Money Creation

This article provides an overview of what money is and the various forms it takes in a modern economy, briefly mentioning how each type is created. This article delves into the specifics of money creation in the contemporary economy.

This article starts by addressing two common misconceptions about money creation and explains how, in today's economy, commercial banks primarily create money through loans. It then examines the limitations of the banking system’s ability to create money and highlights the crucial role of central bank policies in ensuring that credit and money growth align with monetary and financial stability. The final section explores the role of money in the monetary transmission mechanism during quantitative easing (QE) periods, debunking some myths about money creation and QE.

Misconceptions About Money Creation

Most money held by the public is in the form of bank deposits, but the origin of these deposits is often misunderstood. A common misconception is that banks merely act as intermediaries, lending out deposits from savers. This view suggests that deposits are created by household saving decisions, and banks then lend these existing deposits to borrowers, such as companies or individuals purchasing houses.

In reality, when households save more in bank accounts, these deposits simply reduce the deposits that would have otherwise been paid to companies for goods and services. Saving does not increase the deposits or ‘funds available’ for banks to lend. Viewing banks solely as intermediaries overlooks the fact that, in the modern economy, commercial banks create deposit money. This article explains that instead of lending out pre-existing deposits, the act of lending itself creates deposits—contrary to traditional textbook descriptions.

Another misconception is that the central bank controls the quantity of loans and deposits in the economy by managing the amount of central bank money—a concept known as the ‘money multiplier’ approach. This view posits that central banks implement monetary policy by setting a quantity of reserves, which are then multiplied to a greater change in bank loans and deposits based on a constant ratio of broad money to base money. For this theory to hold, the amount of reserves must strictly limit lending, and the central bank must directly control the amount of reserves.

While the money multiplier theory serves as an introductory tool in economic textbooks, it inaccurately depicts how money is actually created. Instead of controlling the quantity of reserves, central banks typically set the price of reserves—namely, interest rates.

In practice, reserves do not strictly limit lending, nor does the central bank fix the available amount of reserves. Similar to the relationship between deposits and loans, the relationship between reserves and loans often works in reverse to textbook descriptions. Banks decide how much to lend based on profitable opportunities, heavily influenced by the interest rate set by the Bank of England. These lending decisions determine the creation of bank deposits. The volume of bank deposits then affects how much central bank money banks need to hold in reserve (to accommodate withdrawals, interbank payments, or regulatory requirements), which is normally supplied on demand by the Bank of England. The rest of this article explores these practices in greater detail.