Money creation: how does it work?

What was the context surrounding the ECB’s announcement of these new €100 and €200 banknotes?

The Eurosystem has all but ceased issuing the €500 banknote. As of January 27, 2019, 17 of 19 central banks belonging to the Eurosystem had stopped issuing the larger banknote, while the central banks of Germany and Austria will follow suit in April. Announced by the ECB in 2016, this decision was motivated by an effort to combat illicit activities, since the banknote could facilitate large cash payments. At the same time, a new series of €100 and €200 bills will be introduced on May 28, 2019. The goal is to improve security (with innovations like the ‘satellite hologram’ and the ‘emerald number’), but above all to increase the quantity of €100 and €200 notes in circulation, in order to hasten the disappearance of the €500 bill. 

Are money creation and printing banknotes the same thing? 

Printing banknotes accounts for only a tiny fraction of money creation. There are two different types of money creation. On the one hand, the central bank creates so-called ‘central bank’ money (or ‘high-powered money’, the ‘base money’ or the M0 monetary aggregate), consisting in all issued bills and coins, plus commercial bank reserves with the central bank. This form of money is only exchanged between banks on the interbank market. 

On the other hand, banks create scriptural money (non-cash), representing short-term customer deposits included in their liabilities. These deposits are an integral part of money since they are extremely liquid and allow for fast payments. Scriptural money accounts for a greater share of all money creation than fiduciary money. 

As for the M3 monetary aggregate (also known as the ‘money supply’ or ‘broad money’), 95% of it is composed of the money that you and I use, meaning the bills and coins in our wallets and the amounts of our demand deposits (checking accounts), our holdings requiring a notice of withdrawal of three month or less (savings accounts) and our term-deposits with a maturity of two years or less. More precisely, the M3 aggregate also includes debt securities with a maturity of less than two years issued by banks, which can be traded on the money market, as well as shares in money mutual funds. But these instruments account for only a small share of the money supply (about 5%). So the money supply consists in a portion of central bank money (bills and coins) and scriptural money, which is by far the larger share. In December 2018, fiduciary money amounted to 1,175 billion euros, scriptural money (short-term customer deposits) totaled 10,541 billion euros, while the total money supply in the eurozone reached 12,638 billion euros. 

That is why printing money (or producing fiduciary money) is actually part of money creation, but it is only a small fraction of the whole. Moreover, this form of money creation is mostly offset by the monetary destruction caused by the Eurosystem pulling old bills out of circulation. In 2018, these actions represented 94% of the flow of new bills placed in circulation in the same year, and 83% of the total value of all bills in circulation. 

Finally, despite the development of new payment methods (debit cards, contactless payment, e-wallets, etc.), fiduciary money remains deeply ingrained in our habits. 

 Indeed, bills and coins made up 7.5% of broad money (M3) in 1997. Remaining stable since 2015, their proportion reached 9.5% in 2018. 

What concrete measures do commercial banks employ to create money? 

Commercial banks create money by using book entries. Take the example of an individual, Mister X, who takes out a consumer loan. When issuing the loan, the bank credits Mister X’s checking account (demand deposits) in the amount M corresponding to the loan, which increases the ‘customer deposits’ in its liabilities, and therefore the money supply. At the same time, the bank records its credit to Mister X in its assets under the ‘customer loans’ heading. 

But that’s not the end of the story. Once the loan is issued, suppose that Mister X buys a car from dealer Y, writing a check or sending a wire transfer in the amount M to dealer Y. If the dealer has an account at the same bank, that bank can simply move the money between accounts and its liabilities remain unchanged. But if the dealer Y banks at another institution, Mister X’s payment to dealer Y travels from one bank to the other. But in the end, what counts in the eyes of economists is that on the level of the wider banking system, a short-term deposit amount M was created in the banking system’s liabilities, regardless of the specific bank. Finally, as the loan is repaid, the money created is gradually destroyed: the money supply shrinks by the amount debited to Mister X’s account. At the same time, in terms of the bank’s assets, its credit to Mister X is reduced with each payment on the principal balance. Within a single bank and, to an even greater extent, across the banking system, the total amount of new loans issued typically exceeds repayments on existing loans, so that credit and money supply continually expand. 

So credit is the main counterpart (source) of the money supply. But what does ‘credit’ mean exactly? 

The definition is very broad. It comprises all financial instruments among the bank’s assets that may lead to the creation of short-term deposits in its liabilities. That includes loans granted to non-bank resident agents, such as households, businesses, municipalities or the government, though that’s not all. The term also covers debt obligations, and even equity, issued by businesses, the government or non-monetary market funds and purchased by banks. Regardless of the legal status of these instruments (loan, treasury bill, bond, stock, etc.), their inclusion in the banking system’s assets can lead to a rise in customer deposits and therefore the money supply. 

How does the central bank influence money creation? 

The central bank’s main goal is to ensure price stability. In practice, that means maintaining low inflation (the ECB’s target is 2%). With an inflation target near zero, the risk of tumbling into a deflationary spiral (falling prices) – which is especially difficult to curb – would be too great. The main tool wielded by the central bank in this effort is the benchmark interest rate. In this way, it can influence the cost of refinancing operations for commercial banks on the money market. On the low end, falling benchmark rates enable banks to create more money (by issuing loans), which stimulates activity and inflation. 

On the other hand, when the economy is close to overheating, and inflationary tensions emerge, raising benchmark rates gradually influences the cost of banking resources and the terms imposed on borrowers, leading to a healthy moderation in bank loans demand.