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Notes and coins deposited
A condition under which the above is plausible is if the original deposit is made in N&C, assuming that N&C do rank as reserves. Let us explore this. First of all, N&C are issued by the CB. Thus, if Mr A deposits LCC 100 million N&C (which he had in a tin under his bed) at the bank his balance sheet will change as indicated in Box 10.
BOX 10: MR A (LCC MILLIONS)
The bank's balance sheet in Box 11 shows the deposit and an asset in the form of N&C. The bank now has a deposit on which it is paying interest and an asset that does not earn interest.
BOX 11: BANK (LCC MILLIONS)
Because N&C are liabilities of the CB, the bank will deposit them immediately with the CB; the results are shown in (continuous) boxes 12 and 13.
BOX 12: BANK (LCC MILLIONS)
BOX 13: CENTRAL BANK (LCC MILLIONS)
Because bank deposits increased by LCC 100 million, ARR = +LCC 10 million. The balance of +LCC 90 million is reserves that are in excess of RR, i.e. the bank now has LCC 90 million = ER. Like in the case of holding LCC 100 million in non-interest-bearing N&C, it now also has an asset (ER) that also bears no interest. If this bank liquidity state was permitted by the CB, interest rates will fall sharply and the bank will feverishly make loans in order to create a balance sheet that will produce an income.
How is this done? It is done by making loans, which creates deposits (= money); and this can take place up to the point where ER is absorbed into RR. This level is reached when new loans and deposits created are equal to:
The total deposit increase of course = LCC 1 000 million = this LCC 900 million + the original LCC 100 million N&C deposited. It will be evident that the M3 creation of LCC 900 million was based on the loans made by the bank and this could take place up to the point where the ER = RR. The outcomes are shown in Boxes 14 and 15 (continuous).
BOX 14: BANK (LCC MILLIONS)
BOX 15: CENTRAL BANK (LCC MILLIONS)
As these boxes may not be easy to follow, and to properly elucidate this issue, we present the net changes to all the balance sheets in Boxes 16-19.
BOX 16: MR A (LCC MILLIONS)
BOX 17: REST OF NBPS (LCC MILLIONS)
BOX 18: BANK (LCC MILLIONS)
BOX 19: CENTRAL BANK (LCC MILLIONS)
The above is just a pleasant and neat exercise, and it is presented in the interests of completeness and as an introduction to what follows. As we saw earlier, N&C make up a small part of M3, and while the above example is possible, it is unrealistic. However, it did demonstrate a critical point: that the banks can only "get rid of" ER in the manner shown. We will touch upon this later again.
It is often expounded that government spending (when government uses the CB as its banker) leads to money creation. In this example government spends LCC 100 million on goods bought from the NBPS (see Boxes 20-23).
BOX 20: GOVERNMENT (LCC MILLIONS)
BOX 21: CENTRAL BANK (LCC MILLIONS)
BOX 22: NBPS (LCC MILLIONS)
BOX 23: BANK (LCC MILLIONS)
The banks have ER of LCC 90 million. They can now lend up to the point where ER is fully transmuted / absorbed into RR. The end point is the same as in the N&C example: M3 can increase up to ER / r = LCC 100 million / 0.10 = LCC 1 000 million.
As in the above N&C example, this exposition is nonsense, and it is so because the original transaction is omitted from the story. It is a critical part of the story. The original transaction is that government either receives revenue from taxes or borrows the money. We will explore the latter case: government borrows LCC 100 million by the issue of bonds (bought by the banks) and spends this on goods bought from the NBPS (see Boxes 24-27).
BOX 24: GOVERNMENT (LCC MILLIONS)
BOX 25: CENTRAL BANK (LCC MILLIONS)
BOX 26: NBPS (LCC MILLIONS)
BOX 27: BANK (LCC MILLIONS)
Note the difference from the previous example where the original transaction was omitted: M3 (deposits of the NBPS) increased by LCC 100 million and the BSCoC is bank loans (buying new bonds = new loans extended). The previous example gives a starkly different picture: the creation of ER.
In fact the correct story is that the banks are actually short of RR - because bank deposits have increased (that carry an r of 10%). We omitted this issue in the interests of simplicity. We now correct the issue in Boxes 28-29.
BOX 28: CENTRAL BANK (LCC MILLIONS)
BOX 29: BANK (LCC MILLIONS)
As we have said before, the banks are not able to create CBM; only the CB itself can do this. The bank is therefore obliged to take a loan from the CB at the KIR rate.
Money creation starts with a bank loan
In real life the causation path on money creation runs from bank loans (= bank asset) to money (= bank liability). Note the following:
• All money creation takes place this way when N&C do not rank as reserves (as is the case in some countries).
• The vast majority of money creation takes place this way when N&C do rank as reserves. The latter is so small that it can be ignored.
The RR is often presented as a crucial factor in money creation. It only comes into play in that as NBPS bank deposits (= money) increase, as a result of new bank loans or bank purchases of newly issued securities (= loans in a different form), the amount of RR increases. The banks can get the additional RR only by borrowing from the CB (remember the banks cannot create CBM).
The previous example of the government borrowing and spending is a true life example. Here we provide another (see Boxes 30-33). It is the same as the first one presented earlier but with the RR and the CB included.
BOX 30: COMPANY L (LCC MILLIONS)
BOX 31: COMPANY B (LCC MILLIONS)
BOX 32: BANK (LCC MILLIONS)
BOX 33: CENTRAL BANK (LCC MILLIONS)
The introduction of the RR here does not indicate that the RR is an important element in money creation. It is not; in fact it is a quantity that is a consequence of money creation and not a quantity that steers money creation. It is just one of the many factors that affect bank liquidity, an issue that CBs deal with every day. We will return to this issue, which is part of monetary policy, but in a different form.
Essentially, monetary policy is about the item "CB loans to banks" and the KIR that is applied to these loans. The existence of CB loans to banks, the outstanding amount of which is also called the money market shortage (MMS) or the liquidity shortage (LS), is what makes the KIR effective and influences the banks' interest rates on both sides of their balance sheets, and through this the demand for loans.
It needs to be swiftly added that in exceptional times (as during the recessionary period of 2008/09), some CBs resort to creating ER for the banks, but buying large amounts of government bonds. This policy "encourages" interest rates down to very low levels and thereby an increased demand for loans (remember underlying an increase in bank loans / money is an increase in C + I = GDE). This vital issue is not discussed in detail here.
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