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The multiplier effect is relevant to considering monetary and fiscal policies, as well how the banking system works. For example, the deposit, the monetary amount a customer deposits at a bank, is used by the bank to loan out to others, thereby generating the money supply. Most banks are FDIC insured (Federal Deposit Insurance Corporation), so that customers are assured that their savings, up to a certain amount, is insured by the federal government. Banks are required to reserve a certain ratio of the customer's deposits in reserve, either in the form of vault cash or of a deposit maintained by a Federal Reserve Bank.[http://www.federalreserve.gov/monetarypolicy/reservereq.htm#table1] . Therefore, if the Federal Reserve Bank (and hence its monetary policy) requires a higher percentage of reserve, then it lowers the bank's financial ability to loan. |
The multiplier effect is relevant to considering monetary and fiscal policies, as well how the banking system works. For example, the deposit, the monetary amount a customer deposits at a bank, is used by the bank to loan out to others, thereby generating the money supply. Most banks are FDIC insured (Federal Deposit Insurance Corporation), so that customers are assured that their savings, up to a certain amount, is insured by the federal government. Banks are required to reserve a certain ratio of the customer's deposits in reserve, either in the form of vault cash or of a deposit maintained by a Federal Reserve Bank.[http://www.federalreserve.gov/monetarypolicy/reservereq.htm#table1] . Therefore, if the Federal Reserve Bank (and hence its monetary policy) requires a higher percentage of reserve, then it lowers the bank's financial ability to loan. |
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====Criticism==== |
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{{also|Liquidity trap}} |
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The theory of the money multiplier, particularly as it applies in [[financial crises]], is criticized as follows: |
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{{quotation|By increasing the volume of their government securities and loans and by lowering Member Bank legal reserve requirements, the Reserve Banks can encourage an increase in the supply of money and bank deposits. They can encourage but, without taking drastic action, they cannot ''compel.'' For in the middle of a deep depression just when we want Reserve policy to be most effective, the Member Banks are likely to be timid about buying new investments or making loans. If the Reserve authorities buy government bonds in the open market and thereby swell bank reserves, the banks will not put these funds to work but will simply hold reserves. Result: no 5 for 1, “no nothing,” simply a substitution on the bank’s balance sheet of idle cash for old government bonds.|{{Harv|Samuelson|1948|loc=pp. 353–354}}}} |
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Restated, increases in central bank money may not result in commercial bank money because the money is not ''required'' to be lent out – it may instead result in a growth of unlent reserves ([[excess reserves]]). This situation is referred to as "pushing on a string": withdrawal of central bank money ''compels'' commercial banks to curtain lending (one can ''pull'' money via this mechanism), but input of central bank money does not compel commercial banks to lend (one cannot ''push'' via this mechanism). |
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This described growth in excess reserves has indeed occurred in the [[Financial crisis of 2007–2009]], US bank excess reserves growing over 500-fold, from under $2 billion in August 2008 to over $1,000 billion<!-- Please leave as 1,000 billion, not as 1 trillion, as otherwise the scale of increase is unclear, because one does not mentally compare “billion” to “trillion”; please see http://xkcd.com/558/ for an illustration. --> in November 2009.<ref>[http://research.stlouisfed.org/fred2/series/EXCRESNS EXCRESNS] series, St. Louis Fed</ref><ref>[http://krugman.blogs.nytimes.com/2009/12/14/followup-on-samuelson-and-monetary-policy/ Followup on Samuelson and monetary policy], [[Paul Krugman]], ''[[New York Times]],'' December 14, 2009</ref> |
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==Money creation through quantitative easing== |
==Money creation through quantitative easing== |
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== References == |
== References == |
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{{reflist}} |
{{reflist}} |
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* {{Citation | last = Samuelson | first = Paul | title = [[Economics (textbook)|Economics]] | year = 1948 }} |
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{{Central banks}} |
{{Central banks}} |
Revision as of 22:14, 20 December 2009
Money creation is the process by which new money is produced or issued. There are three ways to create money: by manufacturing paper currency or metal coins, through fractional reserve banking and lending by the banking system, and by government policies such as quantitative easing. The practices and regulation of production, issue and redemption of money are of central concern to monetary economics (e.g. money supply, monetarism), and affect the operation of financial markets and the purchasing power of money.
Central banks measure the money supply, which shows the amount of money in existence at a given time. An unknown portion of the new money created is indicated by comparing these measurements on various dates. For example in the US, one of the various money supply measurements, called M2, grew from $286.6bn in January of 1959 to $8,327bn in May 2009.[1]
The destruction of currency may occur when coins are scrapped to recover their precious metal content, which can be motivated by the value of the metal coming to exceed the face value of the coin, or when the issuer redeems the securities.
Money creation by mints
Money created by manufacturing a new monetary unit, such as paper currency or metal coins, is most often a responsibility of a government's treasury. In modern economies, relatively little of the money supply is in currency (i.e. coins and banknotes); most is created by lending or quantitative easing (see below) using fractional reserve banking. In the U.S., only about 2% to 3% of the total money supply consists of physical coins and paper money[2].
Under competitive minting
Competitive minting means that the business of manufacturing coins is open to many competing manufacturers. The mints buy bullion on the bullion market, and manufacture it into coins that they use to pay for the bullion and their other production costs, and to provide a profit.
Analysis of supply and demand cannot proceed in the normal way because by definition, the money price of money is fixed at unity. Instead, metal producers need money to pay their expenses and to realize their profits in money, and so their demand for money is expressed by their willingness to produce and sell uncoined metal at a discount to its value as coin. This discount is the gross profit margin of manufacturing metal into coin, and the greater this is, the more metal the mints will find economical to manufacture into coin.
Under nationalized minting with a right to exchange
Nationalized minting means that the government has monopolized the business of minting coins, and the government operates mints that produce a national system of coinage. Under a metallic or bimetallic standard with a national mint, individuals normally have a right to bring precious metal to the national mint and to have it coined at a fixed discount. This discount is called seigniorage.
Basic economic analysis of this arrangement is that it makes the supply of coin elastic at the fixed price, however this fixed price is effectively a price control, and price control theory implies that the supply of coin would be more elastic (responsive) under competitive supply and no price controls.
Under nationalized minting with no right to exchange
Where there is no legal right to take metal to the national mint and to have it coined into a particular coin, the supply of the coin depends on government or mint policy. This can result in arbitrary debasement of coinage, where the government mint re-manufactures coin with a lower metallic value as a way to raise revenue. However it also enables some more complex coinage arrangements such as the composite legal tender system where gold coin was unlimited legal tender (produced under a right of exchange arrangement as above) and where silver coins are limited legal tender, and have a substantially reduced metallic value below their legal value, but are effectively redeemable at the mint for their legal value in gold coins. This makes the silver coins 'token' coins, and a form of financial asset (and a financial liability to the mint).
Money creation through the fractional reserve system
There are two types of money in a fractional-reserve banking system, currency originally issued by the central bank, and demand deposits at commercial banks. By the working of the modern banking system, banks expand the money supply of a country whenever a new loan is created. [3][4]:
- central bank money (all money created by the central bank regardless of its form (banknotes, coins, electronic money through loans to private banks))
- commercial bank money (money created in the banking system through borrowing and lending) - sometimes referred to as checkbook money[5]
When a commercial bank loan is extended, new commercial bank money is created. As a loan is paid back, the commercial bank money disappears from existence.
Re-lending
The mainstream economics theory of monetary creation is that commercial bank money is created by commercial banks re-lending central bank money: the central bank (an institution that can be characterised as a partnership between the government and a private coorporation ) lends money to another commercial bank, which re-loans part of it, due to fractional reserves, and this portion is in turn itself re-lent (it is re-re-lent central bank money). This theory is disputed by some schools of heterodox economics, termed endogenous money, which instead argue that money is created endogenously by demand for credit and by commercial bank-initiated lending, rather than exogenously by central bank lending.
The table below displays how central bank money is used to produce commercial bank money via successive re-lending in this theory.
Fractional-Reserve Lending Cycled 10 times with a 20 percent reserve rate[6] [7][8][3] | ||||
---|---|---|---|---|
individual bank | amount deposited | amount loaned out | reserves | |
A | 100 | 80 | 20 | |
B | 80 | 64 | 16 | |
C | 64 | 51.20 | 12.80 | |
D | 51.20 | 40.96 | 10.24 | |
E | 40.96 | 32.77 | 8.19 | |
F | 32.77 | 26.21 | 6.55 | |
G | 26.21 | 20.97 | 5.24 | |
H | 20.97 | 16.78 | 4.19 | |
I | 16.78 | 13.42 | 3.36 | |
J | 13.42 | 10.74 | 2.68 | |
K | 10.74 | |||
total reserves: | ||||
89.26 | ||||
total amount deposited: | total amount loaned out: | total reserves + last amount deposited: | ||
457.05 | 357.05 | 100 | ||
commercial bank money created + central bank money: | commercial bank money created: | central bank money: | ||
457.05 | 357.05 | 100 |
Although no new money was physically created in addition to the initial $100 deposit, new commercial bank money is created through loans. The 2 boxes marked in red show the location of the original $100 deposit throughout the entire process. The total reserves plus the last deposit (or last loan, whichever is last) will always equal the original amount, which in this case is $100. As this process continues, more commercial bank money is created. For more information on how this system works, see Fractional-reserve banking.
An earlier form of such a table, featuring reinvestment from one period to the next and a geometric series, is found in the tableau économique of the Physiocrats, which is credited as the "first precise formulation" of such interdependent systems and the origin of multiplier theory.[9]
Money multiplier
The most common mechanism used to measure this increase in the money supply is typically called the money multiplier. It calculates the maximum amount of money that an initial deposit can be expanded to with a given reserve ratio – such a factor is called a multiplier.
Formula
The money multiplier, m, is the inverse of the reserve requirement, R:
This formula stems from the fact that the sum of the "amount loaned out" column above can be expressed mathematically as a geometric series[10] with a common ratio of .
To correct for currency drain (a lessening of the impact of monetary policy due to peoples' desire to hold some currency in the form of cash) and for banks' desire to hold reserves in excess of the required amount, the formula
can be used, where Currency Drain is the percentage of money that people want to hold as cash and the Desired Reserve Ratio is the sum of the Required Reserve Ratio and the Excess Reserve Ratio.
Example
For example, with the reserve ratio of 20 percent, this reserve ratio, R, can also be expressed as a fraction:
So then the money multiplier, m, will be calculated as:
This number is multiplied by the initial deposit to show the maximum amount of money it can be expanded to[11].
Another way to look at the monetary multiplier is derived from the concept of money supply and money base. It is the number of dollars of money supply that can be created for every dollar of monetary base. Money supply, denoted by M, is the stock of money held by public. It is measured by the amount of currency and deposits. Money Base, denoted by B, is the summation of currency and reserves. Currency and Reserves are monetary policy that can be affected by the Federal Reserve. For example, the Federal Reserve can increase currency by printing more money and they can similarly increase reserve by requiring a higher percentage of deposits to be stored in the Federal Reserve.
Mathematically:
M=C+D
B=C+R
M=Money Supply
C=Currency
D=Deposits
B=Money Base
R=Reserve
So that money supply over money base:
M/B = (C+D)/(C+R)
Multiply the right side by [(D/CR) / (D/CR)]. Since this equals to 1, it is mathematically justified to multiply it to only the right side.
Then multiple the right side of the equation by the Money Base
So we get:
M=B * [(D/R)(1+D/C) / (D/R + D/C)]
[(D/R)(1+D/C) / (D/R + D/C)] is the multiplier. Therefore, if money base is held constant, the ratio of D/R and D/C affects the money supply. When the ratio of deposits to reserves (D/R) reduces, the multiplier reduces. Similarly, if the ratio of deposits to currency (D/C) falls, the multiplier falls as well.
The multiplier effect is relevant to considering monetary and fiscal policies, as well how the banking system works. For example, the deposit, the monetary amount a customer deposits at a bank, is used by the bank to loan out to others, thereby generating the money supply. Most banks are FDIC insured (Federal Deposit Insurance Corporation), so that customers are assured that their savings, up to a certain amount, is insured by the federal government. Banks are required to reserve a certain ratio of the customer's deposits in reserve, either in the form of vault cash or of a deposit maintained by a Federal Reserve Bank.[1] . Therefore, if the Federal Reserve Bank (and hence its monetary policy) requires a higher percentage of reserve, then it lowers the bank's financial ability to loan.
Criticism
The theory of the money multiplier, particularly as it applies in financial crises, is criticized as follows:
By increasing the volume of their government securities and loans and by lowering Member Bank legal reserve requirements, the Reserve Banks can encourage an increase in the supply of money and bank deposits. They can encourage but, without taking drastic action, they cannot compel. For in the middle of a deep depression just when we want Reserve policy to be most effective, the Member Banks are likely to be timid about buying new investments or making loans. If the Reserve authorities buy government bonds in the open market and thereby swell bank reserves, the banks will not put these funds to work but will simply hold reserves. Result: no 5 for 1, “no nothing,” simply a substitution on the bank’s balance sheet of idle cash for old government bonds.
— (Samuelson 1948, pp. 353–354)
Restated, increases in central bank money may not result in commercial bank money because the money is not required to be lent out – it may instead result in a growth of unlent reserves (excess reserves). This situation is referred to as "pushing on a string": withdrawal of central bank money compels commercial banks to curtain lending (one can pull money via this mechanism), but input of central bank money does not compel commercial banks to lend (one cannot push via this mechanism).
This described growth in excess reserves has indeed occurred in the Financial crisis of 2007–2009, US bank excess reserves growing over 500-fold, from under $2 billion in August 2008 to over $1,000 billion in November 2009.[12][13]
Money creation through quantitative easing
Quantitative easing is the creation of a significant amount of new base money (usually electronically) by a central bank. The intent is to stimulate the economy by promoting bank lending, even when interest rates cannot be pushed any lower. As usual, the central bank creates base money by buying securities. This creates reserves for the banking system (e.g., electronic bank deposits at the central bank), giving depository institutions such as banks the ability to make new loans. The securities can be government bonds, commercial loans, asset backed securities, or even stocks. Quantitative easing is usually used when lowering official interest rates is no longer effective because they are already close to or at zero. (See the article on the liquidity trap.)
Alternative theories
The above gives the mainstream economics theory of money creation. In heterodox economics, there are a number of alternative theories of how money is created, and generally emphasize endogenous money – that money is created by internal workings of an economy, rather than external forces – under whose rubric they thus fall. These theories include:
- Chartalism, which holds that money is created by government deficit spending, and emphasizes (and advocates) fiat money.
- Circuitist money theory, held by some post-Keynesians, which argues that money is created endogenously by the banking system, rather than exogenously by central bank lending. Further, they argue that money is not neutral – a credit money system is fundamentally different from a barter money system, and money and banks must be an integral part of economic models.
- Credit Theory of Money This approach was founded by Joseph Schumpeter [14] A major proponent, who correctly warned about the pending Japanese banking crisis, [15] as well as the British banking crisis [16], is Southampton University Professor of International Banking, Richard Werner. His approach is characterised by the inductive research methodology (building theories not on axioms and assumptions, but empirical facts), the recognition of pervasive disequilibrium and hence quantity-rationing, the central role of banks as creators and allocators of the supply-determined money supply, and the disaggregation of credit into 'productive' credit creation (allowing non-inflationary growth even at full employment, in the presence of technological progress) and 'unproductive credit creation' (resulting in inflation of either the consumer or asset price variety).[17] Werner also points out that today many countries' central banks or financial regulators do not impose reserve requirements on banks, such as is the case in the United Kingdom. In this case, the textbook representation of fractional reserve banking becomes inapplicable. This, according to Werner, demonstrates that each bank has the power to create credit (and hence money); it is not a sequential process of banks lending their deposits, as textbooks say.
See also
- Fractional-reserve banking
- Central bank
- Federal Reserve
- Fiat currency
- Quantitative easing
- Inflation
- Money
- Money supply
- National bank
- Open market operations
- Reserve requirements
- Chartalism
External links
- Federalreserveeducation.org - The Principle of Multiple Deposit Creation
- Reserve Requirements - Fedpoints - Federal Reserve Bank of New York
- Bank for International Settlements - The Role of Central Bank Money in Payment Systems
References
- ^ US Federal Reserve historical statistics June 11, 2009
- ^ http://www.federalreserve.gov/releases/h6/Current/
- ^ a b Bank for International Settlements - The Role of Central Bank Money in Payment Systems. See page 9, titled, "The coexistence of central and commercial bank monies: multiple issuers, one currency": http://www.bis.org/publ/cpss55.pdf
A quick quote in reference to the 2 different types of money is listed on page 3. It is the first sentence of the document:
- "Contemporary monetary systems are based on the mutually reinforcing roles of central bank money and commercial bank monies."
- ^ European Central Bank - Domestic payments in Euroland: commercial and central bank money:
http://www.ecb.int/press/key/date/2000/html/sp001109_2.en.html One quote from the article referencing the two types of money:
- "At the beginning of the 20th almost the totality of retail payments were made in central bank money. Over time, this monopoly came to be shared with commercial banks, when deposits and their transfer via checks and giros became widely accepted. Banknotes and commercial bank money became fully interchangeable payment media that customers could use according to their needs. While transaction costs in commercial bank money were shrinking, cashless payment instruments became increasingly used, at the expense of banknotes"
- ^ Chicago Fed - Our Central Bank: http://www.chicagofed.org/consumer_information/the_fed_our_central_bank.cfm
- the reference is found in the "Money Manager" section:
- "the Fed works to control money at its source by affecting the ability of financial institutions to "create" checkbook money through loans or investments. The control lever that the Fed uses in this process is the "reserves" that banks and thrifts must hold."
- the reference is found in the "Money Manager" section:
- ^ Table created with the OpenOffice.org Calc spreadsheet program using data and information from the references listed.
- ^ Federal Reserve Education - How does the Fed Create Money?
- See the link to "The Principle of Multiple Deposit Creation" pdf document towards bottom of page.
- ^ Federal Reserve Bank of New York: An explanation of how it works from the New York Regional Reserve Bank of the US Federal Reserve system. Scroll down to the "Reserve Requirements and Money Creation" section. Here is what it says:
- "Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51.20+...=$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity."
- ^ The multiplier theory, by Hugo Hegeland, 1954, p. 1
- ^ http://www.mhhe.com/economics/mcconnell15e/graphics/mcconnell15eco/common/dothemath/moneymultiplier.html
- ^ Mankiw, N. Gregory (2001), Principles of Macroeconomics
- ^ EXCRESNS series, St. Louis Fed
- ^ Followup on Samuelson and monetary policy, Paul Krugman, New York Times, December 14, 2009
- ^ see Richard A. Werner (2005), New Paradigm in Macroeconomics, Basingstoke: Palgrave Macmillan
- ^ The Great Yen Illusion, Oxford Applied Economics Discussion Papers No. 129, Institute of Economics and Statistics, University of Oxford, October 1991
- ^ Richard A. Werner (2005), New Paradigm in Macroeconomics, Basingstoke: Palgrave Macmillan
- ^ Richard A. Werner (2005), New Paradigm in Macroeconomics, Basingstoke: Palgrave Macmillan
- Samuelson, Paul (1948), Economics