Currency Creation

Currency Creation Procedure on Central Bank level

The creation of new money in a modern economy is a complex, interconnected process that involves both central banks and commercial banks. 

  1. Central Bank Monetary Policy: This is the starting point for money creation. By setting the policy interest rate, the central bank influences the cost of borrowing in the economy. A lower rate encourages more borrowing and thus more money creation, while a higher rate discourages it.
  2. Bank Lending: When a bank approves a loan, it creates a deposit in the borrower's account. This deposit is new money that didn't exist before. The act of lending is therefore the primary way that commercial banks create new money.
  3. Reserve Requirements and Capital Requirements: Banks are required to hold a certain amount of reserves and capital. These requirements act as constraints on how much money banks can create. If a bank doesn't have enough reserves or capital, it can't make new loans and thus can't create new money.
  4. Central Bank as Lender of Last Resort: If a bank is short of reserves, it can borrow from the central bank. This allows the bank to meet its obligations and continue making loans, supporting the creation of new money.
  5. Open Market Operations: When the central bank buys securities from banks, it pays by creating new reserves. This increases the amount of reserves in the banking system, allowing banks to make more loans and create more money.
  6. Quantitative Easing: This is another way the central bank can inject money into the economy. By buying large amounts of securities, the central bank increases the amount of reserves in the banking system, enabling more money creation.
  7. Repurchase Agreements: Repurchase agreements, or repos, are another tool the central bank uses to manage the amount of money in the economy. When the central bank buys securities through a repo, it creates money. When the repo is reversed and the securities are sold back to the banks, the money is destroyed.

In all these ways, the central bank and commercial banks interact to create new money. The central bank sets the conditions for money creation through its monetary policy and provides the necessary reserves through its lending and open market operations. The commercial banks create new money through their lending activities, within the constraints set by the central bank's reserve and capital requirements. This interconnected process ensures that the amount of money in the economy is responsive to the demand for loans and is consistent with the central bank's objectives for inflation and financial stability.

Reverse Repo as critical part of the financial System

The reverse repo market is a crucial component of the financial system, playing a significant role in money market operations and liquidity management. To understand the reverse repo market, it's essential to first grasp the concepts of repurchase agreements (repos) and reverse repurchase agreements (reverse repos).

Repos and Reverse Repos:

  • A repurchase agreement, or repo, is a short-term financial transaction in which one party (the seller) agrees to sell a security (typically government bonds, corporate bonds, or other marketable securities) to another party (the buyer) with a commitment to repurchase the security at a predetermined date and price. Essentially, it's a collateralized loan where the security serves as collateral
  • A reverse repurchase agreement, or reverse repo, is the opposite side of this transaction. In this case, the buyer agrees to purchase a security from the seller and to sell it back at a later date for a higher price. In other words, the buyer is effectively lending money to the seller, and the security serves as collateral for the loan.

The Reverse Repo Market:
The reverse repo market is an essential component of the money market, where participants (such as banks, financial institutions, and central banks) engage in reverse repo transactions for various purposes. These purposes include:

  • Managing liquidity: Financial institutions use reverse repos to invest their excess cash temporarily. Reverse repos provide a secure, short-term investment vehicle with a known return, allowing them to earn a return on their idle cash while maintaining liquidity.
  • Central bank operations: Central banks, such as the Federal Reserve in the United States, use reverse repo operations as a monetary policy tool to control short-term interest rates and manage the money supply. By engaging in reverse repo transactions, central banks can absorb excess liquidity from the financial system, which helps maintain the target interest rate.
  • Collateral transformation: Reverse repos can also be used by financial institutions to obtain high-quality collateral, which they can use to meet regulatory requirements or for other purposes, such as securing other loans or entering into derivatives transactions.

Mechanics of the Reverse Repo Market:

In a reverse repo transaction, the buyer (lender) and the seller (borrower) agree on the terms, such as the amount, interest rate (also called the repo rate), and maturity date. The buyer provides cash to the seller in exchange for the security, which serves as collateral. The agreement states that the seller will repurchase the security at a specified future date and a predetermined higher price, which includes the principal amount plus interest. When the transaction matures, the seller repurchases the security and returns the cash plus interest to the buyer.

Risks and Benefits:

The reverse repo market offers benefits such as providing a secure, short-term investment option for cash-rich institutions, enabling central banks to manage liquidity and implement monetary policy, and facilitating collateral transformation for financial institutions.

However, there are risks associated with the reverse repo market, including counterparty risk (the risk that the other party will not fulfill its obligations), collateral risk (the risk that the value of the collateral declines), and operational risk (the risk of errors or failures in the transaction process).

Overall, the reverse repo market plays a vital role in the financial system, helping institutions manage liquidity and supporting the implementation of monetary policy by central banks.

The repo and reverse repo markets play a key role in the implementation of monetary policy by central banks, including the Federal Reserve, the European Central Bank, and the Reserve Bank of India. Here are the key points:

Repos and reverse repos are used by central banks as tools for open market operations to control the money supply and influence short-term interest rates.

  • When the central bank wants to increase the money supply, it conducts repo operations by buying securities from banks and other counterparties, temporarily injecting cash into the financial system.
  • Conversely, when the central bank wants to reduce the money supply, it conducts reverse repo operations by selling securities to counterparties, temporarily draining cash from the system.

Provide a Backstop for Money Markets
The repo and reverse repo facilities operated by central banks, such as Overnight Reverse Repo Facility and Standing Repo Facility, help provide a floor and ceiling for overnight interest rates.

  • These facilities act as a backstop, allowing a broad range of counterparties to access a risk-free investment option when rates fall below the central bank's target, or to borrow cash when rates rise above the target.

Facilitate Central Bank Operations

  • The repo market provides a ready-made collateral market that enables central banks to implement monetary policy more efficiently, as they can use a wider range of assets as collateral compared to outright purchases.
  • A liquid repo market also provides central banks with a sensitive gauge of short-term interest rates that can serve as an operational target for open market operations.

So in summary, the repo and reverse repo markets are essential tools used by central banks to implement monetary policy, control the money supply, and support the smooth functioning of short-term funding markets.

The terms M0, MB, M1, M2, and M3  (also known as ‘currency aggregates’) refer to different measures of the currency supply in an economy. These measures provide a way to quantify the amount of currency available in an economy at a given point in time and are typically used by economists and policymakers to understand economic conditions and guide monetary policy.

Here's a brief explanation of what each of these measures includes:

  1. M0: M0 includes liquid currency in circulation. It includes coins, paper money, and other forms of currency that are in circulation but not held by the government or financial institutions. M0 also includes central bank reserves, which are the deposits that commercial banks hold with the central bank.
  2. MB (Monetary Base): The Monetary Base also known as Narrow Currency, includes currency in circulation (coins and banknotes) and reserves held by commercial banks at the central bank. In some definitions, it might also include vault cash — money kept in the vault of commercial banks.
  3. M1: M1 includes all of M0, plus other assets that are nearly as liquid as cash. Specifically, M1 includes checking accounts (funds in current accounts that can be withdrawn at any time without any notice) and other demand deposits. In essence, it includes all funds that are readily accessible for spending.
  4. M2: M2 includes everything in M1, plus other types of deposits that are less immediately accessible. Specifically, M2 includes savings accounts, money market accounts, and small-denomination time deposits (certificates of deposit that are below a certain size, often $100,000). These are forms of money that can be converted into cash relatively easily, but not as quickly or conveniently as the components of M1.
  5. M3: M3 includes everything in M2, plus large time deposits, institutional currency market funds, short-term repurchase agreements, along with other larger liquid assets. These are types of currency that are less liquid than those included in M2, but still contribute to the total amount of currency available in the economy.

Each of these measures provides a different perspective on the currency supply, and each can be useful for understanding different aspects of the economy. M0 and M1, for example, are often used to analyze the most immediate forms of liquidity in the economy, while M2 and M3 are used to understand broader trends in the currency supply.

It's important to note that the exact definitions of these measures can vary between different countries. 

Approximate figures for major economies as of February 2023 for M0, M1, M2, and M3 for some major economies (in Billions of US Dollars)

Please note that the figures are approximate and should be used for illustrative purposes only. For the most accurate and up-to-date information, refer to the official sources, such as the respective central banks or statistical agencies.

Central Bank Monetary Mechanisms

Central banks have access to a variety of sources beyond off-balance sheet items that they can activate to influence the money supply and implement monetary policy. Here are some additional types of sources and mechanisms central banks might utilize:

1. On-Balance Sheet Assets

a. Foreign Exchange Reserves:

  • Intervention in Forex Markets: Central banks can buy or sell foreign currencies to influence exchange rates and stabilize the currency.
  • Liquidity Management: These reserves can be used to provide liquidity in times of financial stress.

b. Government Securities:

  • Open Market Operations: Regular buying and selling of government bonds to control the money supply and influence interest rates.
  • Quantitative Easing (QE): Large-scale purchases of long-term securities to inject liquidity into the economy.

c. Gold Reserves:

  • Collateral for Loans: Gold reserves can be used as collateral to secure international loans or other financial instruments.
  • Market Stability: Selling or buying gold to stabilize the market or manage inflation expectations.

2. Central Bank Facilities

a. Discount Window Lending:

  • Emergency Liquidity: Providing short-term loans to financial institutions in need of liquidity, usually against collateral.
  • Interest Rate Influence:  Adjusting the discount rate to influence short-term interest rates and monetary conditions.

b. Repurchase Agreements (Repos):

  • Short-Term Lending: Central banks can engage in repurchase agreements, lending money to financial institutions while holding their securities as collateral.
  • Liquidity Control: Managing the liquidity in the banking system through these short-term agreements.

c. Term Auction Facility:

  • Auctioning Loans: Offering term loans to banks via auction, providing liquidity while allowing market-based determination of interest rates.

3. Special Programs and Facilities

a. Emergency Lending Programs:

  • Crisis Management: During financial crises, central banks can create special lending programs to support specific sectors or institutions.
  • Backstop for Markets: Providing a safety net to prevent systemic collapse.

b. Credit Easing Programs:

  • Targeted Asset Purchases: Purchasing private-sector assets like corporate bonds or mortgage-backed securities to improve credit flow to specific sectors.

4. Regulatory and Supervisory Powers

a. Reserve Requirements:

  • Reserve Ratio Adjustments: Changing the reserve requirements for commercial banks to control the amount of money they can lend out.
  • Influence on Money Supply: Increasing reserve requirements to tighten, or decreasing to loosen, the money supply.

b. Prudential Supervision:

  • Financial Stability: Implementing regulatory measures that ensure the stability and soundness of the financial system.
  • Macroprudential Tools: Utilizing tools like countercyclical capital buffers to manage systemic risks.

5. Collaboration with Government

a. Fiscal Policy Coordination:

  • Stimulus Packages: Coordinating with the government to implement fiscal stimulus, such as infrastructure spending or tax cuts, to complement monetary policy.
  • Debt Management: Working with the treasury to manage public debt and its implications for monetary policy.

6. Innovative and Unconventional Tools

a. Negative Interest Rates:

  • Encouraging Spending: Setting negative interest rates to encourage banks to lend more and discourage hoarding of cash.
  • Boosting Inflation: Aimed at preventing deflation and encouraging economic activity.

b. Yield Curve Control:

  • Interest Rate Targeting: Directly targeting long-term interest rates by committing to buy securities to maintain rates at a desired level.
  • Market Confidence: Providing forward guidance to influence market expectations and stabilize the economy.

c. Digital Currencies:

  • Central Bank Digital Currencies (CBDCs): Issuing digital currencies to enhance payment systems, increase financial inclusion, and provide a new tool for monetary policy.
  • Innovation in Monetary Policy:  Offering real-time tracking and implementation of policy measures.

Monetary Policy Decision Bodies

Monetary Policy Decision Bodies in different Central Banks

Federal Reserve

The key entities involved in the Federal Reserve's monetary policy decisions, including the creation of new money, are:

The Federal Open Market Committee (FOMC)

  • The monetary policy-making body of the Federal Reserve
  • Consists of the 7 Board of Governors members, the President of the Federal Reserve Bank of New York, and 4 other Reserve Bank presidents who serve on a rotating basis. Responsible for formulating monetary policy, including decisions on interest rates and the creation of new money through open market operations.

The Board of Governors

  • The central governing board of the Federal Reserve, located in Washington D.C. 
  • consists of 7 governors appointed by the President and confirmed by the Senate and provides general guidance and oversight for the entire Federal Reserve System, including monetary policy decisions.

The advisory councils such as the Federal Advisory Council and the Community Depository Institutions Advisory Council, provide expert advice to the Board of Governors, but do not have a direct role in the monetary policy-making process.

European Central Bank

The key committees and councils involved in monetary policy decisions at the European Central Bank (ECB) are:

The Governing Council

  • The main decision-making body of the ECB
  • Consists of the 6 members of the ECB Executive Board and the governors of the national central banks of the euro area countries
  • Responsible for formulating monetary policy, including setting key interest rates and the supply of reserves in the Eurosystem

The Executive Board

  • The 6 members, including the ECB President and Vice-President, who are part of the Governing Council
  • Responsible for the day-to-day implementation of monetary policy and the preparation of Governing Council meetings

The General Council has an advisory role and is not directly responsible for monetary policy. Financial Committee (EFC) and the Financial Stability Table (FST) of the EFC, which advise on the assessment of risk in the European financial system and on IMF issues.

Bank of England

The Monetary Policy Committee (MPC)

  • The main decision-making body responsible for formulating and implementing the UK's monetary policy
  • Consists of 9 members, including the Governor of the Bank of England and external members
  • Meets 8 times per year to decide the official interest rate (Bank of England Base Rate) and other monetary policy tools like quantitative easing[2][3]

The Court of Directors

  • The governing body of the Bank of England
  • Provides oversight and governance for the Bank, including on monetary policy matters

Bank of Japan

The Policy Board

  • The Bank of Japan's highest decision-making body
  • Determines the guideline for currency and monetary control, sets the basic principles for the Bank's operations, and oversees the fulfillment of the Bank's duties
  • Consists of the Governor, two Deputy Governors, and six Policy Board members[2]

The Committee for Promoting the Integrated Economic and Fiscal Reforms

  • An associated committee that reports to the Council on Economic and Fiscal Policy
  • Promotes initiatives related to "Reform with Innovation" in public-related services, incentives, and public services
  • Provides guidance and advice to government offices on the implementation and assessment of the integrated economic and fiscal reforms[1]

The Council on Economic and Fiscal Policy in an advisory role, providing surveys and discussions on important economic and fiscal policies also to the Prime Minister.

People’s Bank of China (PBOC) 

The Monetary Policy Committee (MPC)

  • The main advisory body that provides guidance on monetary policy to the PBOC
  • Composed of the PBOC Governor and Deputy Governors, as well as representatives from other government agencies and the banking industry
  • Responsible for advising on the formulation and adjustment of monetary policy targets, the application of monetary policy instruments, and the coordination of monetary policy with other macroeconomic policies
  • The MPC meets regularly, with its opinions and policy advice recorded in meeting minutes
  • The MPC's policy advice is then submitted to the State Council for approval before the PBOC implements the monetary policy decisions

In a broader role the State Council and the Communist Party's leadership rule over the MPC

Reserve Bank of India (RBI)

The Monetary Policy Committee (MPC)

  • The main decision-making body responsible for setting the benchmark interest rate (repo rate) and formulating monetary policy in India
  • Consists of 6 members: The Governor of the RBI (as Chairperson), the Deputy Governor in charge of monetary policy, an Executive Director of the RBI, 3 external members nominated by the Government of India
  • Meets at least 4 times a year to decide on monetary policy

The Financial Markets Committee (FMC)

  • Meets daily to review liquidity conditions and ensure the operational implementation of the monetary policy decisions made by the MPC[1]

The Monetary Policy Department (MPD)

  • Assists the MPC in formulating and analyzing monetary policy[1][3]

The previous Technical Advisory Committee on Monetary Policy had an advisory role, but was replaced by the MPC.

Monetary Policy Decision Bodies on Supranational Level

The International Monetary and Financial Committee (IMFC)

  • The advisory body to the IMF Board of Governors on the supervision and management of the international monetary and financial system
  • Consists of 24 members who are central bank governors, ministers, or others of comparable rank, usually drawn from the IMF's 190 member countries
  • Provides Strategic Direction to the IMF including on monetary policy issues. Deliberates on matters concerning the growth and stability of the global economy including discussing and providing guidance on the appropriate use of monetary policy by central banks to support economic and financial stability.
  • The IMFC serves as a forum for international cooperation and coordination on monetary policy and other macroeconomic issues. It allows finance ministers and central bank governors to discuss and align on policy responses to emerging global economic and financial developments.

The Financial Stability Board (FSB)

  • The FSB is an international body that monitors and makes recommendations about the global financial system.
  • The FSB was established by the G20 countries and has 71 member institutions, comprising ministries of finance, central banks, and supervisory and regulatory authorities from 25 jurisdictions. It also includes 13 international organizations and standard-setting bodies, as well as 6 Regional Consultative Groups reaching out to 65 other jurisdictions.
  • The FSB is hosted and funded by the Bank for International Settlements (BIS) under a five-year agreement, with the BIS bearing the majority of the FSB's operating expenses.
  • The FSB is tasked with identifying vulnerabilities in the international financial system and proposing/monitoring the implementation of actions needed to address them. It coordinates regulatory and supervisory policy in financial sector issues at an international level and promotes cooperation and information exchange among relevant authorities. Key areas of focus include promoting resilient market-based finance, developing robust financial market infrastructure, supporting effective macroprudential arrangements, and addressing new and emerging vulnerabilities.

The Paris Club

  • An informal group of official creditors that seeks coordinated and sustainable solutions for debtor nations facing payment difficulties
  • Has no legal basis but members agree to a set of rules and principles to reach debt rescheduling agreements quickly

The dynamics of currency creation by central banks versus commercial banks are foundational to understanding the broader monetary system’s functioning. Central banks, authorized uniquely to issue currency, play a pivotal role in regulating the economy’s currency supply and maintaining price stability. Through mechanisms like open market operations, central banks adjust the supply of currency to meet economic objectives, such as controlling inflation and stabilising the banking system. This process influences short-term interest rates and, consequently, the broader economic activity .

The introduction of digital currencies, especially Central Bank Digital Currencies (CBDCs), presents new considerations for the traditional dynamics of money creation and monetary policy implementation. The IMF’s exploration into digital currency and central bank operations sheds light on how the advent of CBDCs and other digital financial innovations might influence the roles and functions of central banks, including the potential effects on monetary policy, seigniorage, the monetary base, and the transactional velocity of digital currency. As these digital forms of currency become more prevalent, their impact on the liquidity outside the monetary base and the demand for currency could signify a shift in how monetary policy tools are utilised and the overall approach to managing economic stability.

Commercial banks, in contrast, contribute to the vast majority of currency creation (see the ratio of M3, M2, M1 to M0) through lending practices. When these banks issue loans to individuals or businesses, they effectively create new deposits in the banking system, thereby expanding the currency supply. This aspect of currency creation, often termed as the creation of “commercial bank currency,” is facilitated under the regulatory framework and monetary policy guidelines established by central banks. Commercial banks’ ability to create currency is inherently linked to their lending activities, which, unlike central banks, do not include the power to issue currency but significantly impact the currency supply through the multiplication of bank deposits .

Currency creation on Bank level

Banks, themselves, create also currency through a combination of deposit-taking, lending, and the fractional reserve banking system. It's important to note that banks do not create physical currency (i.e., cash), but rather, they create new currency in the form of bank deposits, which function as a widely accepted medium of exchange.

Here's an overview of the process:

  1. Customer deposits: When customers deposit money in a bank, whether through cash, checks, or electronic transfers, they increase the bank's reserves. These deposits are essentially liabilities for the bank because they represent the amount owed to the customers.
  2. Fractional reserve banking: Banks are required to hold a certain percentage of their deposit liabilities as reserves. This reserve requirement is set by the central bank, such as the Federal Reserve in the United States. The purpose of this requirement is to ensure banks maintain sufficient liquidity to meet withdrawal demands and to promote financial stability. The remainder of the deposits, known as "excess reserves," can be used for lending or investing.
  3. Lending: When banks lend currency to borrowers, they create new currency in the form of bank deposits. For example, when a bank approves a loan, it credits the borrower's account with the loan amount. This creates new deposits in the banking system, effectively expanding the currency supply.
  4. Currency multiplier effect: The process of banks creating currency doesn't stop with the initial loan. When the borrower spends the loaned money, it ends up in the bank account of another person or business. This recipient, in turn, may deposit the funds in their bank account, which can lead to further lending and additional creation of currency. This chain of events is known as the currency multiplier effect.

It's important to recognize that there are constraints on the currency creation process, such as the reserve requirement, capital adequacy requirements, and market demand for loans. Additionally, central banks can influence the money supply through monetary policy tools like open market operations, changes in reserve requirements, and adjustments to the policy interest rate.

If you want to discuss with us your specific needs regarding currency creation, please contact our director Isof Baco.