1. How modern money supply is created: From textbook to reality
Sigitas Šiaudinis
26 Sep 2015
Vilnius university

2. Types of money and their counterparts
Commercial banks
Assets
Liabilities
Equity, bonds
Loans
Time deposits
to economy
Demand
deposits
Loans from CB
Bank reserves
Money
holders
Time deposits
Demand
deposits +
Currency in
circulation
Central bank
Assets
Liabilities
Loans to
Bank reserves
banks
Currency in
Bonds
circulation
 Monetary base 2

3. Bank reserves with central banks:
special type of money indeed
Commercial banks
Assets
Liabilities
Equity, bonds
Loans
Time deposits
to economy
Demand
deposits
Loans from CB
Bank reserves
Money
holders
Time deposits
Demand
deposits +
Currency in
circulation
Central bank
Assets
Liabilities
Loans to
Bank reserves
banks
Currency in
Bonds
circulation
Bank reserves for inter-bank settlements to serve clients’ flows from one bank to another bank.
Main function of inter-bank market: to offset temporal outflows of clients’ funds by opposite transaction with bank receiver.
Can households and non-bank enterprises open reserve accounts with the central bank? No: central bank does not compete with commercial banks for clients.
Can bank lend its reserves to their borrowers: directly no, indirectly yes, if bank provides credit to client for payments to supplier who has account with another bank (in such a case bank transfers adequate amount of reserves to account of bank of supplier with the CB rather than account of supplier. If client makes payments within the same bank: bank reserves has not been used in the process of granting loans. 3

4. Transfer of client funds and bank reserves
Commercial bank A
Assets
Liabilities
Equity, bonds
Loans
Time deposits
to economy
Demand
deposits
Bank reserves -100
-100
Commercial bank B
Assets
Liabilities
Equity, bonds
Loans
Time deposits
to economy
Demand
deposits
Bank reserves
+100
Bank reserves for inter-bank settlements to serve clients’ flows from one bank to another bank.
Main function of inter-bank market: to offset temporal outflows of clients’ funds by opposite transaction with bank receiver.
Can households and non-bank enterprises open reserve accounts with the central bank? No: central bank does not compete with commercial banks for clients.
Can bank lend its reserves to their borrowers: directly no, indirectly yes, if bank provides credit to client for payments to supplier who has account with another bank (in such a case bank transfers adequate amount of reserves to account of bank of supplier with the CB rather than account of supplier. If client makes payments within the same bank: bank reserves has not been used in the process of granting loans. 4

5. Offsetting outflows: inter-bank transaction (the first best solution)
Commercial bank A
Assets
Liabilities
Equity, bonds
Loans
Time deposits
to economy
Demand
deposits
Bank reserves +100
Interbank +100
Commercial bank B
Assets
Liabilities
Equity, bonds
Loans
Time deposits
to economy
Demand
deposits
Bank reserves -100
Interbank +100
+100
Bank reserves for inter-bank settlements to serve clients’ flows from one bank to another bank.
Main function of inter-bank market: to offset temporal outflows of clients’ funds by opposite transaction with bank receiver.
Can households and non-bank enterprises open reserve accounts with the central bank? No: central bank does not compete with commercial banks for clients.
Can bank lend its reserves to their borrowers: directly no, indirectly yes, if bank provides credit to client for payments to supplier who has account with another bank (in such a case bank transfers adequate amount of reserves to account of bank of supplier with the CB rather than account of supplier. If client makes payments within the same bank: bank reserves has not been used in the process of granting loans. 5

6. Offsetting outflows: borrowing from CB (second best solution)
Commercial bank A
Assets
Liabilities
Equity, bonds
Loans
Time deposits
to economy
Demand
deposits
Bank reserves +100
CB +100
Central bank
Assets
Liabilities
Loans to banks
Bank reserves
+100
Currency in
Bonds
circulation
Bank reserves for inter-bank settlements to serve clients’ flows from one bank to another bank.
Main function of inter-bank market: to offset temporal outflows of clients’ funds by opposite transaction with bank receiver.
Can households and non-bank enterprises open reserve accounts with the central bank? No: central bank does not compete with commercial banks for clients.
Can bank lend its reserves to their borrowers: directly no, indirectly yes, if bank provides credit to client for payments to supplier who has account with another bank (in such a case bank transfers adequate amount of reserves to account of bank of supplier with the CB rather than account of supplier. If client makes payments within the same bank: bank reserves has not been used in the process of granting loans. 6

7. CB steers interest rate: textbook approach
Bank reserves (R) or Monetary base (MB) 7
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8. Money multiplier: textbook approach
CB money injection
𝑚= 𝐶+𝐷 𝐶+𝑅 = 1+𝐶/𝐷 𝐶/𝐷+𝑅/𝐷
𝑀 𝐵 ×𝑚=𝑀= 𝐶+𝑅 ×𝑚=𝐶+𝐷;
Source: Primer on the Widely Misunderstood Money Creation Mechanism 8
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9. CB steers interest rate: empirical approach
Bank reserve (R) demand is inelastic to the price (short- term inter-bank interest rate) in the short run
even small shortage / surplus of bank reserves vis-à-vis demand (required + some excess reserves) would cause significant deviations of inter-bank interest rate from the CB target
CB must precisely match bank reserve supply and demand to steer inter-bank interest rates close to the policy target
How the CB (ECB, Fed, BOE etc.) change interest rates without manipulation with bank reserve supply:
the CB does simply change pricing of monetary policy operations (policy rates), if needed
credit institutions have no choice: they will accept the CB policy rate due to heavy dependence on CB-made bank reserve supply 9
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10. Commercial bank balance sheet
Commercial bank can create loans and deposits out of thin air within constraints
Commercial bank balance sheet
Assets
Liabilities
8 risk-free assets
8 capital
+100 loan 
+100 deposit
Credit demand and supply constraints:
Credit demand constraints:
borrowing costs
prospects of income and risk-adjusted return on investments
Credit supply constraints:
the bank’s capital adequacy and attitude towards risk (procyclic)
the liquidity (including roll-over) risk
the cost of funding and the risk-adjusted return on lending 10
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11. Practitioners on bank money creation
A.Holmes, FRBNY (1969):
In the real world, banks extend credit, creating deposits in the process, and look for the reserves later.
Ed Prescott, FRB of Minneapolis (1990):
There is no evidence that the monetary base leads the credit cycle, although some economists still believe this monetary myth.
A.Turner, FSA (2011):
Banks do not just intermediate financing flows – taking pre-existing savings and funneling them to users of funds – they create bank money, with bank deposits and bank lending rising in a self-generating cycle.
Reading: BOE Quarterly Bulletin Q1: Money creation in the modern economy 11
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12. Sequence of money creation
Commercial banks
Assets
Liabilities
Equities
Loans
Time deposits
to economy
Demand
deposits
Loans from CB
Bank reserves
Given interest rate environment (shape of yield curve)
CB policy rates
Financial markets:
non-bank bonds, equities
Supply
of funds
Demand
for loans
Supply
of loans
Money holders:
Financial asset allocation decisions
Central bank
Assets
Liabilities
Loans to
Bank reserves
banks
Banknotes
Bonds
Demand for liquidity 12

13. Credit and asset price cycle: upswing at given interest rates
Source: Turner (2011). Debt and deleveraging: Long term and short term challenges 13

14. Credit and asset price cycles: downswing at given interest rates
Source: Turner (2011). Debt and deleveraging: Long term and short term challenges 14

15. Mainstream vs. Post-Keynesianism
Features
Mainstream (New Neoclassical synthesis )
Post-Keynesian school
The supply of money is
Exogenous
Endogenous and demand led
Money
is neutral in the long-run
is neither neutral nor an inessential veil in the long- run
Money is tied to
Exchange
Production
Monetary causality
Deposits allow credits
Credits make deposits
Macro causality
Saving determines investment
Investment determines saving
Source: A Modern Guide to Keynesian Macroeconomics and Economic Policies (2011), pp. 34–61. 15

16. Quantitative easing
Making monetary policy more accommodative in a situation
where the policy rate is at the zero lower bound
or remaining scope for further cuts is not sufficient
by pro-active and large-scale purchases of private and/or public debt securities, expanding the CB balance sheet
instead of reliance on banks’ demand for monetary operations (when monetary expansion is not guaranteed)
QE when policy rate is not yet at zero lower bound, but remaining scope for further cuts is nor sufficient to make MP accommodative enough: Fed, BOE at QE start ( ).
Zero lower bound: a situation where CB policy rate reached its lowest technical level equal or close to zero, and further cuts are impossible (Fed: 0,0-0,25%, ECB MRO 0,05%, DF -0,20; MLF 0,30%).
Fed and BOE started QE in the late 2008 and spring of 2009 respectively in a situation where liquidity problems of the banking sector had been already solved to a large extent, however, it became obvious that subprime and banking crisis had transformed to the economic recession. 16

17. Bank reserves before QE
Commercial banks
Assets
Liabilities
Equity, bonds
Loans
to economy
Deposits
Bonds 300
Loans from CB
Bank reserves
Central bank
Assets
Liabilities
Loans to banks
Bank reserves
Currency in
Bonds 100
circulation 17
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18. Quiz: where CB gets money for QE from?
QE: bond purchases from banks
Commercial banks
Assets
Liabilities
Equity, bonds
Loans
to economy
Deposits
Bank reserves
+300
(Bonds -300)
Loans from CB
Quiz: where CB gets money for QE from?
Central bank
Assets
Liabilities
Loans to banks
Bank reserves
+300
Bonds 100
Currency in
circulation 18
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19. QE: bond purchases from non-banks
Assets
Equities, bonds
Deposits
+300
(Bonds -300) +
Currency in
Circulation
QE: bond purchases from non-banks
Commercial banks
Assets
Liabilities
Equity, bonds
Loans
to economy
Deposits
Bonds
+300
Bank reserves
Loans from CB
Central bank
Assets
Liabilities
Loans to
Bank reserves
banks
+300
Bonds 100
Currency in
circulation
Actually, the counterparties of CB monetary operations (including bond purchases) are financial institutions, normally banks. The CBs select banks as eligible counterparties thanks to their ability to widely spread monetary signals into real economy.
Bond purchases from non-banks is executed technically through the banks as typical market makers. 19
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20. Ačiū už dėmesį 20
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21. Inelasticity of bank reserve demand to the interest rate: empirical approach
R – bank reserves; RR – minimum required reserves (if any); RW – working balance of reserves; ER – excess reserves; r – short-term interest rate; D – bank reserve demand; 0/T – the first/the last day of particular period of reserve requirements. 21
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