INTRODUCTION TO

MONEY CREATION
Yangon Jan Gottschalk, TAOLAM
October 2, 2014 This activity is supported by a grant from Japan.
 Overview
2

I. Impact of other sectors

on monetary survey
a) External sector
b) Fiscal sector
II. Endogenous money
creation

This training material is the property of the IMF – Singapore Regional Training Institute (STI) and is intended for the use in STI
courses. Any reuse requires the permission of the STI.
 I Impact of Other Sectors on
Monetary Survey—External
Survey External Sector
3

External Sector
Monetary survey
Assets Liabilities
Net foreign assets
Currency in
Accumulation of foreign circulation
reserves in BOP

“money flowing in from Deposits

abroad”

NFA
M1 & M2
 Impact of Other Sectors on
Monetary Survey—Fiscal
Survey Fiscal Sector
4

Fiscal Sector
Monetary survey
Assets Liabilities
Net domestic assets
Currency in
E.g., increase n fiscal spending that circulation
i b
is bank-financed
k fi d

“government injects liquidity Deposits

into economy by buying goods
and services”
M1 & M2
Net credit to g
government increases

NDA
 II Endogenous Money Creation
5

Example
p for boundless endogenous
g money y creation: a bank extends credit of
Kyat 100, which fuels further deposit and credit creation …

Increase in Increase in
Deposits Deposits
Bank 1 Bank 2 Bank 3 Kyat 200
Kyat 100
Deposit
Credit Deposit
K t 100
Kyat Credit
C di Credit
C di
Kyat 100 Kyat 100
Kyat 100 Kyat 100

Kyat 100 Kyat 100

Private Private Private Private
sector sector sector sector
1 2 3 4
 Endogenous Money Creation—Reserve
Requirements & Currency Demand
6

Assets Liabilities

Net foreign assets (NFA) Reserve money (RM)

Net domestic assets (NDA) Currency issued

Reserves of commercial banks

Net claims on the government
with central bank (deposits with
(NCG)
CB)

Cl i
Claims on commercial
i lbbanks
k R
Required
i d reserves

Claims on other resident

Excess reserves
sectors

Other items net Other deposits

 Endogenous Money Creation—Reserve
Requirements & Currency Demand
7

Now: a bank extends credit of Kyat 100 with 10% reserve

requirements and currency-to-deposit ratio of 15 %
Hold reserves Hold
Bank 1 Bank 2 Kyat 8.7 Bank 3 reserves
Kyat 6.8
Deposit
Credit Deposit Credit
K t 87
Kyat Credit
Kyat 100 Kyat 68.1 Kyat 61.3
Kyat 78.3

Kyat 100 Kyat 78.3

Private Private Private Private
sector sector sector sector
1 2 3 4

Hold currency Hold currency

Kyat 13 Kyat 10.2
 Endogenous Money Creation—Reserve
Requirements & Currency Demand: End-Result
End Result
8

End result:
Increase in broad money by Kyat 460
Central Bank (deposits 400 + currency 60) and in
reserve money by Kyat 100 (required
Increase in Reserve money
reserves 40 + currency demand 60)
Kyat
K t 100
Currency
Required reserves demand
Kyat 40 Kyat 60

Banking sector Increase in Broad money:

Currency Kyat 60 +
Deposits Kyat 400 =
Credit Deposits Kyat 460
Kyat 460 Kyat 400

Private sector
 Endogenous Money Creation—Reserve
Requirements & Currency Demand

Exercise 4
9
Replicate this process in the supplied Excel spreadsheet in
order to verify that the end-result shown here is correct.
Start out with the first round:
r = 0.10=10/87
Deposit req. reserves-to-deposits ratio Hold res.
$87 $8.7
Credit $100 to
households or
businesses

c = 0.15=13/87 Credit
currency-to- $78.3
deposits ratio

Hold currency
$13
 Endogenous Money Creation:
Money Multiplier
10
 Endogenous Money Creation—Deriving
the Money Multiplier
11

The extent of endogenous money creation can be analyzed via the money
multiplier
lti li which
hi h lilinks
k bbroadd money (M2) tto reserve money (RM)
(RM):
M2
M 2  m  RM m
RM
C D

M2 CD D D  c 1
m  
RM C  R C  R cr
D D
where C = currency in circulation, R = Reserves held at CB (commercial
bank deposits at CB) and D = deposits of private sector with
commercial banks).

The money multiplier is a function of

• c = currency-to-deposits ratio (behavioral
( variable))
• r = reserve-to-deposits ratio (policy variable)
 Endogenous Money Creation—
Determinants of the Money Multiplier
12

Fundamental determinants of the money multiplier:

• reserve requirements decided by the central bank 
matters for reserve-to-deposits
reserve to deposits ratio
• Willingness of banks to hold excess reserves (liquidity
risks credit risk
risks, risk, foregone interest earnings)  matters
for reserve-to-deposits ratio
• Willingness of households and firms to hold cash instead
of deposits (liquidity risks, foregone interest earnings) 
matters for currency-to-deposits ratio
 Endogenous Money Creation—Numerical
Example for the Money Multiplier
13

Consider our previous example for the money creation

process:
Currency-to-deposit ratio c = 15%
Required reserves-to-deposit ratio = 10%
c 1 0.15 1 1.15
m    4.6
46
c  r 0.15  0.1 0.25
Increase in reserve money by Kyat 100 leads to
increase in broad money by Kyat 460.
 Endogenous Money Creation—Money
Multiplier and Causality
14

What about the direction of causality? y

• The money multiplier concept suggests that creation of reserve
money, which is under the control of the central bank, leads to an
increase in broad money via the money multiplier
multiplier. In essence
essence, the
central bank creates liquidity that then is lent out by banks,
thereby starting the credit-deposit money creation process.
• But
B t in
i our example, l money creation
ti started
t t d with
ith iincrease iin
bank lending, not increase in reserve money. The money
multiplier should still matter because banks need to satisfy
reserve requirements;
i t the
th supplyl off reserve money can become
b
a binding constraints for bank lending by limiting the amount of
liquidity available to meet reserve requirements, thereby tying
reserve and broad money closely together.
 Endogenous Money Creation—Money
Multiplier and Excess Reserves
15

The ppresence of excess reserves can lead to variabilityy in the

money multiplier and undermine its usefulness:
• Imagine that banks hold excess reserves and the central bank
increases these reserves further through open market operations
operations.
What happens to the money multiplier? What does this mean for
the effectiveness of money policy for stimulating credit creation?
• Consider
C id a situation
it ti where
h b
banks
k hhold
ld excess reserves and d fifind
d
new lending opportunities, leading to an increase in bank lending
and rise in broad money. What happens to the money multiplier
h ?
here?
 Endogenous Money Creation—Money
Multiplier in Myanmar
16

Exercise 5
Work out approximate Money Multiplier
currency-to-deposit and 2.5

reserves-to-deposit ratios
2.0
that could explain key
movements of the money 15
1.5
multiplier.
1.0
What kind of
developments could have 0.5

led to these changes in

0.0
the moneyy multiplier?
p
20
20
20
20
20
20
20
20
20
20
20
20
20
001/02
002/03
003/04
004/05
005/06
006/07
007/08
008/09
009/10
010/11
011/12
012/13
014M2
 III Summary
17

 Monetary accounts are critical for analysis of

monetary conditions and formulation as well
as implementation
i l t ti off monetary
t policy
li
 Money creation is partly linked to
developments in other sectors and partly an
endogenous process that can be influenced
b monetary
by t policy
li
18

Thank You!

This presentation provides you with a

basic
bas c introduction
t oduct o to tthe
e monetary
o eta y
accounts that we will put into practice
soon tomorrow
tomorrow.