The Origin of Money – Part III: Central Bank Money
The euro is the single currency used in the euro area. Here, euro banknotes and coins are the legal tender.
Only the central banks – in Germany’s case, the Deutsche Bundesbank – are permitted to put euro banknotes and coins into circulation. They do this via the commercial banks.
Each commercial bank has an account at the central bank and is able to withdraw cash from this account. This lowers the account’s balance. Cash-in-transit companies transport the euro banknotes and coins from the Bundesbank to the commercial bank in armoured vehicles.
The commercial bank’s account balance at the central bank increases whenever it makes cash deposits at the central bank. In other words, funds held at the central bank can be converted into cash – and vice versa.
"Central bank money" is the term used to refer to deposits held at the central bank and cash brought into circulation by the central bank, as only the central bank can create this money.
But how do central bank balances arise?
One way in which central bank balances arise is when the central bank extends a loan to a commercial bank. The central bank then credits the loan amount to the commercial bank’s account. However, the commercial bank is required to pledge collateral, one example being securities, against the loan and pay interest on it. If the commercial bank pays back the loan using its account balance, the central bank money that was previously created ceases to exist.
Central bank balances also arise if the central bank purchases assets such as government bonds, gold and property from a commercial bank. The central bank then credits the purchase amount to the commercial bank’s account; as a result, the account balance goes up.
By contrast, if the central bank sells an asset to the commercial bank, it debits the amount to be paid from the commercial bank’s account.
And why do commercial banks need to hold balances at the central bank?
First, the central bank may call for commercial banks to maintain a certain minimum balance on their central bank accounts – otherwise referred to as the minimum reserve requirement. The minimum reserve amount required is calculated by multiplying customers’ deposits at a bank by a percentage set by the central bank. If the banks create additional funds – in other words, additional "book money" – they are then also required to increase their minimum reserves held at the central bank.
Second, commercial banks need central bank reserves because their customers are withdrawing more and more cash: ever since the euro was introduced in 2002, the total value of cash in circulation has been steadily rising. The commercial banks have to obtain this additional cash from the central bank. To do so, they need central bank reserves that they can draw upon.
Third, commercial banks need central bank reserves for interbank transactions – that is to say, for cashless payments.
If Mr Maier, a customer of Bank A, transfers money to Ms Müller, a customer of Bank B, his bank balance at Bank A goes down. At the central bank, the amount is transferred from Bank A’s account to Bank B’s account. Bank B credits the amount to Ms Müller’s account.
Central bank reserves are only ever transferred between accounts held at the central bank. Customer deposits held at commercial banks do not count as central bank money. The commercial banks are therefore in constant need of central bank money. Only the central bank can create these funds – this "central bank money".
But how do the commercial banks obtain it?
As previously mentioned, the central bank can extend loans to commercial banks. The commercial banks are required to pay interest on these loans at the ECB’s policy rate. This interest rate, in turn, serves as the lever for the Eurosystem’s monetary policy.
The primary objective of the Eurosystem is to safeguard price stability. This is achieved when the annual increase in the price level is close to, but below, 2% over the medium term.
But how does the Eurosystem achieve its objective?
The Eurosystem has the option of using the policy rate – that is to say, the rate at which the commercial banks pay interest on central bank money – to influence interest rate levels in the euro area.
If there is a risk of deflation, the ECB Governing Council will lower interest rates.
As a result, the commercial banks will then also lower their interest rates. This results in more loans being taken out, the banks creating additional book money and greater demand for goods. With time, downward pressure on prices eases, allowing companies to raise their prices again. In this way, lowering the interest rate on central bank money can help fight deflation.
If there is a risk of inflation, the Eurosystem will increase the interest rate on central bank money – known as the policy rate. In turn, the commercial banks will increase their interest rates on loans. This results in fewer loans being taken out, less book money being created and lower demand for goods. Companies might not be able to sell as many of their products, meaning they are unable to raise their prices. Some might even lower their prices. In this way, raising the interest rate on central bank money can help fight inflation until prices stabilise again. Central bank money therefore has an important role to play.
The commercial banks are in constant need of central bank money to meet their minimum reserve requirements, to be able to withdraw cash and to settle cashless payment transactions.
They obtain this central bank money, in part, by taking out loans from the central bank. Hence, raising and lowering the interest rate on central bank money serves as an important tool for achieving the Eurosystem’s primary objective: price stability.