Money creation in the modern economy

5th May 2014

• This article explains how the majority of money in the modern economy is created by commercial banks making loans.

• Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits.

• The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’.

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 their effective 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. This article explains how, just as in normal times, these reserves cannot be multiplied into more loans and deposits and how these reserves do not represent ‘free money’ for banks.

See the full article at -
http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf