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What is Money Creation?

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  • Written By: Mary McMahon
  • Edited By: Kristen Osborne
  • Last Modified Date: 06 December 2016
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Money creation is a process for making the money supply in a country larger. There are a number of ways to increase the money supply, and growing the supply over time is a key economic function, making funds available for when people need them. Regulatory agencies responsible for setting and enacting monetary policy can engage in money creation and so can banks, while they go about their daily business and regular financial activities.

Printing money to increase the currency supply is one option for making more money available, but money creation involves some different approaches. One option is for monetary policymakers to acquire assets, exchanging money for them and increasing the supply of available money by getting more money into circulation. Exchanging money for something of value allows the money supply to grow in a stable and controlled fashion.

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Another option is through the fractional reserve banking system used in most nations. When people deposit money in a bank, the bank is required to keep a percentage of the deposit on hand. It can take the rest of the money and use it for investments and loans. This results in money creation, as the original amount of the deposit still exists and is counted in the assets and liabilities of the bank. In a simple example, if someone deposits 100 units of currency in a bank working in a country with a 3% reserve requirement, the bank must keep three units on hand, and it has 97 to loan or otherwise use, effectively turning the 100 unit deposit into 197 units.

Banks engage in money creation every time they make loans and investments, and they earn money in the process by charging or receiving interest. This causes a steady growth in the size of the economy, as every time people bank, they contribute to money creation. The money loaned by the bank will come back in with another deposit, with the bank placing some funds in reserve and lending the rest out, and so forth. The amount of money in circulation actually exceeds the total of available currency, as often money moves in the form of numbers from account to account, without actually being physically present.

Checks on money creation are designed to prevent problems like inflation. The money supply can be decreased by changing interest rates, making credit less available and restricting the numbers of loans banks can offer. Currency can also be recalled to affect the currency supply, and reserve requirements may be adjusted to make banks keep more money on hand.

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burcinc
Post 3

@alisha-- That's such a good question. When the government "prints money," it goes to the US treasury. So the government has more money to spend on the economy (invest, fund social programs, tax benefits etc.). It indirectly reaches you in some way and will affect your household economy.

But the government doesn't really print money. As far as I know, there is no "actual" money being printed. When the government says that it is printing money, it is actually increasing the funds in the treasury.

This is a bit confusing because the government can't just say to the treasury "oh, you're going to have x amount of more money now." It does it by purchasing bonds from third

party investors. The government sort of buys its own bonds (without actually spending money) so that the investors can buy even more from the treasury, raising treasury funds.

Then the treasury will go ahead and spend as it as is necessary to help the economy and the public.

Did this clear it up for you or confuse you even more?

serenesurface
Post 2

@alisha-- If the supply of money in the country is low, the government may want to print more money to counteract that because if it continues, it will result in deflation which has negative affects on the economy (like raising unemployment).

It is still a tricky practice though because if you print too much money, then the opposite of deflation- inflation- will occur where there is too much money supply. The more the money supply, the lower the value of money. This might make it harder for you and me to buy our needs at the store. It will also make it harder for businesses using our currency to compete internationally.

But if there is deflation, the government can print some money to improve the situation. As long as it is not overdone, it can definitely help the economy.

discographer
Post 1

Whenever the country is in an economic recession, I hear that more money is being printed and released into the market.

I've always wondered, where does this money go exactly?

And how does printing more money help the economy? How does it help us regular folks with their budget?

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