the monetary authorities (central banks) that determine what should be the progression of this volume. The money supply flows from monetary policy. To measure the money supply, we are using of aggregates. Define what we meant by these aggregates:

Monetary aggregates in the strict sense: They are all means of payment held by the agents. These aggregates are divided into two subcategories. The first is the fiducial money (coins and banknotes) that take their value in reliance we are giving to them. The second is the deposit money (checks) that takes its value by what we are writing on.

Broad monetary aggregates: These are the aggregates in the strict sense as well as all financial assets that can be transformed into means of immediate payment (from savings books.)

Investment aggregates: It’s durable savings such as Housing savings plans, Treasury bills.

The aggregates are differentiated by the degree of liquidity of their components, the most liquid to least liquid. In the official language of central banks, here are the aggregates:

M1: Notes + coins + sight deposits (current account)

M2: M1 + saving books + Housing Savings plans

M3: M2 + term deposits + mutual funds + Fund + treasury bunds + commercial paper

Today, money supply becomes less and less liquid because less the money is liquid, the more it is remunerated. However, the concept of money supply is not limited to liquid forms of money. We must also consider the investment aggregates that are reserves of purchasing power to economic agents. (Called P1, P2, P3).

Note that the aggregate retained by the central bank to set monetary policy is M3. The money creation should not be abusive because it follows inflation. However, all central banks do not set a limit and do not have as primarily objective to fight the inflation but rather get a high growth rate of their economies. However, one of the main objectives of the ECB is the fight against inflation. It is for this reason that the ECB limits the annual growth in M3 money supply yo 4.5% per year. The ECB therefore adjusts its rates accordingly.

The counterparty notion of the money supply

All currencies are created based on counterparts. Counterparties are the sources of money creation, they explain at which occasion a currency is created. There are two families of counterparties:

The net claims on the Outside: The entries of foreign currency within a country increase the money supply. It takes into account all currency held by financial institutions. Gold is also a counterparty

The net internal credit: These are letters of credit on public treasury held by the central bank

Letter of credit on the economy: They are all credits granted to economic agents by the State. Indeed, the credit means to grant a purchasing power that did not exist before.

Mechanism of money creation

Two mechanisms explain the money creation :

The deposit multiplier

It is the fact that credits of agents are making deposits of others.  The bank collects savings from various maturities of economic actors. These banks use these deposits to grant loans. Economic agents are involuntary lender.

The bank is an intermediary who plays a transformation role. The bank transforms the savings deposits (sometimes short) in long loan. Potentially, a part of this credit (the majority being used for consumption or investment) may be deposit in the same bank or another.

The bank which is receiving a new deposit will then grant new credits. This is one mechanism of money creation. This phenomenon can be described as automated as banks create money without intending to.

However, this mechanism is controlled by central banks. Indeed, commercial banks are not allowed to lend the full amount of the deposit they have received. A party shall be set aside (fraction given by the rate of reserve requirement). This is one of the privileged instruments of monetary policy in the United States. In addition, the money put in reserve is not remunerated in United States in opposition to the ECB who pay interest to commercial banks. To reduce the growth of money supply, central banks just have to raise the reserve requirement rates

The credit divider

This is the mechanism of money creation through debt. Commercial banks seek to maximize their profits and, consequently, will want to grant a maximum credit.

To get money, in addition to deposits, they can get it by borrowing from central bank. The central bank cannot refuse to lend to a bank because it was his role as lender of last resort. This bank refinancing is not free and the refinancing rate of the central bank is applied.

Thus, more the interest rates are low, more the money creation will be important. However, the amount that commercial banks can borrow from the central bank is not unlimited.

Each week, the central bank allocates an amount which will be allocated based on commercial bank that will offer the highest rate.

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