The Money Creation Process
LET US ASSUME that the central
bank places a statutory reserve requirement (SRR) ratio of 10 per cent;
and that the SRR is the only policy variable used for affecting the
money creation process [1]. The reserve requirement is the proportion of
deposits which the banking sector must keep as reserves to fulfill
withdrawal needs. An original deposit of RM1,000 will enable the banking
sector to increase deposits to a maximum amount of RM10,000 (i.e.
RM1,000 divided by the reserve requirement of 0.10) through loan
creation (i.e. money creation). Let us illustrate how this is done. Say
that Mr X found RM1000, which he decided to deposit into a bank account.
For simplicity, let us assume there is only one bank in the economy
(alternatively you may think of all banks being consolidated or merged
into a single entity). A T-account balance sheet entry of the bank would
appear as below:
The cash account (reserve) is debited while Mr
X's deposit account is credited with RM1,000. The cash reserve now is
100 per cent of the deposit. However, since the bank is required to keep
only 10 per cent as reserves, the bank creates additional deposits
until the reserve is 10 per cent of total deposits. How can additional
deposits be created? By means of giving loans! The balance sheet
position after money creation (assuming maximum money creation) [2]3
would be as follows:
Notice that for the original RM1,000 deposit,
an additional RM9,000 deposit is created by means of loans [3]. After
money creation, the original RM1,000 deposit is now equivalent to 10 per
cent of the current total deposits of RM10,000, i.e. the required
reserve ratio. This increase in money through multiple deposit creation
is a one-time increase in the 'money base'. The formula for multiple
deposit creation may be written as follows:
Interest Rates and the Growth in Money Supply
In
addition to the above, the interest rates given and charged by banks
also increase money supply in the long run [4]. In the conventional
economic thinking, interest rate is said to be the price of money
capital, following the normal demand-supply theory. However, we should
notice that interest rates themselves, ceteris paribus, would increase
the money supply. This fact is very important. Therefore, we expound on
this matter further.
Continuing with the earlier example, let us
assume that interest rates are as follows - 5 per cent for the deposit
rate and 10 per cent for the lending rate. We shall also assume that
borrowed money does not earn interest. Now, in the next period the
RM1,000 deposit money would earn RM50 interest and thus becomes RM1,050.
The depositor would now be able to buy things in the economy for
RM1,050. On the other hand, the loan balances would become RM9,900
(RM9,000 + 0.10 x RM9,000). The extra RM900 is simply the interest
income to the bank. After paying depositors the interest of RM50, the
bank makes a spread of RM850, which is 85 per cent of the original
deposit. It is with this spread, the bank would pay the salaries of its
employees, utility bills, etc., the remainder of which would comprise
the bank's retained earnings. The current balance sheet position is as
shown below:
Notice that the current reserve of 1,000 is now
inadequate for a total deposit of RM10,050. This suggests that, in the
long run, the central bank would be forced to continually increase fiat
money and/or the banks would continuously extend loans so that the
reserve requirement can be met and thereby sustain the system [5]. The
implication of this is that the existence of interest rates would
themselves, ceteris paribus, force a continuous increase in both state
money (fiat money) and bank money (loans).
Hence with the simple
existence of interest rates alone, under normal circumstances, money
supply in an economy will grow by default. However, it is possible for
this money supply to shrink back if a depositor withdraws cash from the
banking system (and keeps it from re-entering the financial system), or
when a loan is repaid, or when a borrower defaults on loan repayment
(which at serious levels may cause banking crises, as was the case with
non-performing loans or NPLs during the 1997 Malaysian financial
crisis).
In summary, a fiat money interest based financial system
continuously creates money in the economic system, and by the reverse
process, the money so created can also be destroyed in the event
deposits are withdrawn, loans repaid or borrowers default on loan
repayments.
Credit Cards and Growth in Money Supply
The
credit card system also increases the money supply. This is because
every credit card transaction is a credit transaction. The implication
of this is easy to see using a T-account. Assuming Mr A purchases
something from Mr B for RM1,000 using his credit card. The Bank that
issued the credit card will record the transaction as follows: Mr A's
account is debited as a loan to reflect a credit transaction while Mr
B's account is credited. This simple accounting entry is, however,
interpreted as follows: The Bank had paid Mr B on behalf of Mr A.
Therefore, Mr A owes the Bank RM1,000!
Now
since Mr B's account is considered as a deposit, the Bank could also
create money as discussed earlier through the fractional reserve
requirement system. The bank can create multiple deposits by means of
loans from this accounting "deposit". If the reserve ratio is 10 per
cent, then additional RM9,000 deposits can be created through loans.
Apart
from this, the bank also has an additional way to create money. Let us
assume that Mr A fails to pay the Bank when he receives his statement.
Then the Bank will impose two charges on Mr A: (i) interest on the
$1,000 for not settling it! and (ii) a late payment fee! Note that Mr A
has to pay these charges even though the bank did not pay anything to Mr
B in the first place. It's all in accounting!
While it is
possible to reduce (or control) money supply in the short run, for
example, by increasing the reserve requirement ratio or through open
market operations (i.e. the selling of government bonds or by increasing
bank discount rates), we postulate that the net long-run effect will
still be an increase in money supply. This is simply due to the
existence of interest rates in the economy (note that government bonds
too pay interest even though the money obtained through the sale of such
bonds may be simply kept in the vaults).
Therefore, in an
interest-based fiat monetary system, money supply simply grows in the
long run, even though in the short run it may be altered through
monetary policies.
Dr Ahamed Kameel Mydin Meera
Dean, Institute of Islamic Banking & Finance
International Islamic University Malaysia
205A, Jalan Damansara
50480 KUALA LUMPUR
[1] Other variables include the capital adequacy ratio, which we ignore here for simplicity.
[2]
Although real world multipliers may never create the maximum amount, in
principle the fractional reserve system allows 'money to be created'.
[3]
Notice how banks create money out of thin air. Money is created when
banks extend loans. Hence money in most part is only accounting entries
in the books or computer records in the form of binary bit memory space.
[4] See Tarek El-Diwany, The Problem With Interest, TA-HA Publishers, United Kingdom, 1997.
[5] In most countries the domestic debt levels have continuously grown.
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