6.8 Money creation in a modern economy

two ways that a dollar or type of currency began its life

(1) bank created it when it made a loan to a customer which leads to an increase in bank money

(2) central bank created it when it bought a government bond that was previously owned by a public entity which leads to an increase in base money

what happens on a commercial bank’s balance sheet if it approves a loan for $1000?

asset is created: $1000 loan

liability is created: $1000 bank deposit

if A buys something from B with that money, that bank deposit just moves from A to B

how do commercial banks create money through loans?

basically when they approve a loan, they create an asset (the loan) and a liability on their balance sheet for $1000 for the bank deposit.

the loan is self-financing for the bank - there’s no change in net worth for the bank because it’s assets and liabilities have increased by equal amonuts and it also expects to make a profit on the loan

**but, the supply of bank money has increased - they basically created money out of thin air

what if companies a and b have accounts at diff banks? alpha and beta?

deposit of $1000 leaves alpha bank and goes to beta bank. this means alpha’s bank reserve account falls by $1000 and beta’s rises by $1000. now there is a higher level of debt in the economy and this enables new economic activity to occur. new bank money has still been created bc the total deposit liabilities of the two banks have increased. alpha bank’s liabiliites remain unchanged but beta’s have increased

interbank market

banks borrow and lend reserves from each other to clear their balances and manage their reserves - normally interest rates are very close to the policy rate

3 constraints on the amount of loans banks will make (and therefore on the amount of money they reate)

(1) demand for loans - there has to be a demand from households and firms on terms bank is willing to offer (bank has to expect to make a profit by setting lending IR > PIR) CBs monetary policy affects amt of lending by banks bc it affects the demand for loans

(2) capital adequacy requirements - bank is required by gov to have enough equity relative to its assets to meet regulatory requirements; when bank makes a new loan, this doesn’t change net worth but A & L have both increased so ratio of equity to assets has fallen

(3) reserve requirements - minimum reserve requirements imposed by central bank, banks have to have enough to respond to depositors’ requests for withdrawals, if it doesn’t have enough, it borrows reserves in the interbank market

what happens if a commercial bank is below the capital adequacy requirements required by the regulator?

it will have to sell some assets and use the proceeds to reduce liabilities or it has to raise more capital from investors to continue operating

central bank creating money

when central bank buys bonds or any other asset from the non-bank public —> increase in reserves and a new deposit in the banking system = increase in money