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Class of 2020! Money Matters (Part 2): Money Creation.

In the previous article, we had learnt about the currency that how all the world currencies are pegged by dollar and dollar is pegged by nothing, all the currency market is working on faith and this currency is known as fiat currency. In this article, we will dive into the world where the money is created out of nothing and how this benefit only a tiny section of society.

The paper notes that are in your wallet are printed by the government and you, like many other people, believe that they have some value and you can buy goods and services from it. Only this trust gives the value to the paper notes you hold. The printing cost of these paper notes is very less compared to the value they hold. Say it takes Re. 1 to print a Rs.10 note, here we get a clear profit of Rs.9 while printing the note. As government prints the paper notes or currency, the profit is enjoyed by the government as a revenue source, known as seigniorage. As nothing backs the currency, it is technically possible for the government to print an unlimited supply of currency. In this scenario, there would be no need for taxes, no one would be poor and the government could fund every project in the country. It would be a win-win situation for all. Then why the governments do not do this?


The supply and demand determine the value of an asset. If supply is greater than the demand, then the value of the asset will depreciate and if demand is greater than the supply, then the value of the asset will appreciate. Currency, as an asset behaves similar to this, printing more currency will result in vast supply which will depreciate the value it holds and eventually will make it another worthless piece of paper. This loss of purchasing power of an asset over time is known as Inflation. Economists believe that controllable inflation is good for an economy. They suggest 2% inflation for developed nations and 4 to 6% for developing nations. This helps increase spending by the consumer and thus helps in to grow the economy. If the government don’t keep the supply of currency in check, inflation can go out of hands easily resulting in hyperinflation, where purchasing power is reduced drastically. There are countries who have faced hyperinflation in the past. An apt example of this is Zimbabwe who clocked the hyperinflation rate of massive 79.6 billion percent on the month on month basis. Zimbabwe was forced to print currency note of denomination 100 Trillion. So the government walk on a tight rope when it prints money.

The Role of Commercial Bank

Debt Based Money

In the money creation process, the government plays a very minuscule role compared to the role played by commercial banks. Banks create whopping 90% of the currency is in circulation in the world. Initially, banks were mere financial intermediaries and held no power more than accounting firm. But it all changed when banks were allowed to create their own money based on debt. Debt is a promise by someone to repay the money loaned to him with interest on it. From the bank’s perspective, this promise is as good as money because that person owes an obligation to the bank. So, when someone goes to the bank for a loan, say Rs.1 Lakhs to buy a house, the bank creates Rs. 1 Lakhs digitally out of nowhere on the promise that the person will give it back to the bank. This promise or the debt of Rs. 1 Lakhs is written as an asset in the bank accounts book and bank will give this asset as money to the seller of the house which he will spend to buy more goods. This money creation based on debt has huge implications in the modern economy. It is a bit complicated but you can see it from a distinct point of view, from the bank side, as debt is actually money. For more growth we need more debt. When banks lend, they are not lending someone else’s money, but they are creating brand new money out of the thin air.

Fractional Reserve Lending

The other way the bank helps in creation of money is through fractional reserve lending. All banks around the world are required to maintain a cash reserve ratio (CRR) against the deposit they have from the bank account holders. For example, if you deposit Rs. 100 in the bank (Say bank A) and the CRR is 10% then the bank has to maintain Rs. 10 as a reserve with the central bank (RBI in case of India) and can use the rest Rs. 90 for lending. Suppose the bank lends that Rs. 90 to someone and that person deposits this money in another bank (Bank B). Now the bank B has to maintain Rs.9 with the central bank and can use the rest Rs. 81 to lend. Bank B can lend to someone else and he can again deposit in another bank and this cycle goes on. This whole process is known as fractional reserve lending and you have a created a multiplier effect by depositing Rs. 100 as of this Rs. 100 there will be a total of Rs. 1000 in the circulation. Again the money is created by the banks out of nowhere.

The Role of Government

Loans By Central Banks

Central Bank of any country is responsible for the printing and circulation of money in a country. It acts as the bank for the commercial banks and the government and loans out money to these entities via buying their bonds. Bonds are a kind of written debt obligation on the government or the commercial banks to repay back the money they owe to the central bank. The government pay back that money from the revenue it generates from the taxes from the taxpayers. As government takes more loans, it will result in more burden on the taxpayers. Most of the Central Banks around the world work independently and are not in the scrutiny of anyone in the country. Central Bank, which has no saving with it, can create money to lend to the government. Because of this power of creating money, a central bank can never go bankrupt. Technically, central banks can create as much money as they want.

Central Bank and Economy

For the past many years central banks across the globe are lending an enormous sum of money directly to the private corporations by buying their bonds under the measures of quantitative ease. This was done by the central banks in the hope to support the economy. Now Central Banks around the world ends up in owning various assets around the world. For e.g. the Central Bank of Japan holds assets that worth more than the GDP of Japan and owns 80% of the stock market of Japan. The central banks are bailing the ill struck banks as these banks are so intertwined in the money circulation that fall of one will lead to cascading effect and huge destruction to the economy. So these central banks are creating money out of nothing, they can’t go bankrupt but they buying are real assets. Anyone can say that this is not right, but it’s happening.

Central Bank has increased the supply of currency by many folds, but why we are not seeing that much inflation in the currency itself? This inflation is hidden in the prices of the asset like the stock market and real estate. The prices of these are going beyond the rational explanation. The excessive buying of the central bank is the reason the stock market no longer follows the economy. While the economy is falling the stock market is touching new highs only because of the money infusion by the central banks in the stock market. This buying rather being supportive of the economy is making few people at the top, who owns most of the stock market, rich. The loan money by the central bank ultimately is to be paid by taxpayers is benefiting a small section of society and thus increasing the income inequality.


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