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Frankfurt am Main | 25.04.2017

How money is created

Since the Eurosystem launched its accommodative non-standard monetary policy measures, the central bank reserves of commercial banks in the euro area have gone up sharply, more than seven-fold within a period of not quite ten years. At the same time, the broader monetary aggregate M3, which comprises the liabilities of domestic banks and central banks against domestic non-banks such as households and enterprises, grew only moderately. In the April issue of the Monthly Report, the Bundesbank's economists look at this issue and explain how book money is created and how the Eurosystem's expanded asset purchase programme (APP) impacts on monetary growth. They also comment on proposals for banks to hold central bank money against 100% of their sight deposits.

Book money created only by transactions between banks and non-banks

In terms of volume, the majority of the money supply is made up of book money, which is created through transactions between banks and domestic customers. Sight deposits are an example of book money: sight deposits are created when a bank settles transactions with a customer, ie it grants a credit, say, or purchases an asset and credits the corresponding amount to the customer's bank account in return. This means that banks can create book money just by making an accounting entry: according to the Bundesbank's economists, "this refutes a popular misconception that banks act simply as intermediaries at the time of lending – ie that banks can only grant credit using funds placed with them previously as deposits by other customers". By the same token, excess central bank reserves are not a necessary precondition for a bank to grant credit (and thus create money).

Commercial banks' ways of creating money are not infinite, however. According to the Monthly Report, they are constrained by the banking system's interaction with non-banks and the central bank, by regulatory policy and, not least, by banks' own inherent interest in maximising their profits. Despite its ability to create money, a bank still has to fund the loans it has created since it needs central bank reserves for the cashless settlement of payments when sight deposits created by lending are transferred to other banks. These are balances which only the central bank can create. A bank decides on the structure of its funding depending on relative costs as well as on interest rate risk and liquidity risk. In order to be able to grant additional loans, a bank can offer more favourable credit conditions. However, if funding costs remain static, the returns on lending will be lower, and, all other things being equal, additional lending will be less attractive.

Complex interactions

The banking system's ability to create money is additionally constrained by the behaviour of enterprises and households, especially by their demand for credit and their investment decisions. In turn, the central bank shapes monetary and credit growth indirectly by adjusting policy rates, which influence the funding and portfolio decisions of banks and non-banks through a variety of channels. According to the Monthly Report, monetary growth is, overall, "the result of complex interactions between banks, non-banks and the central bank." In a conventional monetary policy implemented by manipulating the policy rate, the ups and downs of central bank reserves are shaped by banks' demand.

The Bundesbank's economists also describe how monetary policy asset purchase programmes fundamentally impact on central bank reserves and the money supply. Whereas such programmes necessarily increase central bank reserves, this does not apply to the same extent to the broad monetary aggregate. The only way asset purchases can have a direct positive impact on the money supply is if the end sellers are domestic non-banks, with the report adding that, "in this case, the transaction leads to an increase in the central bank holdings of government bonds and an increase in sight deposits held by the seller". However, the ultimate sellers of the instruments could also be commercial banks or non-residents. In addition, the money supply could also be indirectly influenced by, in particular, the transmission of the asset purchase programme to asset prices and yields or lending. This is why there is no mechanistic relationship between the increase in central bank reserves and the broader monetary aggregate.

Benefits of full backing of deposits with central bank money questionable

The authors also comment on proposals for banks to hold central bank money against 100% of their sight deposits. These proposals are designed to constrain banks' money creation and thereby improve the stability of the banking sector. However, it is not evident, the Bundesbank's economists argue, that this constraint would indeed make for a financial system that is more stable overall than could be achieved through targeted regulatory action. At the same time, that kind of transition to a new system would risk impairing important functions which the banking system performs for the economy and are crucial for keeping real economic growth on a steady path, they write. The Monthly Report says further on that "given the economic costs a change of system would entail, the question arises as to whether the benefits could outweigh the drawbacks".

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