Monday, September 12, 2011

How Money is Created

I've been fascinated and somewhat confused of late by the concept of how money is created. Given certain developments recently involving the Swiss unilaterally instituting an exchange rate ceiling, summarized by Kash over at The Street Light, Canada's horror and dismay what we would do when "currencies go to war", and the general idea about how Canada "creates" money, I thought I'd link to some thoughts on the subject. This does not necessarily clarify much on the matter, but does indicate the Bank of Canada is somewhat of a black box and there is no ultimate online authority I was able to dig up.

Gilligan's Corner: Canada’s Private Banks have no Reserve Requirements (read the comments too)
First year macro textbook chapters on money in Canada ch10 and ch11 (PDF)

When trying to get information on the basic functions of the banking system and currencies, I am reminded that the web has a few disagreements, and can make things seem rather complicated.


Declan said...

The Central Bank can print actual currency notes, or they can print money by simply buying something and paying for it with dollars they created out of thin air.

Regular banks can't (not these days anyway) print currency notes, nor can they simply buy something by creating money out of thin air to pay for it, but when they lend, the money they lend is also created out of thin air. i.e. if I go down to the bank and borrow $5,000, they simply put $5,000 in my bank account, and create an offsetting entry to reflect that I owe them $5,000 (plus interest of course). They don't lend me someone else's deposit, they lend me my own deposit which they just created.

I can move my deposit somewhere else, but it will still end up in a bank, and the central bank makes sure that each individual bank is able to balance it's deposits and loans.

Banks (non-central) are constrained in their lending by capital requirements (reserve requirements are irrelevant) which require them to have a certain amount of their own money on hand for each dollar they lend (how much depends on how risky the loan is). So if banks are lending to someone not considered very risky (e.g. mortgages backed by CMHC) they can create a lot of loans against a small amount of capital (the lower this risk, the greater the leverage that is permitted).

I think the Steve Keen piece on the roving cavaliers of credit is a great explanation of how money works if you take the time to read it through carefully.

W. Peden said...


You could say that when an ordinary bank buys a security, it is creating money out of thin air to buy that security. So when a bank purchases a corporate bond, it does so with a new deposit. Of course, this is still lending, but in a very indirect sense. A bank might buy a collateralised debt security from customers about which they know basically nothing...