Saturday, March 22, 2014

How is New Bank Money Created?

Updated: in the original post I caused confusion by not properly distinguishing total money from broad money supply.

By “bank money” I mean the type of “credit money” represented by demand deposits and demand deposit-like accounts, such as checking accounts, transactions accounts and even some (so-called) savings accounts.

This credit money forms part of the broad money supply.

In general money supply measures can be divided into two categories (with the example below using the US money supply aggregates):
(1) High-powered money (= monetary base, base money, M0)
The “money base” consists of currency in circulation and bank reserves (both required and excess reserves). The monetary base includes all cash and coins, even vault cash at banks, as well as deposits that banks hold at the Fed (which are reserves).

(2) Broad Money (M1, M2, M3)
To take M1, this includes:
(1) currency in circulation outside bank vaults (and also excluding bank reserves),
(2) demand deposits and demand deposit-like accounts (checking/transactions accounts), and
(3) travellers checks.
M1 excludes vault cash and bank reserves at the central bank. “Demand deposit” money can also be called “book money” or “bank money.”
When cheques, debit cards, electronic funds transfer at point of sale cards (EFTPOS or UK “chip and PIN” cards) are used in purchases, this is an example of a sale made by means of bank money. Although final clearing between banks is effected by transfers of high-powered money (which, because of information technology, happens much faster these days than in the past when people used cheques), nevertheless the “bank money” or “demand deposit” money is used extensively in everyday transactions.

But how is bank money created and destroyed? The process is obscured by the way “broad money” aggregates (like M1 or M2) exclude vault cash and bank reserves at the central bank.

But some examples of how bank money is created and destroyed can be made clearer in a simple model:

(1) Method 1:
When a person “deposits” cash in a bank account, this creates bank money, because the demand deposit increases while the actual cash is transferred to become part of the bank’s reserves. Of course, if the cash was “withdrawn” from another bank account, bank money will be destroyed there, but will be created again when the cash is “deposited” in the new account.

To see this, think of an economy with $120 million of total money, as follows:
(1) High-powered money: $20 million;

(2) Bank Money: $100 million.

(3) Total Money: $120 million.
Now if a person with a demand deposit “withdraws” $1 million in cash from a bank:
(1) High-powered money: $20 million (possession of $1 million in cash transferred from a bank vault cash to a person);

(2) Bank Money: $99 million (decreases by $1 million);

(3) Total Money: $119 million.
Now the person deposits this $1 million in cash into a bank account:
(1) High-powered money: $20 million ($1 million in cash transferred back to a bank’s vault cash)

(2) Bank Money: $100 million (increases by $1 million).

(3) Total Money: $120 million.
(2) Method 2:
When money is paid into a bank account electronically from another bank account, this will destroy broad money in latter case and create broad money in the former demand deposit. Of course here broad money will be destroyed and recreated quickly or simultaneously so that it nets out to zero quickly.

(3) Method 3:
When a bank grants credit by creating a new demand deposit it creates new broad money: again think of an economy with $120 million of total money, as follows:
(1) High-powered money: $20 million;

(2) Bank Money: $100 million.

(3) Total Money: $120 million.
Now a bank creates a new demand deposit by granting credit of $1 million:
(1) High-powered money: $20 million;

(2) Bank Money: $101 million (increases by $1 million);

(3) Total Money: $121 million.
In Method 3, it may be that the central bank will eventually have to create new reserves (or high-powered money) when banks need more for clearing, but here we see how even base money creation is driven by the private sector demand for it.

I also hasten to point out that because of the technical way that broad money aggregates are generally calculated (to exclude bank vault cash and bank reserves at the central bank), method 1 does not technically cause an increase in broad money supply aggregates, because cash held by the public is reduced as it is transferred to bank vault cash (so that changes in both bank money and cash held by the public net to zero).


  1. This is a good *start*, but I think it's worth taking the next step in the argument.

    When you deposit $1 million in the bank, it creates $1 million of bank money, and it transfers $1 million in high-powered money from you to the bank vault.

    Many people will (correctly) argue "But the money in the bank vault isn't in circulation. Only money in circulation really matters; we don't care about the total amount of money, we care about the amount in circulation."

    HOWEVER -- the bank can now lend out the $1 million, putting it back in circulation. The demand deposit still exists *and can be spent* so the bank money still exists. So at this point, there is actually more money in circulation.

    The next objection will be as follows: "Ah, but suppose the bank lends out all its high-powered money, and then $20 million is withdrawn from the demand deposits and spent. The bank won't have the money."

    This is called a bank run, and in the US today, the Federal Reserve *promises* to print enough additional money to satisfy the bank withdrawals. In short, the Federal Reserve *promises* to make enough high-powered money to back up any money the bank makes.

    If we didn't have the Federal Reserve and FDIC, then a bank run would effectively destroy money, as people who thought they had money (in their demand deposits) would discover that they didn't.

    Most of the time, however, people write checks against their demand deposit accounts. *This also creates money*; the check is money. Until it is cashed or deposited, it is circulating additional to the deposit account. When it is cashed or deposited, the money is destroyed.

    Since checks are usually deposited (often back in the same bank), this also means that the banks don't often have to go to the Federal Reserve for high-powered money; they just change numbers around in their internal accounts.

  2. Also worth noting: in poorer communities, postdated checks and IOUs will often circulate. *These are money* -- privately created money. Money is created to fill demand, and for people who the banks won't lend/give money to, they find other ways of making it.

    1. Do you have some references for how "in poorer communities, postdated checks and IOUs will often circulate"? That would be interesting to read.