Saturday, July 14, 2007

Money creation Money Multiplier

Money creation is the process by which the money supply of a country is increased. There are several ways that a government, in coordination with the country's 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 non-currency portion of the money is backed by loans, mortgages, and other bank assets. The currency component of the money is backed by the economic potential of the country and is based on government fiat, or decree. This perceived potential puts a theoretical limit on the amount of money a country can prudently create

The most common mechanism used to generate money is typically called the money 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 reserve ratios on the commercial banks which set the proportion of primary deposits the banks may not lend out.

The reserve ratio is to prevent banks from:

1. having a shortage of cash when large deposits are withdrawn.
2. generating too much money

This system works as follows.

For example, let's assume that a primary deposit ie. cash of 100,000 is made into Bank AA. If the cash reserve ratio is 10%, then 10,000 must be kept on hand by Bank AA (10,000 is 10% of 100,000) and up to 90,000 of new loans can be issued by Bank AA. When the 90,000 worth of loans are deposited into Bank BB, this sum is added to the reserves of Bank BB and an additional 81,000 of new loans can then be issued by Bank BB (81,000 is 90% of 90,000).

Money Multiplier
The money creation process is affected by 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.

Deposit Multiplier Example

It is sometimes said that banks make tremendous profits through the deposit multiplier effect. One should however keep in mind that for every additional fraction of deposit banks not only have additional income from extra advances but also extra expenses as extra deposits are their liabilities. For example, a reserve of $1,000,000 will allow banks to make almost $9,000,000 of advances. They will receive income on 9x the reserves, but also pay interest on 10x the same reserves as well.

Assuming a 10% reserve ratio requirement, 4% on deposits and 6% from advances (loans), net interest income is ultimately tending towards 14% of the reserves, which is 9x the 2% spread between interest received minus interest paid, minus the 4% interest paid on the deposits which make up the reserves itself.

An example of the creation of new money in the USA

The following steps describe one way that new money can be created in the USA.

1. The government issues a Treasury security. 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.
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 of bonds 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 Fed can sell these bonds which are a liability of the government. Individual investors, pension funds, mutual funds, insurance agencies, banks, foreign government central banks, can all buy the bonds, effectively loaning money to the treasury. They do this to invest their money and receive interest in return.
4. The government deposits the check in its own account. 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 make loans so long as it retains a 10% cash reserve. This lending of money that it has on deposit is the precise point at which new money is created, because the depositor still has his money, and the person getting the loan now has money too. If the $1,000,000 is held by the bank as notes then it can lend $900,000 to borrowers.
6. $900,000 is loaned for various purposes eg. to buy a house. These loans are in the form of money transfer. The bank transfers the money to the buyer's attorney who transfers it to the seller, who deposits it right back into the bank. Note however, in real life that money would only come from the bank temporarily, which 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. This money is put into reserves, and 90% of that, or $810,000 is lent out. As soon as the $810,000 is deposited back into the bank, the cycle repeats and repeats until there are no more borrowers.
8. The total amount lent out to borrowers is $900,000. Add that to the $100,000 that it still has on deposit and the total is $1,000,000. 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 $900,000 it will earn $54,000 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 $10,000 per year. With 90% of that money lent out, if the original 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, or the federal funds rate in the US). This is called "asset-liability bouncing", and is a delicate balancing act all banks must work on every day.

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