In the subject of financial economics, there comes the point when an organization needs to plan for increasing its money supply. To do so efficiently, marketers came up with the concept of money creation. Well, before the introduction of this concept, other methods were being used to increase the money supply. But, none of them gained popularity as the method of money creation. It is because of this method that marketers find it very convenient to boost the money supply of their company. Here, you will learn about the process of money creation including its theories, examples, and working fundamentals.
What Is Money Creation?
Money creation is the concept of financial economics dealing with the processes adopted to boost the supply of money in an economy. Among various methods used to promote the amount of money, the most common one adopted by the marketers is money creation. This process holds a strong significance in an economy as it contributes to a boost in the liquidity of an economy. Considering the subject of modern economics, most of the money supply in an economy is done in the form of bank deposits. The central banks must regulate the total amount involved in the development of an economy. To do so effectively, the central banks seek the help of numerous tools to measure monetary aggregates.
The process of money creation is also considered to be one of the most important responsibilities of commercial banks. Money creation is a technique that allows these banks to generate credit which is a lot more than the initial deposits. Thus, the process of money creation compels the banks to maintain a minimum amount of money from their deposits as cash reserves. The central bank must fix this fraction of money is known as the Legal Reserve Ratio (LRR).
Fundamental Money Creation
The fundamental of this method acts as an introduction helping you to gain a better understanding of money creation. It educates you regarding the contribution of the financial system and banking sector to the creation of fresh money. Apart from this, accounting entries also play a vital role in generating money stock and bank deposits. Money creation majorly depends on the Reserve Requirement (RR) which acts as the heart of the process. According to the reserve requirement, it is essential to place the required reserves in possession of the central bank. This reserve is then introduced back in the banking system in the form of deposit.
Further, the RR is calculated based on this deposit, and the central bank owns the new reserve. But, have you ever thought about how do countries manage to create money with their central banks lacking the required reserves? The reason behind this being is that they have money in the form of bank deposits created when banks make loans. Therefore, in fundamental money creation, reserve requirement (RR) is one of the various aspects of economics affecting the liquidity in a bank.
Example of Money Creation
Let us try to decipher the code of money creation with the help of an example given as follows:
Say the initial deposits in a bank is $10000 out of which the legal reserve ratio (LRR) is 20%. According to LRR, it is imperative for the banks to maintain $2000 as a cash reserve allowing them to trade freely with the remaining $8000. Now, trading the remaining 80% of the sum doesn't allow the bank to lend this money in cash. Instead, they can utilize this amount to lend the money as a loan at a fixed rate of interest. Now, if the amount lent by the bank is exhausted by the borrower; it is diverted back to the banks in the form of cash deposits. This in return, profits the bank by increasing its deposits by $8000. Now, with this new deposit of $8000, banks need to maintain 20% out of it as the legal reserve ratio; and the remaining $6400 can be traded again. Again, banks lend the remaining money to borrowers which again deposits this amount in the banks and process keeps repeating itself. Therefore, this repetitive process helps to equalize the total cash reserves to the initial deposit contributing to the money creation.
Fractional Reserve Theory of Money Creation
Fractional reserve theory gives us an understanding of the procedures involved in the maintenance of cash reserves by the bank. It highlights the possible ways in which a bank trades the remaining amount in the market. The money which is being used in trading is the people's money deposited in the bank. Therefore, the demand for money is generated by the willingness of the people to trade their money. The theory of the fractional reserve emphasizes an economic point of view producing a similar outcome to that produced by a contemporary method.
Therefore, this theory results in earning profits out of nowhere leading to the increasing consumption independent of the production. But, in the real market, the central banks are not concerned with the money supply; instead, they target the overnight, growing interest rates. In various aspects of the economy, it is argued that the demand for loans is the most crucial source for monetary expansion. Thus, the extension of credit and money supply leads to the increasing demand for loans contributing to money creation.
The Credit Theory of Money
The credit theory is referred to as the monetary economic theory highlighting the relationship between credit and money. This theory also proposes that money and credit hold almost equivalent value depending on the viewer's perspective. According to this theory, credit is an essential aspect of money where the money does not have a reliable backup. It sheds light on the two most common ideas for money creation. One of the two ideologies states that the position of money creation comprises of a regular generation of debt.
On the other hand, the second ideology gives an argument that debt is the best way to understand the concept of money creation. After comparing both the doctrines, it can be concluded that the value of money and credit becomes equivalent in fiat money. Thus, it can be successfully stated that all forms of money can be classified under numerous categories of credit money.
Money and Multiplier Effect: Formula and Reserve Ratio
The multiplier effect elucidates the increase in economic activity contributing to a more significant increase in economic output. In financial terms, the money deposited in a bank goes through various filters in the economy varying from a depositor to borrower. Moreover, if there is any change in bank reserves, it will directly affect the money supply by a multiple of that amount. The multiplier effect educates you regarding the increase in one economic activity. The increase in this economic activity leads to a much higher increase in economic output.
The formula for money multiplier is given as follows:
Money Multiplier = 1/Requiured Reserve Ratio (RRR)
It is nothing but a fraction of a customer's deposit that is being held by the bank for its functional operations. This fraction of money is maintained by the bank in its vault or deposited with the central bank. Thus, banks are compelled to maintain a reserve ratio as they need to deposit a portion of the investment made by an investor.
Why Are Banks Allowed to Create Money?
In the continuously developing economy, the need for liquidity is also overgrowing. To carry out the daily operations successfully, it becomes crucial to create money. Thus, it is the central bank's duty of that nation to introduce an effective monetary policy to boost its economy. The main objective of the central bank is to ensure the price stability considering factors like inflation, the employment rate, interest rate, etc. Being a banker of the government it is the role of the central bank to provide with an effective layout to create money.
Moreover, ignoring a few exceptions central banks operate successfully in almost every nation around the globe. These central banks are independent and work without any governmental interference. It is the central bank's authority to impose interest rates by controlling the base rates affecting the stocks in an economy. Thus, due to the deep significance of the central banks, they must carry on money creation for a nation.
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