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Money Creation in the Modern Economy

In the Bank of England’s Quarterly Bulletin “Money creation in the modern economy”, signed by three economists from the Bank’s Monetary Analysis Directorate, the endogenous nature of money creation, monetary circulation dynamics, and the way banks manage risk in the modern economies are thoroughly analyzed. The conclusions are controversial.

The orthodox analysis of the functioning of money creation tells us that banks act as intermediaries, as the deposits generated by families’ savings, are subsequently used by the banks to create new credit. What is more, the Central Bank determines the money supply in the economy by controlling the money base (banks reserves plus currency in circulation), and letting the money multiplier do its part.

The Bank of England argues that these conceptions may, after all, not be correct.

In reality, instead of commercial banks acting as intermediaries, receiving families’ savings and lending them afterwards, it is the loan itself that generates the deposits: the phenomenon is the inverse of the today’s consensual sequence of money creation. The choice of saving made by families, thereby increasing their deposits, instead of using such wealth in the consumption of goods and services, is made at the expenses of companies’ deposits which otherwise would have received by the payment of those same goods and services. There are no new deposits in the economy, and there is no money creation.

On the other hand, and as it is explained in the article, when someone mortgages a house, s/he does not receive hundreds of thousands of euros in bills that come from deposits of other clients of the bank. Instead, s/he sees his/her account credited with the amount of the mortgage. In that moment a new deposit is created in the economy: new money is created.
This process is depicted in the following figure, with the balance sheets of the Central Bank, commercial banks, and of the consumer, during the provision of a loan. In the consumer’s balance sheet, passives and actives are increased by the new deposit and the new loan, respectively: there is money creation in its broader sense. Despite that, this money creation is not necessarily followed by an increase in the Central Bank monetary base. While it is true that the increase in deposits might demand from banks a demand for reserves to cover their liquidity needs, that have just increased as well, the supply of reserves is unlimited on a collateralized basis and therefore is not what constraints the amount of loans.

balance sheet

The authors conclusion is simple, “Bank deposits are simply a record of how much the bank itself owes its customers. So they are a liability of the bank, not an asset that could be lent out”. The conception of banks as intermediaries in the allocation of one’s savings to another’s consumption or investment is not necessarily accurate.

Regarding the money multiplier, the Bank of England also disputes its current conception. It can be read in the bulletin that the theory would only be correct if the amount of reserves was a relevant restriction in the concession of credit, and if Central Banks directly determined the amount of reserves. However, neither the first nor the second conditions holds. Instead of controlling the amount of reserves, Central Banks dictate monetary policy by fixing the price of reserves, the interest rate. It is in the price of money and not in its quantity that monetary policies focuses on. In fact, banks face indebtedness restrictions, but these are not due to the imposition of legal reserves. Banks are instead constricted by the capital ratio requirements, and by the interbank competition that makes them develop risk management strategies, gauging the relation risk-return in each loan, to avoid unprofitable loans.

It’s the decision of how much to lend, which is fundamentally constrained by the available opportunities of creating profitable loans, that determine the amount of deposits generated. And it is the amount of deposits that creates the banks’ demand for reserves. As it can be read in the bulletin, as in the relationship between deposits and loans, the relationship between reserves and loans operates in the inverse way of the commonly thought.

The article is worth a full read, to understand the limitations of money creation, being it due to monetary policy or due to families and companies behavior. And also to study what happens to the newly-formed money, the ‘reflux theory’, and the ‘hot potato’ effect. But above all, it is worth to ponder that the monetary system is not as clear and simple as one may think.

Gonçalo Pessa – 750
José Ricardo Sequeira – 729

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Author: studentnovasbe

Master student in Nova Sbe

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