Money creation and circulation in the economy

(This is a draft version of an article. Therefore any comments, corrections and suggestions for improvement are welcome as they will be used to improve it.)

1. Money in economic universe

Economy universe consists of two sets of processes:

• Products/Services Creation, Trading and Consumption /Destruction


• Money Creation, Multiplication and Destruction

They interact in the following way:

- all Products/Services (including financial) are Supplied onto the Marketplace

- Cash (narrow money) is as the medium of exchange and store of value

- through Market Transactions such as producing goods, selling/buying goods, destroying (consuming) goods, selling/buying services, consumer banks operations (depositing money in a bank, lending money by a bank, withdrawing deposits, paying back loans)

- Credit Creation by circulating Cash through Deposit – Loan Cycle: by accepting Deposits and Lending them out, money is circulated in the economy multiplied in the process (also sometimes referred to as broad money), this is reflected on Loan/Deposit Balance Sheets and Cash Reserves; Loan to Deposit Ratio defines Money Multiplier (an underlying attribute of Credit Creation)

- Central Bank operations such as Creating or Destroying Cash, setting up Interest Rates, Open Market Operations, lending as the Lender of Last Resort

The graph below shows the structure and flow of money in the economy:

Economic universe has the following characteristics:

- ownership/supply of Product/Service

- value/price of Product/Service

- Cash Reserves and Loan/Deposit Balance Sheets

- Credit Creation (Deposit – Loan Cycles) information

2. Economic activities

An economic activity is a Market Transaction which is a transfer of ownership/supply for a price or Depositing or Lending money through as a Deposit – Loan Cycle (Credit Creation).

The model presented on the graph above separates and abstracts a Service of depositing and lending money from a process of Multiplying Money, i.e. Credit Creation, which is a result of lending deposits out. The former is modelled on the graph by a Market Transactions process (of Supplying a Product/Service) while the latter is modelled by Credit Creation. This a dual role of a bank as a Credit Creator and, possibly through it, as Product/Service Supplier is central to money creation and circulation in the economy.

2.1 Products and Services Demand and Supply

Products and services are created and they are ready for sale on the market in exchange for money. This constitutes Supply and Demand characteristics whose balance may be described, for example, by a Fisher’s “Equation of Exchange”, MV = PT. As an example we can observe that if we do not control the growth of Supply of Products and Services (due to its complex structure, natural and unpredictable phenomena, etc.) and we control growth of Money Supply (for example by setting Interest Rates or controlling Loan to Deposit Ratio) then additional Money Supply, through Credit Creation, will result in inevitable Inflation to balance Supply with Demand. A gradual increase of Demand results in gradual increased economic activities to satisfy it on a Supply end.

It is not a purpose of this model to argue the correctness of any theory or equation of Supply and Demand but to show that the model presented in this paper can accommodate any Supply and Demand theory.

2.2 Market Transactions

Money received for provision of Products/Services is either held outside of a Bank e.g. by a Product/Service Supplier), spent on Products/Services (Direct Cash Exchange, No Credit Creation) or is Deposited in a bank (in a form of Deposit or repayment of a Loan previously obtained).

2.3 Credit Creation (Deposit – Loan Cycle)

Banks (modelled as Bank on the graph above) provide Deposits back to the market (to depositors: Deposits paid out) or give loans (to creditors: Loans given), which is Credit Creation. Loans are given using Fractional Reserve Banking method. In extreme cases:

- if Loan to Deposit Ratio is 0% then effectively no loans are provided only deposits paid in are paid out to depositors (Cash Reserves equals liabilities on Loan/Deposit Balance Sheet); in such case a Bank is a store of Cash (in other words Cash Reserves are 100%). This is called Full Reserve Banking (or 100% Reserve Banking).

- if Loan to Deposit Ratio is 100% then all Deposits are turned to Loans and no Cash Reserves are created. This is called No Reserve Banking.

In the first instance, banks do not play a role as a (re)-lender but are a store for money. In the second instance (no Cash Reserves are accumulated to secure demands of depositors to pay out), if loans were 100% secure repayable on demand then such a model could have practically functioned. Typically banks lend with Loan to Deposit Ratio between 0% - 100%. For example, if Loan to Deposit Ratio were 90% than for every $10 on the Loan/Deposit Balance Sheet of liabilities banks accumulated $1 Cash Reserves, i.e. Money Multiplier is 10.

Such a model is possible to function in practice, since money is circulated through banks and not all depositors demand money at the same time, only a fraction of liabilities (on Loan/Deposit Balance Sheet) need to be satisfied at any one time. However, since there are demands on Deposits to be paid out and some creditors may default (not pay back a Loan) Cash Reserves are necessary. Inter-bank lending makes the system function as one big bank balancing supply and demand of liquidity by different banks. Furthermore a role of Central Bank is to act as a Lender of Last Resort in the event that banks’ Cash Reserves are not sufficient to satisfy demand for Deposits withdrawal (State guarantees of Deposits play an ultimate role in a credibility of such system, which works as a statistical machine).

It is not a purpose of this paper to argue a safe or practical level of Loan to Deposit Ratio which determines Money Multiplier and Cash Reserves level (or that Fractional Reserve Banking with Loan to Deposit Ratio above 0% should be accepted as a model). We observe that it is a philosophical debate what level of risk the society should accept, similar to safety of road, train or air travel, or nuclear power stations. We observe that the higher the Loan to Deposit Ratio the larger the Money Supply in economy, however at the same time, the greater the risk of liquidity shortage as the size of Cash Reserves are relatively smaller to overall banks’ liabilities on Loan/Deposit Balance Sheet.

2.4 Central Bank’s role

Apart from acting as the Lender of Last Resort, a role of Central Bank¸ as a creator of Cash (narrow money), is to set control on Money Supply (through Credit Creation) by setting an Interest Rate and acting through Open Market Operations. For example, a higher Interest Rate encourages saving and discourages borrowing thereby reducing Money Supply by reducing volume of Credit Creation, i.e. amount of broad money in circulation. This, in turn, reduces Products/ Services Demand which reduces pressure on Supply, typically resulting in reduction of Inflation. This, in turn, usually results in reduction of Interest Rates by Central Bank. This is a balancing act that a Central Bank plays (in practice, typically using principles behind MV = PT equation as a guide).

3. Additional comments

3.1 Financial Products/Services

Financial (banking) Products/Services are considered like any other Product/Services in the economy. There is no reason to consider them differently: they are simply Products/Services sold as a part of Market Transactions. The importance of banks’ role as Credit Creators (by executing Deposit – Loan Cycles) suggests that if banks collapse the economy will collapse too. Whilst this may be reasonably assumed as a correct hypothesis, this does not make banks unique suppliers of Products/Services in the economy. For example a collapse of electricity producers/suppliers or water producers/suppliers would bring economy to a collapse too. Therefore whilst banks role may be seen as vital, it is not unique.

In this context we separated and abstracted banks’ role as Credit Creators (through Deposit – Loan Cycles) and a role of Product/Services Suppliers.

- when a bank issues a Loan out of a Deposit, on one side it Creates Credit AND, at the same time, it is selling a Product/Service (provision of a Loan) for which a Creditor pays;

- when a bank accepts a Deposit (which may be later issued as a Loan), on one side it makes the first step in Credit Creation AND, at the same time, it is buying a Product/Service for which it pays a Depositor. We consider a Depositor as a Lender to a bank (i.e. a bank is a Creditor to a Depositor).

As noted before, this approach separates and abstracts a mathematical process of Money Multiplication (resulting from Loan to Deposit Ratio above 0%) from a Products/Services Supply of lending money (and other financial Products/Services). A Bank, as a Credit Creator, makes profit, on the whole, by paying out less for taking Deposits than charging Creditors for Loans. Pensions, endowments, savings, wholesale funding, insurance policies, derivatives and so on are financial Products/Services.

3.2 A role of a State in the model

In this description there is no reason to separate a State impact on economy from other providers of Products/Services. For example, taxation is a Market Transaction whereby taxpayers pay for Products/Services delivered by a State. (Whether efficiently or not is another matter and this question also applies to privately sold Products/Services.) Government bonds are financial products sold on the market. For avoidance of doubt, this model does not imply or support any argument whether a “larger State” is better than a “smaller” one, the State sector is as efficient as private sector etc. It also does not imply that such Market Transactions are voluntary (in some case like payment of taxes or law enforcement services, clearly they are not).

4. Economy dynamics

At any point in time a state of the economy is characterised by a set of information about it. This would include all the information at every level of economic activity: all information about every single Product/Service, its price/value, amount of money in circulation and its allocation, Loan/Deposit Balance Sheet, Cash Reserves, Interest Rate and so on. Any economic activity in such a system is a transition from the existing state to a new one. Examples of transitions to a new state:

- a Product or Service is sold at a certain price

- a new product is offered on the market at a certain price

- a prospective buyer of a service agrees a reduction of a price

- such a buyer (as above) completes a transaction

- a bank lends money to a borrower

- a borrower repays (a part) of a loan

- a deposit is made money in a bank

- Central Bank changes an Interest Rate

- … and so on

In general a transition from one state to another, changes the information defining ownership/supply of Product/Service or value/price of Product/Service or Creating Credit or other attributes in the model.

We can consider any economic activity as a transition from one state of economy to a new one. Some economic activities may be null transitions, i.e. result in no change to information about the state of the economy. For example, a re-evaluation of the price of a Product/Service resulting in the same price is an example of a null transition.

The presented model does not imply whether deposits create loans or vice versa. This is akin to “chicken and egg” dilemma. Money circulation is of cyclical nature with iterative or recursive characteristics and description has to start somewhere which may possibly give a wrong impression of any assumed starting point of a cycle. In the context of this model it is a purely philosophical issue of no practical consequence.