How do central banks create money?

Discussion in 'Economy & Infrastructure' started by ajay_ijn, Sep 11, 2009.

  1. ajay_ijn

    ajay_ijn Regular Member

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    I don't mean printing money. but about how it enters economy.

    first let us simply assume that Central Bank lends commercial banks some money, 100 billion, Commercial banks have to pay back the money with interest of 10% at the end of the year.


    Assume there are 1000 billion already in the system. So when the new money worth 100 billion enters economy, it becomes 1100 billion.

    Now consider Commercial Bank A got the entire 100 billion money. They lend all the money to public at 20% which means at the end year they will get 120 billion.

    Now public got that 100 billion, spend the entire money and the money went into other hands who deposited in other banks,
    banks lend that money others again, they were deposited in another bank, and again that bank lent that money, so it continues.

    no matter who lent to whom, and who deposited in which bank.
    the net money in the system is 1100 billion only. Is this Right?, 100 billion USD is just changing hands from public to banks and to public again like a cycle

    net assets minus liabilities has to be 1100 billion at any point of time.


    now at the end of the year, Commercial Bank A received 120 billion from public.
    So Bank A had repaid the 110 billion to central bank and made a profit of 10 billion .

    Now total money in the system is
    1100 billion - 110 billion = 990 billion

    its less than 1000 billion. So did Central Bank create money or took out money already present in the system?



    the thing which confuses me is
    how money multiplies?

    how can 100 become 120 without that additional 20 being created by the govt?
    if govt doesn't create that additional 20, then it has come from the system which means money is not being created but is simply changing from one hands to another.
     
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  3. ajay_ijn

    ajay_ijn Regular Member

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    Can we assume that whenever Central Banks charges interest rate of greater than 0%, they are just taking out more money from the system because commercial banks have to pay back the principal amount+interest. Interest has to be money already present in the system.
     
  4. LETHALFORCE

    LETHALFORCE Moderator Moderator

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    How Do Central Banks Work? | Ask TheStreet News | Print Financial & Investing Articles | TheStreet.com

    How Do Central Banks Work?
    Jonas Elmerraji
    08/21/07 - 01:47 PM EDT
    Editor's note: Ask TheStreet is designed to answer questions about the market, terms, strategies and investment methods. Please email us to ask a question, but keep in mind that we cannot offer specific investment- or stock-related advice.

    How do central banks inject billions into their economies, and does that money need to be paid back? -- C.P.

    Central banks look out for the monetary policy of their countries. When a country's economy is in trouble, it is the central bank that can "save" the proverbial day, but how central banks manage that feat is the trillion-dollar question.

    What Is a Central Bank?

    Central banks are responsible for controlling the monetary policy of their countries. Essentially, this means that one of their key jobs is to manipulate the money supply in that country to meet its economic goals (such as market growth growth).

    Here in the U.S., the central bank is the Federal Reserve (commonly referred to as "the Fed"). Other important central banks around the world include the European Central Bank european-central-bank-ecb, the Bank of England and the People's Bank of China.

    But you might be wondering why everyone's always on "Fed watch." It's because the money supply really is a big deal. Here's why.

    Money Doesn't Grow on Trees

    Most people will agree that money is a limited resource. While that Lamborghini would definitely make a nice addition to my driveway, I can't really afford the $311,000 price tag. The same is true for the economy -- as a whole, money is scarce.

    But from an economic standpoint, the scarcity of money doesn't just affect what we're able (or not able) to buy. Factors such as inflation inflation, employment rates and market market growth growth are all affected by the money supply situation.

    When the economy is hurting, it's often because the money supply is low. One way to counter this is by simply increasing the amount of money, or liquidity liquidity, that is present in the economy. Conversely, if the economy is growing too fast (a sign of bad inflation to come) decreasing the money supply is often the Fed's solution. Economists refer to increasing the money supply as "expansionary policy," while decreasing it is known as "contractionary policy."

    And the Fed has been pretty successful, according to Tim Gindling, a professor of economics at the University of Maryland, Baltimore County. Gindling says, "Since the Great Depression, the Federal Reserve has done a good job using their control over the supply of money to stabilize the economy. The most clear evidence of this is that we have not had a depression depression since the 1930s."

    Believe it or not, though, there's more to controlling the money supply than hitting the start button on those machines that print greenbacks. Here's how they go about it.

    How Central Banks Control the Money Supply

    Methods used by central banks to control the money supply can vary a bit from country to country, depending on the powers that are vested in the central banks. Here in the U.S., there are three main ways that the Federal Reserve is able to alter the money supply:

    * Reserve requirements
    * Interest rates
    * Open market operations

    Reserve Requirements

    As a rule, banks are mandated to keep a certain percentage of all deposits in the bank. This is known as the "reserve requirement." The Fed sets the reserve requirement for U.S. banks. By decreasing the reserve requirements, more money is available for the bank to lend out, and the money supply increases.

    Interest Rates

    The control that a central bank has over interest rates can differ quite a bit from country to country. Contrary to what many believe, the Fed doesn't set the interest rates you pay on your mortgage mortgage (because it can't). That's not to say that the rates the Fed has control over aren't important -- you can bet that they trickle down to the consumer level.

    Domestically, the Fed has direct control over the "discount rate," the rate the Fed charges banks that borrow from it. The Fed also has some level of indirect control over the "federal funds rate," the rate that banks charge each other for overnight federal loans.

    Most recently, the Fed lowered the discount rate to 5.75% from 6.25% (see "Fed Cuts Discount Rate" and "Fed Plots Measured Course" ), a move that was designed to increase the money supply and add liquidity liquidity to the economy.

    How does changing interest rates accomplish that?

    From an economic perspective, interest rates are the "cost of money." Therefore, decreasing interest rates lowers the cost of money and increases the money supply. But while adjusting reserve requirements and interest rates are effective ways to change the money supply, their results aren't as quickly seen as is often necessary. That's where open market operations come in.

    Open Market Operations

    Open market operations are a way of affecting the money supply by buying or selling securities -- usually government securities. Essentially, if the Fed wants to increase the supply of money, it turns to the market and purchases Treasury securities (such as T-bills treasury-bill-t-bill, T-notes treasury-note and T-bonds treasury-bond). When it buys these securities, it gives the sellers money, and that increases the supply of money in the economy.

    When the Fed wants to decrease the money supply, it does so by selling Treasury securities and collecting money in exchange. The Fed makes these trades by using its reserve cash. And because the Fed doesn't issue the securities that it trades to change the money supply, making good on the promises of those Treasury securities is the responsibility of the U.S. Treasury, not the Fed.

    Because the U.S. economy isn't in dire straits on a daily basis, the most common type of open market operation the Fed engages in is an overnight repurchase agreement, or a "repo." A Fed repo basically alters the money supply for a short time, by temporarily buying or selling government securities (see "What's the Fed Really Up To?" on TheStreet.com TV).

    It's also worth noting that the Federal Reserve's open market operations are not relegated to government securities. While government securities have historically been the instrument of choice for the Fed and other central banks, the Fed has "saved the day" in other ways as well.

    For example, the Fed recently bought $38 billion in subprime mortgages and other securites (see mortgage-backed security mortgage-backed-security), and that increased the money supply and added liquidity to the battered subprime home loan market at the same time (see "Wall Street Limits Damage"). (To learn more about subprime mortgages, check out ""Booyah Breakdown: Subprime Time" and "Why Mortgages Blew Up").

    Consider This

    While most people probably don't pay much attention to the Fed's nightly "repos," the fact is that those actions have a huge impact on the finances of investors and companies.

    And there are definitely right and wrong ways to add money to an economy. The wrong way often includes printing massive amounts of money that can lead to hyperinflation. Many countries have fallen victim to bad monetary policy as a consequence of politics or unrealistic borrowing. Such has been the case most recently with Zimbabwe, a country whose annual inflation rate is climbing beyond 3,700% (see England's Times Online).

    By comparison, U.S. inflation for 2006 was around 2.5% (see CIA data). Zimbabwe's practice of printing money as a means of alleviating debts has proved to be a big contributor to its monster inflation rate.

    By using tactics such as open market operations and interest rate manipulation, central banks (including the U.S. Federal Reserve) work hard to make sure that the country's economy operates in a healthy, sustainable manner.
     
  5. ajay_ijn

    ajay_ijn Regular Member

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    I think i might have understood.

    every single rupee in the system is actually lent by RBI. Even before lent money is paid back, RBI lends even more money depending on the economic situation.

    So even before 1100 billion becomes 990 billion. RBI would lend another 200 billion. RBI continously lends money to the System, its a never-ending process. So the difference between money paid back and money lended is the new money being pumped into the system.
     
  6. Antimony

    Antimony Regular Member

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    I admit to sleeing through my Macro lectures but some of this confuses me more than it should

    The very first assumption is confusing. Why should the Central Bank lend money to the Commercial Banks? Commercial Banks do not usually borrow money from the Central Banks (they do keep deposits there) unless there is a severe liquidity crisis. They do borrow from other banks at a pinch, which is why you have interbank lending rates like LIBOR and MIBOR.

    Normally the public keep deposits in the Commercial Bank, and the Commercial Banks themselves keep a part of that deposit with the Central Bank.

    You said there is 1000 billion in the system. A part of that money would be in the banking system in the form of deposits. The rest would be held in cash by the public.

    Your questions regarding money creation may be answered by an explanation of Fractional Reserve banking

    Simply put, you (or the Central Bank as per your example) deposit Rs. 100 in the bank. The bank keeps part of it in reserve and lends out the rest to some other bank. That other bank then keeps part of it and lends out the rest. After some point, you basically add the amounts lent out and the amounts in reserve and that gives you the total money supply. Wiki has a nice table where it is all worked out

    Money creation

    If you go through the example you will see that the lower the reserve requirements, the greater is the multiplication effect. A 10% reserve requirement multiples money much faster than a 20% reserve.
     
  7. Yusuf

    Yusuf GUARDIAN Administrator

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    I have always wondered that when you have the mint, why do govts borrow money from elsewhere? Why does India have to go to the WB or IMF? Why not print money to finance projects. I know you cannot do that and it's based on some economic rationale, but I never stop wondering why it cannot be done.
    The US has done it in the past to get rid of debt, and it's entirely possible that it will do it again as it owes china trillions.
     
  8. Daredevil

    Daredevil On Vacation! Administrator

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    It will lead to hyperinflation and the currency will lose value. You have to back up the currency you mint with something which has real value like gold, property, manufacturing goods, infrastructure, services, foreign exchange etc. As the economy grows over the time, the value of the above mentioned things will also increase and so your currency value also increases.
     
  9. ajay_ijn

    ajay_ijn Regular Member

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    LIBOR, MIBOR will be trading of wholesale money which is already there in the system. but how would new money enter the system?

    I had read this in some other website. But what i can't understand how can we call that as production of more money.

    It is only the 100 which is changing hands from bank to borrower to another bank.

    Bank A Liability- Rs 100
    Assets - Rs 80
    Reserves- Rs 20
    net Assets- Rs 0 (considering bank doesn't charge any interest)

    So if that 100 is withdrawn from Bank A. all the money created will be gone including the reserves.

    Even if Bank charges any interest, that money has to again come from borrower which is already present in the system. So Banks gain will be Borrowers liability/loss. Net gain in the system is again zero.


    however real life, assets are always greater than liabilities.why
     
  10. ajay_ijn

    ajay_ijn Regular Member

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    antimoney, i read that wiki article on fractional reserve banking, and my previous assumption was right. if Central bank stopped lending, all the money in the banking system will be wiped out or destroyed. because eventually most of the money in the economy will be paid back to central bank.

    Fractional-reserve banking - Wikipedia, the free encyclopedia
    new money is indeed lent by Central Banks and it is lent more n more to pump new money into the system. Its a never ending process of lending. even before old money is paid back, more money is lended to banks depending on economic situation.
     
  11. thakur_ritesh

    thakur_ritesh Administrator Administrator

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    Ajay,

    if you follow the example sighted in the article posted by LF, it becomes rather clear that nothing, absolutely nothing stops the central bank from creating more money, which would mean printing more money and put the same into circulation, and that gets clear from the comparative analysis presented on zimbabwe and the us.

    but so that the economy does not falter and falls in a trap that we today find in the case of zimbabwe, and certain other economies and so that the basic economic fundamentals remain strong we create money on the basis of multiplier effect. the basis of this multiplier effect are the ones specifically sighted by badguy last night, which would be commercial lending to the commercial banks, through trading in foreign exchange, and issuance of bonds, securities, which can both be bought and sold, again these three examples have been well presented in the article posted by LF.

    once this money is in circulation, that is, when this money is given on loan to commercial banks (or any of the other 2 examples sighted above) the multiplier effect starts since the same is given at a certain interest rate, a rate that can be manipulated, depending on the situation that arises or there is a margin made. now as this money grows in the economy, the same gets reflected in the account books of the central bank, and this growth will be dependent on the amount that was loaned as rightly sighted by antimony, and what those factors of lending will be again have been spelt out in LF's article.

    ............. or so i understand :D
     
  12. ajay_ijn

    ajay_ijn Regular Member

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    thakur, your were in saying that Central bank pumps into money depending on the average profit every individual, business entity and bank earns.

    Average profit is nothing but increase in consumption/production or increase in value of production/services. That is exactly the definition of GDP growth.

    But multiplier effect is changing money from one hand to another. If you consider accounts of every person, bank, in the system, the net creation of money is zero.

    just like i pointed in my previous
    if Bank A lends 80 Rs and keeps 20 Rs as reserves. Bank A also has a liability of 100 Rs, it has pay back the money when the depositor demands. So in effect net creation of money by Bank A is zero. Its same for every bank.

    but this changing hands from one to another is what economy is all about. The more money increases in value by this changing hands, the more extra money Central bank will pump into the economy.


    Money creation - Wikipedia, the free encyclopedia
    to be more specific. consider the table in this article posted by antimony.

    consider Central Bank lent 100 Rs to Bank A. and a shown in that table, Bank A lends 80 Rs to Bank B and keeps 20 as reserves. that continues like a never-ending cycle with money changing hands from banks to borrowers to banks etc

    Now Central Bank expects Banks, Individuals, Business entities will multiply this money value by say 10% on average that means they charged interest rate, earned average profit of 10% . So Central Bank will now pump in 110 Rs in the system even before Banks repay 100 Rs.

    if Central Bank pump doesn't pump in 110 Rs, Then Bank A will repay that previous 100 Rs and entire money will be lost in the system.

    if average profit is less than 10%, say 7%. it means there is excess liquidity in the system, So Central Bank will suck out that 3 Rs. if Central doesn't remove excess liquidity, then inflation will rise and money value falls.

    but if average profit is 13%, the Central has to pump 3 Rs more into the system.

    and this cycle continues forever. if Central Bank ever stopped lending to the system, then all the money will repaid to the Central bank and there will be no money in the system.

    for better understanding refer to this article.
    http://en.wikipedia.org/wiki/Fractional-reserve_banking#Money_creation
    It says most of money in any given money supply consists of commercial bank money. So much of money is owed to commercial banks, and commercial banks inturn owes money to mother of all lenders- Central Bank.


    what it simply means is
    when loans are given out money is created in the system
    when loans are paid back money is destroyed in the system.

    if economy grows consistently like ours, then Central Bank has to give out more loans than what is being paid back.

    if there is too much liquidity in the system and inflation is rising, then Central will give out less loans than what is being paid back.

    if economy doesn't grow at all, and is in a recession like US, still Central bank will give out more loans than what is being paid back to encourage spending. But there is risk of inflation, So Central Bank will also have make sure excess liquidity is taken out before prices start rising.

    when Central Bank raises interest rates when inflation is high because that money for interest taken out the system when loan is being paid back. That effectively sucks out liquidity.

    But if Bank is still lending more than what is being paid back, it will negate that rise in the interest rates because people don't mind borrowing costly money as there money supply is still growing.
     
  13. thakur_ritesh

    thakur_ritesh Administrator Administrator

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    absolutely right and no contradiction there mate, you and i or some one else does not create money, it is as a matter of fact same money that is going around in circulation, where some one is making money and some one is loosing, which in effect is just exchange of hands.

    what i am pointing to is that the when the money flows from the source (ie the central bank) then the same happens on 3 basis as was sighted by badguy, and it is here where the money supply increases and depending on this increase the same gets reflected in the account books of the CB, which in turn means there has been creation of the money.
     
  14. ajay_ijn

    ajay_ijn Regular Member

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    the basis sighted by badguy or in many articles says

    1- open market operation
    Central banks buys Govt bonds from people there by injecting new money into the system. Every article says this is how new money created in the system by Central Banks.

    But i can't understand how.
    When Public buys bonds from the govt, it pays money to Govt.
    Money is out of the sytem.

    Now Central banks buy the bonds from public in exchange of money.
    Money is in the system.

    net creation of money is zero.


    When bond period matures, Govt pays money to Central Bank. So Central bank also got their money back.

    Also most articles indicate the same thing as antimony posted- fractional reserve banking. Every one says money multiplies with that. But net money creation is zero again.

    most articles talk a lot about commercial bank reserves by which Central Bank controls money supply. But still that money must be lent by Central Bank. if Central bank lends, money should finally go back to the central bank itself.

    the only easy thing to understand here is forex market. Central Banks simply can buy dollars in exchange of rupee there by creating money into the system.

    i have been banging my head to the wall for days to understand this but i am still not confident that my own answer for this true. I couldn't confirm it clearly from any other sources. question is so simple but getting convincing answer is so difficult.
     
  15. Antimony

    Antimony Regular Member

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    Reply to DD, Yusuf

    As of now I don't think there is anything of tangible value backing the guarantee the Central Bank provides on notes in circulation. The US kept the Gold Reserve but has moved away from that decades ago.

    At any point of time, if the government chooses to print more money and push it into the system, that would mean that more money chases the then available set of goods and products in the system. Put it simply, everyone has more money , but they can buy only the same amount of stuff. Result, price increase or inflation.

    This is why fiscal deficits are dangerous. The government does not have the money for its financial commiments and therefore resorts to taking debt (selling binds) or financing the deficit by printing money.

    What about the interest component? Central Bank would sell bonds below par. A T-bill might be marked as Rs. 100 (face value) but would be sold at Rs. 90. When it is redeemed, the investor gets Rs. 100. The Rs. 10, in effect, is the gain in investment. If the government has not got that money from somewhere, it is going to print it and give it out.
     
  16. Antimony

    Antimony Regular Member

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    Reply to Ajay

    Ajay,

    I would suggest a study of the concept of Money supply and associated terms like M0, Monetary Base, M1, M2 etc. Wikipedia gives a passable definition but a book on Macro eco is better.

    Money supply - Wikipedia, the free encyclopedia

    To put it very crudely, the "money is the system" is the sum of reserves (currency in circulation and accounts held by Commercial banks with their Central bank), the deposits in banks and the amount lent out by banks.
    Different banking systems may define each term diofferently. but a broad understanding may be achieved. Even if no new set of notes is introduced into the system, each time a loan or a deposit is made, the new amounts will enter into the calculations.

    Now, if you look at the example given on wiki, you will see that they have assumed a reseve of 20%. If you play around with that, you will see that the summation increases with a low reserve ration, and decreases with a high one.

    If the reserve rate is zero, then the bank reseves fall, but they amount they lend out increases hundredfold.

    Please note that when RBI wants to combat inflation, they sometimes raise the Statutory Liquidity Ration and Cash Reseve Ration, which are RBI's proxy for the "Reserves ratio".
     

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