ME#3 money creation

Assets side of CB balance sheet

• Gold and currency reserves

• Loans to banks

• Loans to the government

• Securities

• Government bonds

• Corporate bonds

• Other securities

Liability side of CB balance sheet

▪ Cash in circulation (‘C’)

▪ Reserve accounts of banks (‘R’)

▪ Debt securities

▪ Government account

▪ Other liabilities

How is base money created

• Central banks extend loans to commercial banks

• CB buy securities from commercial banks/other institutions via a bank

• Central bank buy foreign currencies from commercial banks

What’s money multiplier

relation btw monetary base and money in circulation

Some notes about the formula

• either c or k increase → m decrease4

• cashless society → m = 1/k

• people wants all cash → k =1 → no money creation

Draw backs of money multiplier

• strongly dependent on assumptions

• much too mechanical in character

• ignores demand side

• ignores other sources of money creation:

  • banks buying assets from non-banks

  • cross-border transactions → changes in money supply

What's the difference btw monetary financing and QE

• Monetary financing: CB creates new money (M0) to finance new gov spending (buy new gov bonds)

• QE: only existing bonds are bought by CB

Differences btw monetary financing and helicopter money

• helicopter money is given directly to people → less certain about if effectiveness

• helicopter money takes effect immediately while monetary financing takes longer → helicopter money more effective in acute crisis

Pros of fractional reserve banking

• flexible system

  • the money supply varies with the economy

  • money is created and destroyed on the initiative of the banks’ clients in the right amounts and in the right place in the economy

Cons of fractional reserve banking

• Liquidity reserves < current accounts → all banks vulnerable for bank run (liquidity risk)

• In normal times: banks with a liquidity shortage can finance themselves on the money market (borrowing from banks or other professional counterparts with cash surplus

• If the money market as a whole has a liquidity shortage and/or a solvent bank has an acute liquidity shortage the central bank has to step in as ”lender of last resort” (LOLR)

Alternative system ?

full (liquidity) reserve banking

• banks must cover their current liabilities with 100% liquid reserves

• Bank lending has to be financed with savings that already exist

• No money creation by commercial banks ==> government is given a monopoly for the creation of money

• An independent government committee will announce ex-ante monetary targets

Pros of full reserve banking

• Probability of a bank run (almost) fully eliminated

• Liquidity risk for banks much smaller

Cons of full reserve banking

• Depositors are forced to hold their savings in deposits with a longer maturity. Liquid savings should be held on an non-interest current account

  (note that in today’s world this doesn’t make any difference)

• Banks lose a source of income

• It won’t work in a world with large cross-border financial flows

• Government monopoly on money creation may be dangerous

• Banks become more stable because the risks are to a large extent shifted to depositors.

• It becomes more expensive to hold a bank account