There are several ways that a government, in coordination with the countries commercial banks, can increase or decrease the money supply of a country. If a country follows a fractional-reserve banking regime, as virtually all countries do, not all of the money in circulation needs to be backed by other currencies, physical assets such as gold, or government assets. Instead, the country's currency is backed by the economic potential of the country. This perceived potential puts a theoretical limit on the amount of money a country can prudently create.
The most common mechanism used to create money is typically called the deposit creation multiplier. It measures the amount by which the commercial banking system increases the money supply. To control the amount of money created by the system, central banks place strict reserve ratios on the commercial banks. For example, central banks generally restrict the proportion of primary deposits that commercial banks can lend out. This is called the cash reserve ratio.
For example, lets assume that a primary deposit of $1000 is made into bank A. If the cash reserve ratio is 12%, then $120 must be kept on hand by the bank and $880 is available to be lent to someone else (called the excess reserve). Now if bank A uses its $880 in excess reserve by lending it out, and that is deposited in bank B, it represents a primary deposit to the second bank. Bank B must keep 12% of $880 on hand but can lend out $774.40. If that $774.40 is eventually deposited in bank C, the third bank must keep $92.93 on hand but can lend out $681.47. The process continues until there is no excess reserve left (For simplicity we will ignore safety reserves.). By adding all the derivative deposits we can calculate the amount of money created. Alternatively we can use the deposit multiplier equation:
TD = ID / crr
- TD = change in Total Deposits
- ID = Initial change in Deposit
- crr = cash reserve ratio
The initial change in deposit of $1000 will increase total deposits by $7333.33 given a reserve ratio of 12% (1000/.12=8333.33).
In actual fact, the money creation multiplier is more complex than this simple description. We must add to the equation the currency drain ratio (the propensity of the public to hold cash rather than deposit it in the banking system),the clearing house drain (the loss of deposits from the system due to interactions between banks), and the safety reserve ratio (excess reserves beyond the legal requirement that commercial banks voluntarily hold - usually a very small amount). Also, most jurisdictions require different levels of reserves for different types of deposits. Foreign currency deposits, domestic time deposits, and government deposits often have different cash reserve ratios.
An example of the creation of new money
The following steps describe one way that new money can be created. It is an example from the US.
- 1. The government prints a treasury bond. This is simply an IOU, a promise to pay the holder a specified sum of money on a particular date. In this example, let’s say the government issues $1,000,000 worth of bonds. Individual investors, pension funds, mutual funds, insurance agencies, banks, foreign government central banks, can all buy the bonds, effectively loaning money to the federal reserve. They do this to invest their money and receive interest in return.
- 2. The Federal Reserve prints a check, in the amount of $1,000,000 and makes it payable to the government. This check is the proceeds from the sale of the bonds.
- 3. The $1,000,000 is recorded as an asset by the Fed. (money owed to the central bank is called an "asset" by the bank) It is assumed the government, with its power to tax, will make good on its debt (this is why the people buying the bonds from the fed consider it a risk free investment. The government deposits the check in its own account.
- 4. The government hires employees and buys things with the $1,000,000, and it does so by writing government checks. These government checks are then deposited in commercial banks. For the sake of simplicity, assume it all goes into one commercial bank, which has a zero balance to begin with.
- 5. The commercial bank now claims $1,000,000 in new liabilities (the amount on deposit in a bank is called a "liability" by the bank, because the bank has to pay interest to it, amongst other things). In the US, the law allows the bank to loan out 90% of what it has on deposit. This loaning of money that it has on deposit is the precise point new money is created, because the depositor still has his money, and the person getting the loan now has money too.
- 6. $900,000 is loaned out on Friday for someone to buy a house. This loan is in the form of a check. The home buyer signs the check and gives it to the seller, who deposits it right back into the bank on Monday. Note however, in real life that money would only come from the bank temporarily, who then would issue its own bonds or use a company like Fannie Mae to issue its own bonds, so that again investors can actually lend the money while the bank is simply a middleman, called a "servicer".
- 7. The commercial bank now claims $900,000 in new liabilities. 10 percent of that money is put into a reserves, and 90% of that, or $810,000 is loaned out. As soon as the $810,000 is deposited back into the bank, the cycle repeats and repeats until there is no more money to lend.
- 8. The total amount lent out to borrowers is $9,000,000. Add that to the $1,000,000 that it still has on deposit and the total is $10,000,000. Commercial banks make profit by charging fees for transactions, and by charging a higher interest rate to those they lend to, than what they pay for the funds. If the commercial bank charges 6% interest on the $9,000,000 it will earn $540,000 per year. If the bank making the loan pays 1% interest to the person who put the money on deposit in the first place it will cost them $90,000 per year. With 90% of that money lent out, if the originally depositor wants their money back, the bank has to borrow that money from another bank (or maybe from another source), at rate of interest set by the government (the overnight rate). This is called "asset-liability bouncing", and is a delicate balancing act all banks must work on every day.
- Reserve Requirements - Fedpoints - Federal Reserve Bank of New York (http://www.newyorkfed.org/aboutthefed/fedpoint/fed45.html)