Currency Creation Procedure
The creation of new money in a modern economy is a complex, interconnected process that involves both central banks and commercial banks.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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 terms M0, MB, M1, M2, and M3 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:
- M0: Also known as the monetary base or narrow currency, 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.
- MB (Monetary Base): The Monetary Base, 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.
- 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.
- 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.
- M3: M3 includes everything in M2, plus large time deposits, institutional money market funds, short-term repurchase agreements, along with other larger liquid assets. These are types of money that are less liquid than those included in M2, but still contribute to the total amount of money available in the economy.
Each of these measures provides a different perspective on the money 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 money 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.
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 money in the form of bank deposits, which function as a widely accepted medium of exchange.
Here's an overview of the process:
- 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.
- 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.
- Lending: When banks lend money to borrowers, they create new money 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 money supply.
- Money 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 money. This chain of events is known as the money multiplier effect.
It's important to recognize that there are constraints on the money 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.