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2.10. Money creation is not dependent on a cash reserve requirement

The next step in this discussion is to cement the fact that money creation is not dependent on the existence of a RR. Take a country that does not impose a RR on its banks (as noted, they do exist). The banks of this country still create new money (NBPS deposits) by making new loans. Omitting a RR in the previous example produces a balance sheet of the bank as indicated in Box 34.

BOX 34: BANK (LCC MILLIONS)

Assets

Equity and liabilities

Loans (Company B)

+ 100

Deposits (Company L)

+ 100

Total

+100

Total

+100

In this example M3 increases by LCC 100 million and the BSCoC is bank loan extension by the same amount. The real cause of the change in M3 is the additional demand for loans that is satisfied by the banking sector. So the starting point is the demand for loans; if satisfied by the banking sector, it leads to an increase in M3. A RR had nothing to do with the creation of money.

However, scholars of money and banking will know that because of the relationship between the RR (where it exists) and bank deposits, a CB can "control" the creation of money quantitatively. This is sometimes called the "strict-money-rule model"16. In text books it is known as the "monetary base model". According to this model (assuming that N&C do not rank as R - for the sake of simplicity) the money "supply", i.e. stock (see next section), cannot increase by more than the reciprocal of the R supplied by the CB. An example will be useful: the CB creates LCC 100 million ER by purchasing treasury bills (TBs) from the bank (see Boxes 35-36). An assumption is required here: the bank has no outstanding borrowings from the CB.

BOX 35: CENTRAL BANK (LCC MILLIONS)

Assets

Equity and liabilities

Treasury bills

+ 100

SA - ECRs

+ 100

Total

+100

Total

+100

BOX 36: BANK (LCC MILLIONS)

Assets

Equity and liabilities

Treasury bills SA - ECRs

-100 + 100

Total

0

Total

0

The bank is now able to create new loans and money to the extent of:

and the ER of the bank is transmuted into RR (see Boxes 37-38). The banking system cannot create any further loans and its counterpart, money.

BOX 37: CENTRAL BANK (LCC MILLIONS)

CENTRAL BANK (LCC MILLIONS)

BOX 38: BANK (LCC MILLIONS)

BANK (LCC MILLIONS)

As the scholars of money and banking will know, essentially this is a theoretical money "supply" (i.e. money stock creation) model. Some central banks flirted with this model in the past but rejected it because its sideshow was extremely volatile interest rates. The focus (in normal times) is to manipulate interest rates in order to influence the additional demand for loans (= money creation) to a level consistent with the economy's production elasticity.

2.11. Is "money supply" a misnomer?

We know that money is NBPS BD (plus N&C) and we know that new money is created by new bank loans. When money is measured by CBs (see below for more detail) they consolidate the balance sheets of the members on the MBS and derive M3 from this (and the BSCs). Many economists call this magnitude the money supply.

Is this a useful term when AM3 it is the outcome of new bank loans (mainly - see below)? Does "supply" not fit better with the supply of loans, which is theoretically unlimited (subject to the demand for loans, which is a function of the level of interest rates as determined by the CB - specifically bank lending rates), as indicated in Figure 5.

Once new money is created, has the stock of money, i.e. the amount of money in circulation, not increased, rather than the supply? Is the amount measured hereafter (= held) not the outcome of portfolio decisions, rather than the demand (for transactions, speculative...reasons) for money? Is it not true to say that if some people want to hold more bonds instead of money when rates are high, that the money stock will not change - because the bond sellers will get bank deposits and the buyers of bonds will lose deposits?

supply & demand for bank loans

Figure 5: supply & demand for bank loans

 
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