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Money creation, or money issuance, is the process by which the money supply of a country, or an economic or monetary region,[note 1] is increased. In most modern economies, money is created by both central banks and commercial banks. Money issued by central banks is termed reserve deposits and is only available for use by central bank account holders, which are generally large commercial banks and foreign central banks. Central banks can increase the quantity of reserve deposits directly, by engaging in open market operations or quantitative easing. However, the majority of the money supply used by the public for conducting transactions is created by the commercial banking system in the form of bank deposits. Bank loans issued by commercial banks expand the quantity of bank deposits.[1]

Money creation occurs when the amount of loans issued by banks increases relative to the repayment and default of existing loans. Governmental authorities, including central banks and other bank regulators, can use various policies, mainly setting short-term interest rates, to influence the amount of bank deposits commercial banks create.[2]

Monetary policy

Main article: Monetary policy

The monetary authority of a nation—typically its central bank—employs control over money supply, short-term interest rates, and other tools of monetary policy to accomplish broader objectives such as unemployment reduction and price stability.[3][4][5] Monetary policy directly impacts the availability and the cost of credit in the economy,[6] which in turn impacts investment, stock prices, private consumption, demand for money, and overall economic activity.[7] The exchange rate of a country's currency impacts the value of its net exports.

In most developed countries, central banks conduct their monetary policy within an inflation targeting framework,[8] whereas the monetary policies of most developing countries' central banks target some kind of a fixed exchange rate system.[9] Central banks operate in practically every nation in the world, with few exceptions. 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, 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.[2]

Central banks usually conduct monetary policy either through administratively setting interest rates or through open market operations.[10] Lowering interest rates or purchasing debt (resulting in an increase in bank reserves) is called monetary expansion or monetary easing, whereas the opposite is known as monetary contraction or tightening. 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.

Money supply

Main article: Money supply

In accordance to "credit mechanics" bank money expansion or destruction (or not changing) depends on payment flows.

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.[11] The money supply is measured using the so-called "monetary aggregates", defined based on their respective level of liquidity. In the United States, for example:

In most countries the central bank, treasury, or other designated state authority is empowered to mint new physical currency, usually taking the form of metal coinage or paper banknotes. While the value of major currencies was once backed by the gold standard, the end of the Bretton Woods system in 1971 led to all major currencies becoming fiat money — backed by a mutual agreement of value rather than a commodity.

Various measures are taken to prevent counterfeiting, including the use of serial numbers on banknotes and the minting of coinage using an alloy at or above its face value. Currency may be demonetized for a variety of reasons, including loss of value over time due to inflation, redenomination of its face value due to hyperinflation, or its replacement as legal tender by another currency. The currency-issuing government agency typically work with commercial banks to distribute freshly-minted currency and retrieve worn currency for destruction, enabling the reuse of serial numbers on new banknotes.[12]

In modern economies, physical currency consists only of a fraction of the broad money supply.[note 2] In the United Kingdom, gross bank deposits outweigh the physical currency issued by the central bank by a factor of more than 30 to 1. The United States, with a currency used substantially in legal and illicit international transactions, has a lower ratio of 8 to 1.[3]

Debt monetization

Main article: Debt monetization

Debt monetization occurs when a country's central bank loans money to its government to finance public spending. Used to fund government debt as an alternative to raising taxes or selling bonds, the process artificially increases a country's money supply, diluting the value of existing money.[13] Due to its substantial impact on inflation, including the risk of runaway hyperinflation, dept monetization is prohibited in many countries.[14]

In the Eurozone, Article 123 of the Lisbon Treaty explicitly prohibits the European Central Bank from financing public institutions and state governments.[15] In Japan, the nation's central bank "routinely" purchases approximately 70% of state debt issued each month,[16] and owns, as of Oct 2018, approximately 440 trillion JP¥ (approx. $4trillion)[note 3] or over 40% of all outstanding government bonds.[17] 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.[18]

A debt based monetary system is when money creation is issued as debt from commercial banks (primarily). It is essentially leveraged margin that they created themselves, so there is no interest that needs to be paid on the margin. Large banks are required to have a 10% reserve requirement,[19] so they can only leverage up to 10 times their deposits / liabilities. Smaller commercial banks such as community banks and credit unions have zero reserve requirement.[20] The Federal Reserve can only create new money as debt as well, during quantitative easing they buy U.S. Treasuries and mortgage-backed securities.[21][22] When the principal is being paid back to the bank that money is erased/destroyed, the bank only keeps the interest from the loan as income.

Open market operations

Main article: Open market operation

Central banks can use open market operations to exchange liquidity in its currency with a bank or a group of banks. The central bank can either transact government bonds and other financial assets in the open market or enter into a repo or secured lending transaction with a commercial bank. The latter option, often preferred by central banks, involves them making fixed period deposits at commercial banks with the security of eligible assets as collateral. When a central bank buys back its bonds, bank reserves increase while outstanding bonds decrease.

Operations conducted by central banks can either address short-term goals on its agenda or long-term factors such as driving the expansion of its balance sheet or funding the minting of new currency to bolster the amount of physical currency in circulation. Traditionally, such a primary factor has been the trend growth of currency (notes and coins) in circulation.[23]

Money multiplier

Main article: Money multiplier

When commercial banks lend money, they expand the amount of bank deposits.[24] The banking system can expand the money supply of a country beyond the amount created by the central bank, creating most of the broad money in a process called the multiplier effect.[24]

Banks are limited in the total amount they can lend by their capital adequacy ratios and, in countries that impose required reserve ratios, also by these. Reserve requirements oblige commercial banks to keep a minimum, predetermined, percentage of their deposits at an account at the central bank. Many countries in the world, including the United States, Australia, Canada and New Zealand, do not impose minimum reserve requirements on banks. This does not allow commercial banks to lend without limit. However, since there is still, aside from other considerations, the capital adequacy ratio.

Degree of control

Whereas central banks can directly control the issuance of physical currency, the question to what extent they can control broad monetary aggregates like M2 by also indirectly controlling the money creation of commercial banks is more controversial.[25] According to the money multiplier theory, which is often cited in macroeconomics textbooks, the central bank controls the money multiplier because it can impose reserve requirements, and consequently via this mechanism also governs the amount of money created by commercial banks.[25][26] Most central banks in developed countries, however, have ceased to rely on this theory and stopped shaping their monetary policy through required reserves.[25] Benjamin Friedman explains in his chapter on the money supply in The New Palgrave Dictionary of Economics that the money multiplier representation is a short-hand simplification of a more complex equilibrium of supply and demand in the markets for both reserves (outside money) and inside money. Friedman adds that the simplification will work well or badly "depending on the strength of the relevant interest elasticities and the extent of variation in interest rates and the many other factors involved".[3] David Romer notes in his graduate textbook "Advanced Macroeconomics" that it is difficult for central banks to control broad monetary aggregates like M2.[27]: 607–608 

Monetarist theory, which was prominent during the 1970s and 1980s, argued that the central bank should concentrate on controlling the money supply through its monetary operations.[28] The strategy did not work well for the central banks like the Federal Reserve who tried it, however, and it was abandoned after some years, central banks turning to steer interest rates to obtain their monetary policy goals rather than holding the quantity of base money fixed in order to steer money growth.[29]: 464–465  Interest rates influence commercial bank issuance of credit indirectly, so the ceiling implied by the money multiplier does not impose a limit on money creation in practice.[30] By setting interest rates, central-bank operations will affect, but not control the money supply.[24][note 4]

Credit theory of money

Main article: 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[31] and because banks have been able to build up additional reserves when they were needed. 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.[32][33][24]

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".[31] The exact mechanism behind the creation of commercial bank money has been a controversial issue.

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).[34]

The model of bank lending stimulated through central-bank operations (such as "monetary easing") has been rejected by Neo-Keynesian[35] and Post-Keynesian analysis[36][37] as well as central banks.[38][39][note 5] 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.[40]

Bank of England told us in 2019: "Most of the money in the economy is created by banks when they provide loans.",[41] but not every provided loan is heightening bank money amount. It depends on payment flows after given loans.[42] (see table by Decker/Goodhart [2021] beside).

See also


  1. ^ Such as the Eurozone or ECCAS
  2. ^ 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
  3. ^ At a $1=¥0.0094 conversion rate
  4. ^ "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)
  5. ^ "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)


  1. ^ Bell, Stephanie. "The Role of the State and the Hierarchy of Money" (PDF). Research Gate. Cambridge Journal of Economics. Retrieved 29 December 2023.
  2. ^ a b European Central Bank (20 June 2017). "What is money?". European Central Bank. Retrieved 8 March 2018.
  3. ^ a b c Friedman, Benjamin M. (2017). "Money Supply". The New Palgrave Dictionary of Economics. Palgrave Macmillan UK. pp. 1–10. doi:10.1057/978-1-349-95121-5_875-2. ISBN 978-1-349-95121-5.
  4. ^ "Federal Reserve Board - Monetary Policy: What Are Its Goals? How Does It Work?". Board of Governors of the Federal Reserve System. July 29, 2021. Retrieved 15 August 2023.
  5. ^ 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.
  6. ^ "Monetary Policy". Federal Reserve Board. 2024. Archived from the original on March 20, 2024.
  7. ^ "Monetary Policy and Central Banking". International Monetary Fund. 2023. Archived from the original on March 1, 2024.
  8. ^ Jahan, Sarwat. "Inflation Targeting: Holding the Line". International Monetary Funds, Finance & Development. Retrieved 17 October 2023.
  9. ^ Department, International Monetary Fund Monetary and Capital Markets (26 July 2023). Annual Report on Exchange Arrangements and Exchange Restrictions 2022. International Monetary Fund. ISBN 979-8-4002-3526-9. Retrieved 17 October 2023.
  10. ^ Baker, Nick; Rafter, Sally (16 June 2022). "An International Perspective on Monetary Policy Implementation Systems | Bulletin – June 2022". Reserve Bank of Australia. Retrieved 17 October 2023.
  11. ^ Money supply, FRS
  12. ^ Mankiw (2012)
  13. ^ Mishkin, Frederic S. (2003). The Economics of Money, Banking, and Financial Markets (7th ed.). Addison Wesley. p. 643. ISBN 978-0-321-10683-4.
  14. ^ 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.
  15. ^ Fiscal policies, ECB
  16. ^ 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.
  17. ^ Gov't Bonds, Bank of Japan
  18. ^ Garbade, Kenneth D. (August 2014). "Direct Purchases of U.S. Treasury Securities by Federal Reserve Banks" (PDF). FRBNY Staff Reports no. 684.
  19. ^
  20. ^
  21. ^
  22. ^
  23. ^ "Open market operations". 10 May 2021. Retrieved 17 October 2023.
  24. ^ a b c d McLeay, Michael; Radia, Amar; Thomas, Ryland (2014). "Money creation in the modern economy" (PDF). Quarterly Bulletin. Bank of England. Retrieved 8 March 2018.
  25. ^ a b c Ábel, István; Lehmann, Kristóf; Tapaszti, Attila (June 2016). "The controversial treatment of money and banks in macroeconomics" (PDF). Financial and Economic Review. 15 (2): 33–58. Retrieved 17 October 2023.
  26. ^ Ihrig, Jane; Weinbach, Gretchen C.; Wolla, Scott A. (September 2021). "Teaching the Linkage Between Banks and the Fed: R.I.P. Money Multiplier". Retrieved 18 October 2023.
  27. ^ Romer, David (2019). Advanced macroeconomics (Fifth ed.). New York, NY: McGraw-Hill. ISBN 978-1-260-18521-8. The measures of the money stock that the central bank can control tightly, such as high-powered money, are not closely linked to aggregate demand. And the measures of the money stock that are sometimes closely linked with aggregate demand, such as M2, are difficult for the central bank to control.
  28. ^ Jahan, Sarwat; Papageorgiou, Chris (March 2014). "What Is Monetarism?" (PDF). Finance & Development. IMF. Retrieved 8 March 2018.
  29. ^ Blanchard, Olivier; Amighini, Alessia; Giavazzi, Francesco (2017). Macroeconomics: a European perspective (3rd ed.). Pearson. ISBN 978-1-292-08567-8.
  30. ^ Hubbard & O'Brien. "Chapter 25, Monetary Policy". Economics. p. 943.
  31. ^ a b Standard & Poor's (13 August 2013) "Repeat after me: Banks cannot and do not lend out reserves", Ratings Direct
  32. ^ Benes, Jaromir; Kumhof, Michael (2012). "The Chicago Plan Revisited". IMF Working Paper. 202.
  33. ^ Kumhof, Michael; Jakab, Zoltán (2016). "The Truth about Banks". Finance & Development. 53 (1): 50–53.
  34. ^ Schumpeter, Joseph A. (1996) [1954]. History of Economic Analysis. Oxford University Press. ISBN 978-0195105599.
  35. ^ Samuelson, Paul (1997) [1948]. Economics. McGraw-Hill Education. ISBN 978-0070747418.
  36. ^ Kelton, née Bell, Stephanie (1998). "The Hierarchy of Money". The Jerome Levy Economics Institute. SSRN 96845.
  37. ^ Mitchell, William (21 April 2009). "Money multiplier and other myths". Retrieved 8 March 2018.
  38. ^ Tucker, Paul (2007). "Money and credit: Banking and the Macroeconomy" (PDF). Bank of England.
  39. ^ Disyatat, Piti (February 2010). "The bank lending channel revisited" (PDF). BIS Working Papers. Bank of International Settlements. Retrieved 8 March 2018.
  40. ^ Wray, L. Randall (1 September 2000). "Money and Inflation". University of Missouri-Kansas City. SSRN 1010331.
  41. ^ BoE (2019): How is money created
  42. ^ Frank Decker, Charles A.E. Goodhart: Wilhelm Lautenbach’s credit-mechanics – a precursor to the current money supply debate, Taylor & Francis, 2021, DOI=10.1080/09672567.2021.1963796.

Further reading