Money Creation


To give perspective to the Keynesian analysis, I will attempt to give a very brief, and maybe somewhat simplistic, view of how money is created in today's world.
I will create a separate post for each of the different forms of money creation.

Bank Credit.


Firstly we must look at the Banking sector. The commercial banks are given the right to create money, by giving loans, out of the deposits they hold. When a bank grants you an overdraft and you write out a cheque to someone who deposits the money. If that money were deposited in the same bank there would be no complications and the bank would simply have a liability to one of its customers and in turn an asset, in the form of a loan to another customer. When the person you gave the cheque, deposits it in another bank, if that bank is happy to accept your bank as a debtor (your bank borrows money from the other bank), all is well and good. In both these cases money has been created, which if considered with the new deposit that resulted from you writing out a cheque the process begins all over again.
Technically therefore the supply of money is infinite, or, let's say the process is like a chain letter and will continue “ad infinitum”, until people start “breaking the chain” by drawing cash, or importing goods from other countries beyond the level of our exports, or banks start refusing to accept each other as debtors on their books.
Generally Governments control the expansion of bank credit by requiring banks to hold a certain proportion of prescribed assets in relation to the deposits on their books. These assets are usually cash (currency), deposits with the Central Bank and or government bonds. They are called Liquid Reserves, their main functions were to protect Banks against a run on the Bank.
For the record in 1971 in the UK banks were required to hold 1.5% of their liabilities in non interest bearing deposits with the Bank of England and a further 8.5% in cash or government bonds. By the time of the Bank of England Act in 1998 the requirement for a liquid reserve had been abolished outside of a non interest bearing deposit with the Bank of England equal to 0.15% of deposits.
A few statistics
Ratio of Bank Liquid Reserves to Deposits (actual position as opposed to legal requirement):
  1968 1978 1988 1998
United Kingdom 21% 16% 5% 3%
United States 12% 10% 9% 10%
Germany 19% 19% 17% 12%



Sources: IMF Statistical Year Books.


Note in the USA there is only a requirement for a liquidity ratio in respect of demand withdrawal accounts and that is 20%. The UK 3% is not a requirement simply Bank prudence, it appears to have risen to 7% in 2011. In respect of Germany the requirement in the Euro Zone was 2% in 1998, and has been reduced to 1% this year. Japan is still operating around the 12.5% mark. China is currently at 20%.
China actively uses this ratio to increase and decrease money supply in its local market as a means of keeping inflation within a manageable range.




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