Money creation

Money creation, or money issuance, is the process by which the money supply of a country, or of an economic or monetary region,[note 1] is increased. In most modern economies, money creation is controlled by the central banks. Money issued by central banks is termed base money. Central banks can increase the quantity of base money directly, by engaging in open market operations. However, the majority of the money supply is created by the commercial banking system in the form of bank deposits. Bank loans issued by commercial banks that practice fractional reserve banking expands the quantity of broad money to more than the original amount of base money issued by the central bank.

Central banks monitor the amount of money in the economy by measuring monetary aggregates (termed broad money), consisting of cash and bank deposits. Money creation occurs when the quantity of monetary aggregates increase.[note 2] Governmental authorities, including central banks and other bank regulators, can use policies such as reserve requirements and capital adequacy ratios to influence the amount of broad money created by commercial banks.[1]

Money supply

The term "money supply" commonly denotes the total, safe, financial assets that households and businesses can use to make payments or to hold as short-term investment.[2] The money supply is measured using the so-called "monetary aggregates", defined in accordance to their respective level of liquidity. In the United States, for example:

The money supply is understood to increase through activities by government authorities,[note 3] by the central bank of the nation,[note 4] and by commercial banks.[3]

Money creation by the central bank

Central banks

The authority through which monetary policy is conducted is the central bank of the nation. The mandate of a central bank typically includes either one of the three following objectives or a combination of them, in varying order of preference, according to the country or the region: Price stability, i.e. inflation-targeting; the facilitation of maximum employment in the economy; the assurance of moderate, long term, interest rates.[4]

The central bank is the banker of the government[note 5] and provides to the government a range of services at the operational level, such as managing the Treasury's single account, and also acting as its fiscal agent (e.g. by running auctions), its settlement agent, and its bond registrar.[5] A central bank cannot become insolvent in its own currency. However, a central bank can become insolvent in liabilities on foreign currency.[6]

Central banks operate in practically every nation in the world, with few exceptions.[7] There are some groups of countries, for which, through agreement, a single entity acts as their central bank, such as the organization of states of Central Africa, [note 6] which all have a common central bank, the Bank of Central African States; or monetary unions, such as the Eurozone, whereby nations retain their respective central bank yet submit to the policies of the central entity, the European Central Bank. Central banking institutions are generally independent of the government executive.[1]

The central bank's activities directly affect interest rates, through controlling the base rate, and indirectly affect stock prices, the economy's wealth, and the national currency's exchange rate.[4] Monetarists and some Austrians[note 7][8] argue that the central bank should control the money supply, through its monetary operations.[note 8][9][10] Critics of the mainstream view maintain that central-bank operations can affect but not control the money supply.[note 9]

Open-market operations

Open-market operations (OMOs) concern the purchase and sale of securities in the open market by a central bank. OMOs essentially swap one type of financial assets for another; when the central bank buys bonds held by the banks or the private sector, bank reserves increase while bonds held by the banks or the public decrease. Temporary operations are typically used to address reserve needs that are deemed to be transitory in nature, while permanent operations accommodate the longer-term factors driving the expansion of the central bank's balance sheet; such a primary factor is typically the trend of the money-supply growth in the economy. Among the temporary, open-market operations are repurchase agreements (repos) or reverse repos, while permanent ones involve outright purchases or sales of securities.[11] Each open-market operation by the central bank affects its balance sheet.[11]

Monetary policy

Monetary policy is the process by which the monetary authority of a country, typically the central bank (or the currency board), manages the level of short-term interest rates[note 10][12] and influences the availability and the cost of credit in the economy,[4] as well as overall economic activity.[13]

Central banks conduct monetary policy usually through open market operations. The purchase of debt, and the resulting increase in bank reserves, is called "monetary easing". An extraordinary process of monetary easing is denoted as "quantitative easing", whose intent is to stimulate the economy by increasing liquidity and promoting bank lending.

Physical currency

The central bank, or other competent, state authorities (such as the treasury), are typically empowered to create new, physical currency, i.e. paper notes and coins, in order to meet the needs of commercial banks for cash withdrawals, and to replace worn and/or destroyed currency.[14] The process does not increase the money supply, as such; the term "printing [new] money" is considered a misnomer.[1]

In modern economies, relatively little of the supply of broad money is in physical currency.[note 11]

Role of commercial banks

When commercial banks lend money, they expand the amount of bank deposits.[15] The banking system can expand the money supply of a country beyond the amount created or targeted by the central bank, creating most of the broad money in a process called the multiplier effect.[15]

Banks are limited in the total amount they can lend by their capital adequacy ratios, and their required reserve ratios. The required-reserves ratio obliges banks to keep a minimum, predetermined, percentage of their deposits at an account at the central bank.[note 12] The theory holds that, in a system of fractional-reserve banking, where banks ordinarily keep only a fraction of their deposits in reserves, an initial bank loan creates more money than it initially lent out.

The maximum ratio of loans to deposits is the required-reserve ratio RRR, which is determined by the central bank, as

where R are reserves and D are deposits.

Rather than holding the quantity of base money fixed, central banks have recently pursued an interest rate target to control bank issuance of credit indirectly so the ceiling implied by the money multiplier does not impose a limit on money creation in practice.[16]

Credit theory of money

The fractional reserve theory where the money supply is limited by the money multiplier has come under increased criticism since the financial crisis of 2007–2008. It has been observed that the bank reserves are not a limiting factor because the central banks supply more reserves than necessary[17] and because banks have been able to build up additional reserves when they were needed.[18] Many economists and bankers now believe that the amount of money in circulation is limited only by the demand for loans, not by reserve requirements.[19][20][15]

A study of banking software demonstrates that the bank does nothing else than adding an amount to the two accounts when they issue a loan.[18] The observation that there appears to be no limit to the amount of credit money that banks can bring into circulation in this way has given rise to the often-heard expression that "Banks are creating money out of thin air".[17] The exact mechanism behind the creation of commercial bank money has been a controversial issue. In 2014, a study titled "Can banks individually create money out of nothing? — The theories and the empirical evidence" empirically tested the manner in which this type of money is created by monitoring a cooperating bank's internal records:[21]

This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, "out of thin air".

The credit theory of money, initiated by Joseph Schumpeter, asserts the central role of banks as creators and allocators of the money supply, and distinguishes between "productive credit creation" (allowing non-inflationary economic 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).[22]

The model of bank lending stimulated through central-bank operations (such as "monetary easing") has been rejected by Neo-Keynesian[note 13][23] and Post-Keynesian analysis[24][25] as well as central banks.[26][27][note 14] The major argument offered by dissident analysis is that any bank balance-sheet expansion (e.g. through a new loan) that leaves the bank short of the required reserves may affect the return it can expect on the loan, because of the extra cost the bank will undertake to return within the ratios limits – but this does not and "will never impede the bank's capacity to give the loan in the first place". Banks first lend and then cover their reserve ratios: The decision whether or not to lend is generally independent of their reserves with the central bank or their deposits from customers; banks are not lending out deposits or reserves, anyway. Banks lend on the basis of lending criteria, such as the status of the customer's business, the loan's prospects, and/or the overall economic situation.[28]

Monetary financing


"Monetary financing", also "debt monetization", occurs when the country's central bank purchases government debt.[29] It is considered by mainstream analysis to cause inflation, and often hyperinflation.[30] IMF's former chief economist Olivier Blanchard states that:

governments do not create money; the central bank does. But with the central bank's cooperation, the government can in effect finance itself by money creation. It can issue bonds and ask the central bank to buy them. The central bank then pays the government with money it creates, and the government in turn uses that money to finance the deficit. This process is called debt monetization.[31]

The description of the process differs in heterodox analysis. Modern chartalists state:

the central bank does not have the option to monetize any of the outstanding government debt or newly issued government debt...[A]s long as the central bank has a mandate to maintain a short-term interest rate target, the size of its purchases and sales of government debt are not discretionary. The central bank's lack of control over the quantity of reserves underscores the impossibility of debt monetization. The central bank is unable to monetize the government debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to any support rate that it might have in place for excess reserves.[32]


Monetary financing used to be standard monetary policy in many countries, such as Canada or France,[33] while in others it was and still is prohibited. In the Eurozone, Article 123 of the Lisbon Treaty explicitly prohibits the European Central Bank from financing public institutions and state governments.[34] In Japan, the nation's central bank "routinely" purchases approximately 70% of state debt issued each month,[35] and owns, as of Oct 2018, approximately 440 trillion JP¥ (approx. $4trillion)[note 15] or over 40% of all outstanding government bonds.[36] In the United States, the 1913 Federal Reserve Act allowed federal banks to purchase short-term securities directly from the Treasury, in order to facilitate its cash-management operations. The Banking Act of 1935 prohibited the central bank from directly purchasing Treasury securities, and permitted their purchase and sale only "in the open market". In 1942, during wartime, Congress amended the Banking Act's provisions to allow purchases of government debt by the federal banks, with the total amount they'd hold "not [to] exceed $5 billion". After the war, the exemption was renewed, with time limitations, until it was allowed to expire in June 1981.[37]

See also


  1. Such as the Eurozone or ECCAS
  2. For example, in the United States, money supply measured as M2 grew from $6.407 trillion in January 2005, to 18.136 trillion in January 2009. See Federal Reserve (2009)
  3. "A [state budget] deficit will lead to a direct rise in the money supply if the...Treasury finances the deficit not by borrowing but by drawing down balances it holds at commercial banks or [the central bank]." From Cacy (1975)
  4. See "Money multiplier"
  5. Formally, the Treasury's banker, or the banker of the respective competent authority, depending on the country, e.g. of the Ministry of Finance
  6. Established by Cameroon, Central African Republic, Chad, Republic of Congo, Equatorial Guinea and Gabon
  7. "The chief cause of inflation, Hayek wrote, is governmental control of the money supply."
  8. "Empirical studies of relations between the monetary base and the total money supply establish a strong basis for believing that central banks can control the money supply."
  9. "Another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money. ... Rather than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the price of reserves — that is, interest rates." McLeay (2014)
  10. It has been argued that the central bank of a fiscally and monetarily sovereign nation can actually affect, if not dictate, the whole interest spectrum – above which, of course, as it is argued, adjustments are made for their actual conduct of business by commercial banks and the private sector, in accordance to their assessments, objectives, and preferences. E.g.: "Monetary policy – and there we are increasingly certain – cannot only influence the expectations component, but also the term premium. ... Central banks can lower long-term rates by removing duration risk from the market." Cœuré (2017). Also: "There is no evidence that the central bank has any meaningful control over the...spread between the short-term and the long-term rate of interest [but] it is quite clear that the central bank has full control over the long-term rate of interest.
  11. For example, in December 2010, in the United States, of the $8.853 trillion broad money supply (M2, table 1), only about 10% (or $915.7 billion, table 3) consisted of coins and paper money. See Statistic, FRS
  12. Many countries in the world, including major economic powers, including Australia, Canada and New Zealand, do not impose minimum cash reserves on banks. This does not allow banks to lend without limit, since there is always, aside from other considerations, the capital adequacy ratio.
  13. "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. Without taking drastic action, they can encourage but 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."
  14. "In reality, neither are [bank] reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available. ... Banks first decide how much to lend depending on the profitable lending opportunities available to them — which will, crucially, depend on the interest rate set by the [central bank]." McLeay et al. (2014)
  15. At a $1=¥0.0094 conversion rate


  1. European Central Bank (20 June 2017). "What is money?". European Central Bank. Retrieved 8 March 2018.
  2. Money supply, FRS
  3. Cœuré, Benoît (16 May 2017). "Dissecting the yield curve: a central bank perspective". Eurosystem. European Central Bank. Retrieved 8 March 2018.
  4. Monetary policy, FRS
  5. Pessoa, Mario; Williams, Mike (November 2012). "Government Cash Management: Relationship between the Treasury and the Central Bank" (PDF). Fiscal Affairs Dept. International Monetary Fund. Retrieved 8 March 2018.
  6. Buiter, Willem H. (May 2008). "Can Central Banks Go Broke?". SSRN. SSRN 2489665. {{cite journal}}: Cite journal requires |journal= (help)
  7. List of central banks
  8. Spencer, Roger W. (1975). "Inflation, Unemployment, and Hayek" (PDF). Federal Reserve Bank of St. Louis. Retrieved 8 March 2018.
  9. Meigs, A. James; Wolman, William (1971). "Central Banks and The Money Supply" (PDF). Second Konstanz Seminar on Monetary Theory and Monetary Policy. Federal Reserve Bank of St. Louis. Retrieved 8 March 2018.
  10. Jahan, Sarwat; Papageorgiou, Chris (March 2014). "What Is Monetarism?" (PDF). Finance & Development. IMF. Retrieved 8 March 2018.
  11. Open-market operations, FRS
  12. Pilkington, Philip (15 August 2014). "Does the Central Bank Control Long-Term Interest Rates?: A Glance at Operation Twist". Fixing the economists. Retrieved 8 March 2018.
  13. IMF (3 November 2017) "Monetary Policy and Central Banking"
  14. Mankiw (2012)
  15. McLeay, Michael; Radia, Amar; Thomas, Ryland (2014). "Money creation in the modern economy" (PDF). Quarterly Bulletin. Bank of England. Retrieved 8 March 2018.
  16. Hubbard & O'Brien. Economics. Chapter 25, Monetary Policy. p. 943.{{cite book}}: CS1 maint: location (link)
  17. Standard & Poor's (13 August 2013) "Repeat after me: Banks cannot and do not lend out reserves", Ratings Direct
  18. Werner, Richard A. (2016). "A lost century in economics: Three theories of banking and the conclusive evidence". International Review of Financial Analysis. 46: 361–379. doi:10.1016/j.irfa.2015.08.014.
  19. Benes, Jaromir; Kumhof, Michael (2012). "The Chicago Plan Revisited". IMF Working Paper. 202.
  20. Kumhof, Michael; Jakab, Zoltán (2016). "The Truth about Banks". Finance & Development. 53 (1): 50–53.
  21. Werner, Richard (2014). "Can banks individually create money out of nothing? — The theories and the empirical evidence". International Review of Financial Analysis. 36: 1–19. doi:10.1016/j.irfa.2014.07.015.
  22. Schumpeter, Joseph A. (1996) [1954]. History of Economic Analysis. Oxford University Press. ISBN 978-0195105599.
  23. Samuelson, Paul (1997) [1948]. Economics. McGraw-Hill Education. ISBN 978-0070747418.
  24. Kelton, née Bell, Stephanie (1998). "The Hierarchy of Money". The Jerome Levy Economics Institute. SSRN 96845. {{cite journal}}: Cite journal requires |journal= (help)
  25. Mitchell, William (21 April 2009). "Money multiplier and other myths". Retrieved 8 March 2018.
  26. Tucker, Paul (2007). "Money and credit: Banking and the Macroeconomy" (PDF). Bank of England.
  27. Disyatat, Piti (February 2010). "The bank lending channel revisited" (PDF). BIS Working Papers. Bank of International Settlements. Retrieved 8 March 2018.
  28. Wray, L. Randall (1 September 2000). "Money and Inflation". University of Missouri-Kansas City. SSRN 1010331. {{cite journal}}: Cite journal requires |journal= (help)
  29. Mishkin, Frederic S. (2011) [2002]. The economics of money, banking and financial markets (PDF) (4th ed.). Canada: Addison-Wesley. ISBN 978-0-321-58471-7. Archived from the original (PDF) on 2018-03-10. Retrieved 2018-03-11.
  30. Elmendorf, Douglas W.; Mankiw, N. Gregory (January 1998). "The bank lending channel revisited" (PDF). Handbook of Macroeconomicss. Harvard University. Retrieved 8 March 2018.
  31. Blanchard, Olivier; David R. Johnson, David R. Johnson (2012). Macroeconomics (6th ed.). Pearson. ISBN 978-0133061635.
  32. Mitchell, William; Muysken, Joan (2008). Full Employment Abandoned: Shifting Sands and Policy Failures. Edward Elgar Publishing. ISBN 978-1-85898-507-7.
  33. Ryan-Collins, Josh (25 October 2015). "Is Monetary Financing Inflationary? A Case Study of the Canadian Economy, 1935–75". Levy Economics Institute. Retrieved 8 March 2018.
  34. Fiscal policies, ECB
  35. Evans-Pritchard, Ambrose (10 August 2013). "Japan's Debt Has Officially Passed ¥1,000,000,000,000,000 — No Problem". The Daily Telegraph. Retrieved 8 March 2018.
  36. Gov't Bonds, Bank of Japan
  37. Garbade, Kenneth D. (August 2014). "Direct Purchases of U.S. Treasury Securities by Federal Reserve Banks" (PDF). FRBNY Staff Reports no. 684.

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