Financial

Markets

Chapter 5:
The Creation of Money
Objectives:

• Discuss the concept of money including measures of money.

• Identify the example of monetary banking institutions.
• Discuss the roles of money and uniqueness of banks.
• Discuss the role of the central bank in the creation of money.
• Explain how a central bank maintains a bank liquidity shortage.
 Introduction to Creation of Money

Inflation is the rate of money being created or the growth rate allowed
by a central bank. There is a strong relationship between money creation and
price developments (the rate of inflation). The consequences are profound in
terms of the destruction of economic growth and employment when inflation is
high. Excessive money stock growth led to the financial crisis of 2007 -2009.
The aftermath of this crisis is still with us today, as evidenced in the increasing
costs of commodities, transport and food. In the main it is bank loan growth, and
banks are able to create loans / credit at will to satisfy demand, assuming
borrowers are creditworthy.
Bank deposits, which make up the majority of the money supply, are
actually produced by accounting transactions, and the central bank, whose
primary duty is the implementation of a "policy on money," or monetary policy,
marks the territory where these transactions take place.

What constitutes excessive increase in the money stock? It occurs when

a country's capacity for producing the additional demand (i.e., capacity being
"sticky"
country'sand unable
ability to keepthe
to satisfy upincreased
with quickly risingindemand)
demand terms of surpasses theGlobal
bank loans.
balances of payments
inflation takes place, asbecome
shown unbalanced, currencies
by rising prices become
for goods, unstable, and
transportation, and
food.
 What is
Money?
Money is anything that complies with the following
•criteria:
• Store ofofvalue.
Medium exchange.
• Unit of account
• Standard of deferred payment.
 In 2009 the currency of a country with the highest inflation rate ever recorded
was no longer accepted as a medium of exchange, a store of value, a unit of account
or a standard of deferred payment. Inflation fell to low numbers instantaneously.
Currency is made up of two parts: Bank notes (usually issued by the central bank and
in some cases by government) and bank deposits (BD). Medium of exchange is
paramount, and all other criteria are subordinated to it.

Consequently, what is the medium of exchange? It had two components:

•Bank notes (often issued by the central bank, though occasionally
by the
government) and bank notes (typically issued by the central bank) (N&C).

•Bank transfers (BD).

We frequently utilize bank notes and coins as a form of exchange to
make payments on debts and to make purchases. It can often be a little
perplexing when bank deposits are used as a means of exchange. Think about
how many transactions are performed using bank checks (which are rapidly
declining) and electronic financial transfers (EFTs). The EFT or the check are
not money. They only serve as means through which deposits are transferred
from one bank account to another. N&C and the deposit both consist of money.

As a result,ofM3
ownership allispersons
definedand
as the sum of all
businesses at aN&C
givenand BD in the
time.

M3 = N&C + BD
 Measures of
Money
The definitions of money created by central banks around the world
range from M0-M5. We'll employ the M3 definition of money in the purpose of
upholding our beliefs and keeping the study simple.

NBPS
98% ofBD, which
the M3 comprises
definition N&C allThis
of money. BDfigure
of themay
NBPS, takes up 96–
be relatively low in some
underdeveloped
that the majoritynations,
of NBPS which
bankshows thatare
deposits banks are not we
short-term, widely trusted.
are not Given
far off the
mark in terms of liquidity.
Please note: NBPS (Non-Bank Private Sector) ;BD (Bank Deposits) ; N&C (Bank Notes and Coins)
 Monetary Banking Institutions
Most countries have some or all of the following deposit intermediaries:
•Private sector banks
•Central bank
•Rural banks
•Mutual banks
•Building societies
•Post Office Bank
 These intermediates, who also go by the name "monetary banking institutions"
(MBIs), are what make up the "monetary banking sector" (MBS). These intermediaries
have a significant impact on the financial system since they:

• As the custodians of the major part of the money stock of the country (ieNBPS
deposits).

• As issuers of N&C (in some countries certain private banks issue bank notes).
•
As the keepers of government’s surplus balances.
• In providing loans to the public sector (usually lower tiers of government).
•
In purchasing the debt securities of the central government (= loans which are
marketable).
•
• In providing loans to the household and corporate sectors.
In the creation of money.
 In order to determine the monetary aggregate number or numbers and
their balance sheet counterparts, each central bank consolidates the statements
of liabilities and assets (i.e., the balance sheets) of these intermediaries on a
monthly basis (BSCs).

As we have seen, there are various definitions of money, but the one
usually given much attention is:

M3 = N&C (outside the banking sector) + BD (of NBPS with MBIs).

 Money and Its Roles

It is crucial that bank loans and credit are available on demand (from
here on referred to as loans). This is true in both negative and positive ways. A
too rapid increase in the money supply can have a detrimental impact on
economic growth due to its impact on inflation. When economic units focus too
much on inflation (especially when it is rising quickly), it impacts their
spending and investment choices, which lowers economic output and
employment.
 The availability of new loans / money is essential for economic growth
to take place, but the proviso is that it should be monitored and "controlled" so as
not to outpace the capacity of the economy. As we shall see, underlying bank
lending / money creation is the lending rate of banks (prime rate and rates related
to this benchmark rate), and underlying this is the key interest (lending rate of
the central bank) which has to be "made effective" by ensuring the existence of a
bank liquidity shortage.

Scholars
production of economics
capacity) will
are the main know that C
components of+GDE
I (needed
(GrosstoDomestic
increase

Expenditure = domestic demand) and that GDE + exports (X) less imports
(M) (X –M = net external demand) = GDP (Gross Domestic Product –
expenditure on).
 Uniqueness of Banks
In order to meet the demand for additional loans from borrowers, i.e.
the government, household, and corporate sectors, banks must physically be able
to generate money (NBPS BD). New loans include both marketable and
nonmarketable loans used to purchase debt securities, which are marketable
evidences of debt. It is noteworthy that banks respond to loan demand without
even being aware that they are making money.

Why are
have unlimited banks to
capacity in generate
such a peculiar situation?
new assets This must
(i.e., loans) imply that(i.e.,
and liabilities banks
BD, or
money).
The public recognizes their deposit as money, or a way of making
payments or a medium of trade. As for the history of this problem, it dates
back to the 17th century and the goldsmiths of London. We are unable to
explore this fascinating history, though, due to space constraints.

The banks are in this unique situation because the public accepts their
deposits as money. This is largely a difficulty in this regard and manifested itself
on a grand scale in 2007 -2009. It is the job of monetary authorities to see that
this innate weakness is kept at bay (through bank supervision).
 Role of the Central Bank in the Creation of Money

It's also important to think about how the CB affects the production of
money. In a large portion of the industrialized world, interest rates serve as an
operational variable for monetary policy. The prime rate (PR), which serves as
the standard and to which all loan rates are tied, as well as inflation and
economic growth, are summarized on the next slide.
• Through open market operations (OMO), the CB establishes a liquidity shortage
(LS), which, under normal circumstances, is maintained in the majority of nations
permanently. Accordingly, it "forces" the banks to borrow from it constantly. The
term of the loan is brief (usually 1 day to 7 days).
• It charges its KIR for these lent reserves (BR).
• The KIR serves as a model for the bank-to-bank interbank rate (b2b IBM), which
is the market where banks pay their interbank debts with one another.

• The wholesale call money rate, various short-term deposit rates, etc. are all
significantly influenced by the b2b IBM rate.
• Deposit rates affect bank lending rates because banks keep their margins stable.
• Therefore, the KIR affects the banks' PR (the correlation between the KIR and PR
for the period from 1960 to the present is 0.99 in at least one country).
• The NBPS's demand for bank loans is influenced by the PR level, especially in real
terms.

• Changes in interest rates have a significant effect on asset prices, which in turn
affect consumption and investment behavior (C + I = GDE).
•• ΔDLE is the main counterpart of ΔM3.
The pace of demand growth (ΔGDE), which is largely financed by ΔDLE and
reflected in ΔM3, has a significant impact on price movements (inflation).
•
• The rate of inflation plays a significant role on corporate decisions.
Business decisions have an impact on employment and economic growth.
 How Does A Central Bank Maintain a Bank Liquidity Shortage?

The CB generates an LS and maintains it permanently through open market

operations (OMO), as was stated in the preceding section. This is an important and
fascinating issue, and it will be briefly discussed on next slides. The central bank's
balance sheet is shown in simplified form in Box 40 (we have excluded irrelevant
components like other assets, other liabilities, capital, and reserves).

The
are tobanking
the leftsector's net excess
of the identity (as reserves
far as CBM (NER), a measure The
is concerned). of bank liquidity,
amount of loans to the
banking sector
sector's ER (atB2b),
(item the KIR),
givingi.e.,rise
thetoLS
theorformula:
BR (item F), is subtracted from the banking

NER = B2b -F
BOX 40: CENTRAL BANK (LLC MILLIONS)
On the right hand side of the identity we have all the remaining liability and
asset items (the BSCs); thus:

NER = B2b –F = (D + E) –(A + B1 + B2a + C + D

If we group the related liability and asset items we have:

NER = B2b –F = (D –C) + (E –B1) –A –B2a –D

It will also be evident that:

∆NER = ∆(D –C) + ∆(E –B1) –∆A –∆B2a –∆D
Thus, a change in the NER (and the LS which is its main component) of the banking system is
caused by changes in the remaining balance sheet items (i.e. the BSCoCs):

∆NER =
∆(D –C) = net foreign assets (NFA)
+ ∆(E –B1) = net loans to government (NLG)
–∆A – = N&C in circulation
∆B2a – = RR
∆D = central bank securities (CBS)

∆NER = ∆(D –C) + ∆(E –B1) –∆A –∆B2a –∆D

The transactions that support the BSCoCsare what actually trigger change. It
will be clear that NFA (mostly fxswaps), NLG (primarily purchases and sales of
government assets), and CBS (issues) are the instruments of OMO, and that RR can also
be used (and is occasionally used) to influence bank liquidity (NER). For instance, NER
will drop if you sell currency to a bank (a forex swap) (increase the LS). The BSCoC
results in a drop in NFA. Similar to how selling TBs to banks will reduce NER (increase
the LS). NLG declines as a result of the BSCoC. Consequently, the CB has full authority
over bank liquidity (assuming efficient markets).
The information above shows that the CB has complete control over bank
liquidity and that the RR is simply one of many factors that affect bank liquidity. To make
the KIR effective, the majority of nations' monetary policy strategy relies on establishing
and maintaining a liquidity shortage (under normal conditions). Therefore, it is false to
claim that the RR is central to the formation of money. In fact, banks are compelled to top
up their RR for up to 7 weeks after deposit increases in most countries
because it takes time for banks to produce their statements of assets and liabilities.
The maximum deposit growth is equal to ER / r in this explanation,
meaning that the CB is able to generate ER and compel the multiplier on banks.
The result is extraordinarily volatile interest rates because this implies
quantitative restraint and interest rate freedom. Both central banks and the
business community dislike this situation. Instead, they prefer steady interest
rates and use them to affect the demand for loans (the PR in particular, by
making KIR effective). New bank deposits result from new bank loans
(money).
It is a good system, given that the generation of new loans and money
(which represents C + I) is compatible with output elasticity.
 Thank You
For Your Attention ☺