Feb 22, 2010

Money creation: a basic approach

We have argued before the important role of prices within the economy. We should extend this importance to an underlying factor that affect the price level: inflation. Although this article is not about inflation per se, the positive correlation between money creation and the price level must take part of the analysis.

Most modern economies around the world have found and ally in the monetary policy to control the price stability, stabilizing financial markets and boosting economic growth, i.e. production.

The money supply, by its unique nature, is controlled by the Central Bank. Central Banks have many functions, among the most important: clearing house, lender of last resort and implementing monetary policies.

So, how to create money?

Imagine a crusoe economy, well, for the better explanation, imagine an economy with 3 men, one farmer, one engineer and one economist, named Bill, Tom and Steve; and only one commercial bank controlled by the Central Bank.

Each year Bill produces 1000 apples, which he sells at one silver coin each. That makes Bill the happy owner of 1000 silver coins. So, Bill goes to the Bank and deposits his coins. 

The Central Bank in order to prevent a potential disastrous bank run forces the bank to keep 10% of its deposits as reserves. The remaining 90% of the deposits can be lend out. In the case of Bill that would make 100 silver coins as reserves and 900 to lend out. 

So, one day the Tom, the engineer, has a great idea and decides to come by the bank for a loan. He wants to build an apple harvesting machine. The banks loans him the 900 silver coins he has from Bill.

To pay for the things Tom need, he has to deposit his money in the bank. So he goes to the bank and deposit his 900 silver coins. Once again the bank is forced to keep 90 silver coins as reserves.

The next morning, Steve, the economist, comes for a productive loan and gets the remaining 810 silver coins the bank has from Tom. He deposits his money in the Bank, which is forced to keep at leat 10% of each deposit, let assume this time, the bank keeps the 100% of the money.

Now lets review our steps: First Bill deposited 1000 silver coins, then Tom deposited 900 silver coins and finally Steve deposited 810 silver coins. That makes a total 2710 silver coins!! The economy started out with only 1000 silver coins!

Well obviously, there are many simplifying assumptions behind this model. But it is quite the basic functioning of money creation: Banks lend out their reserve surplus to stimulate the economy, whoever receives the money returns it to the banking systems which lend a fraction of it out again, and so on, multiplying the quantity of money in the economy, that’s why we know this as the Multiplier effect of money.

Later on we’ll have to discuss the impact of this fictional money, the role of the Central Bank to prevent massive bank runs, how does the reserve % affects the economy, and how this fictional money affects the price level. But please don’t worry; we’ll continue the story of Bill, Dave and Steve. As they got much to learn about macroeconomics and monetary policies!

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