Review of a Report:Money Creation in the Modern Economy
IntroductionA plethora of contradictory modern economic schools -- neo-classical, Hayek, monetarist, Keynesian, post-Keynesian --have proved fruitless in providing solutions that halt the cycles of prosperity followed by recession. Noting the discrepancies between theories and operations, a new host of economic scholars are challenging academics, education and text books that control economic thought and policies. Just as foreign and domestic affairs are shaped by misleading and incorrect propositions, actions to ameliorate battered business cycles are guided by spurious arguments. A series of articles, interspersed with those on foreign and domestic affairs, will present a look at revisionist economic concepts.
Money creation in the modern economy, a start to understanding the fundamentals of finance, has been a confusing and misinterpreted topic. Realizing the public's gap between truth and belief, the Bank of England, United Kingdom's equivalent to the United states' Federal Reserve, submitted a report that clarifies the issue and, to some extent, surprisingly contradicts concepts from Paul Krugman, Milton Friedman and modern text books. Abstracts of this report constitute the following article. The complete report can be located at:https://templatearchive.com/money-creation-in-the-modern-economy/
In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money. The reality of how money is created today differs from the description found in some economics textbooks:
• Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
• In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money 'multiplied up’ into more loans and deposits.
Although commercial banks create money through lending, they cannot do so freely without limit. Banks are limited in how much they can lend if they are to remain profitable in a competitive banking system. Prudential regulation also acts as a constraint on banks’ activities in order to maintain the resilience of the financial system. And the households and companies who receive the money created by new lending may take actions that affect the stock of money — they
could quickly ‘destroy’ money by using it to repay their existing debt, for instance.
Monetary policy acts as the ultimate limit on money creation. The Bank of England aims to make sure the amount of money creation in the economy is consistent with low and stable inflation. In normal times, the Bank of England implements monetary policy by setting the interest rate on central bank reserves. This then influences a range of interest rates in the economy, including those on bank loans. In exceptional circumstances, when interest rates are at theireffective lower bound, money creation and spending in the economy may still be too low to be consistent with the central bank’s monetary policy objectives. One possible response is to undertake a series of asset purchases, or ‘quantitative easing’ (QE). QE is intended to boost the amount of money in the economy directly by purchasing assets, mainly from non-bank financial companies.
QE initially increases the amount of bank deposits those companies hold (in place of the assets they sell). Those companies will then wish to rebalance their portfolios of assets by buying higher-yielding assets, raising the price of those assets and stimulating spending in the economy. As a by-product of QE, new central bank reserves are created. But these are not an important part of the transmission mechanism, these reserves cannot be multiplied into more
loans and deposits and these reserves do not represent ‘free money’ for banks.
Two misconceptions about money creation
The vast majority of money held by the public takes the form of bank deposits. But where the stock of bank deposits comes from is often misunderstood. One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. (ED: contradicting Paul Krugman's assertion "that banks act simply as intermediaries.") In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses. In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money.
Another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money— the so-called ‘money multiplier’ approach. In that view, central banks implement monetary policy by choosing a quantity of reserves. And, because there is assumed to be a constant ratio of broad money to base money, these reserves are then ‘multiplied up’ to a much greater change in bank loans and deposits. For the theory to hold, the amount of reserves must be a binding constraint on lending, and the central bank must directly determine the amount of reserves.
While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality. Rather than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the price of reserves — that is, interest rates. In reality, neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available. As with the relationship between deposits and loans, the relationship between reserves and loans typically operates in the reverse way to that described in some
economics textbooks. Banks first decide how much to lend depending on the profitable lending opportunities available to them — which will, crucially, depend on the interest rate set by the Bank of England. It is these lending decisions that determine how many bank deposits are created by the banking system. The amount of bank deposits in turn influences how much central bank money banks want to hold in reserve (to meet withdrawals by the public, make payments to other banks, or meet regulatory liquidity requirements), which is then, in normal times, supplied on demand by the Bank of England.
Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank
deposit of the size of the mortgage. At that moment, new money is created. For this reason, some economists have referred to bank deposits as ‘fountain pen money’, created at the stroke of bankers’ pens when they approve loans.
This description of money creation contrasts with the notion that banks can only lend out pre-existing money, outlined in the previous section. 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. A related misconception is that banks can lend out their reserves. Reserves can only be lent between banks, since consumers do not have access to reserves accounts at the Bank of England.
The link between Quantitative Easing (QE) and quantities of money
QE has a direct effect on the quantities of both base and broad money because of the way in which the Bank carries out its asset purchases. The policy aims to buy assets, government bonds, mainly from non-bank financial companies, such as pension funds or insurance companies. Consider, for example, the purchase of £1 billion of government bonds from a pension fund. One way in which the Bank could carry out the purchase would be to print £1 billion of banknotes and swap these directly with the pension fund. But transacting in such large quantities of banknotes is impractical. These sorts of transactions are therefore carried out using electronic forms of money.
As the pension fund does not hold a reserves account with the Bank of England, the commercial bank with whom they hold a bank account is used as an intermediary. The pension fund’s bank credits the pension fund’s account with £1 billion of deposits in exchange for the government bonds. The Bank of England finances its purchase by crediting reserves to the pension fund’s bank — it gives the commercial bank an IOU. The commercial bank’s balance sheet expands: new deposit liabilities are matched with an asset in the form of new reserves.
Two misconceptions about how QE works
(1) Why the extra reserves are not ‘free money’ for banks.
While the central bank’s asset purchases involve — and affect — commercial banks’ balance sheets, the primary role of those banks is as an intermediary to facilitate the transaction between the central bank and the pension fund. The additional reserves shown are simply a by-product of this transaction. It is sometimes argued that, because they are assets held by commercial banks that earn interest, these reserves represent ‘free money’ for banks. While banks do
earn interest on the newly created reserves, QE also creates an accompanying liability for the bank in the form of the pension fund’s deposit, which the bank will itself typically have to pay interest on. In other words, QE leaves banks with both a new IOU from the central bank but also a new, equally sized IOU to consumers (in this case, the pension fund), and the interest rates on both of these depend on Bank Rate.
(2) Why the extra reserves are not multiplied up into new loans and broad money
As discussed earlier, the transmission mechanism of QE relies on the effects of the newly created broad — rather than base — money. The start of that transmission is the creation of bank deposits on the asset holder’s balance sheet in the place of government debt. Importantly, the reserves created in the banking sector do not play a central role. This is because, as explained earlier, banks cannot directly lend out reserves. Reserves are an IOU from the central bank to commercial banks. Those banks can use them to make payments to each other, but they cannot ‘lend’ them on to consumers in the economy, who do not hold reserves accounts. When banks make additional loans they are matched by extra deposits — the amount of reserves does not change.
Moreover, the new reserves are not mechanically multiplied up into new loans and new deposits as predicted by the money multiplier theory. QE boosts broad money without directly leading to, or requiring, an increase in lending. While the first leg of the money multiplier theory does hold during QE — the monetary stance mechanically determines the quantity of reserves — the newly created reserves do not, by themselves, meaningfully change the incentives for the banks to create new broad money by lending. It is possible that QE might indirectly affect the incentives facing banks to make new loans, for example by reducing their funding costs, or by increasing the quantity of credit by boosting activity. But equally, QE could lead to companies repaying bank credit, if they were to issue more bonds or equity and use those funds to repay bank loans. On balance, it is therefore possible for QE to increase or to reduce the amount of bank lending in the economy. However these channels were not expected to be key parts of its transmission: instead, QE works by circumventing the banking sector, aiming to increase private sector spending directly.
This article has discussed how money is created in the modern economy. Most of the money in circulation is created, not by the printing presses of the Bank of England, but by the commercial banks themselves: banks create money whenever they lend to someone in the economy or buy an asset from consumers. And in contrast to descriptions found in some textbooks, the Bank of England does not directly control the quantity of either base or broad mone. (Ed: A contradiction to Milton Friedman's monetarist theories that a central bank had the power to prevent the "Great Depresion" by augmenting the money supply.)The Bank of England is nevertheless still able to influence the amount of money in the economy. It does so in normal times by setting monetary policy — through the interest rate that it pays on reserves held by commercial banks with the Bank of England. More recently, though, with Bank Rate constrained by the effective lower bound, the Bank of England’s asset purchase programme has sought to raise the quantity of broad money in circulation. This in turn affects the prices and quantities of a range of assets in the economy, including money.
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