Implications of Economic Policy for Food Security : A Training Manual

Annex 2C : The Process of Money Creation and Credit Expansion

1. Introduction

There exist close linkages between monetary and fiscal policy. Budget deficits are financed by credits, either by credits from abroad or from internal sources, such as individuals, companies, commercial banks, or the central bank. The latter source of financing budget deficits has been widely used by many governments. In this case, the money spent by the government is not withdrawn from other uses (via taxes or credits from private sources) but leads to an overall expansion of money supply. In essence, this means nothing else than printing of money and bringing it into circulation. The money supply is further increased by credit expansion within the banking system. Government borrowings from the domestic banking sector (central bank and commercial banks) increase the assets of the banks (e.g. in the form of treasury bonds) and provide the basis to expand their lending to others, contributing to an increase of overall money supply. If the increase of money supply exceeds real GNP growth, i.e. the growth in production of goods and services, this leads to what has been called "excess demand" or "excess absorption" which, in turn, is a major cause of inflation.

2. The quantity theory of money

A simple formula known as "quantity equation" shows the relation between money supply and prices:

M x V = P x Q

where

M = stock of money (currency outside banks plus demand deposits),
V = velocity of money circulation (number of times per period that an average unit of money changes hands/accounts),
P = the general price level or a price index,
Q = the number of transactions made in an economy during a year, or the real GNP.

If (as the economists who formulated the quantity theory of money originally assumed) the velocity of circulation and the real GNP are given and constant, then prices are a direct function of the volume of money supply. The above formula can be re-arranged as follows:

P = kM

or, to express the impact of increased money supply on inflation:

where k is a constant defined by V/Q, i the rate of inflation, dP the changes in prices and dM the change in money supply.

In reality, various factors disturb the direct mechanistic link between money supply and prices as assumed in the original quantity theory of money (the theory has been substantially refined and modified by the Keynesian and monetarist schools, but this is beyond the scope of this manual). Nevertheless, there can be no doubt that money supply is, according to the principles expressed in above identity equation, a major determinant of the prevailing price levels and of the rate of inflation. This fact provides the rationale for efforts to restrict the money supply under adjustment.

3. Money creation through credit expansion within the banking sector

Money deposits on checking accounts with a bank, reserve requirements, and the interaction of lending and payments within the banking system are the key elements in credit expansion and money creation within the banking sector. This is illustrated by the following example.

We assume that an initial deposit of $ 1,000 is made on a checking account. The bank keeps a certain percentage (we assume 10 %) of the deposited amount as cash reserve and uses the rest for new loans or investments (e.g. in treasury bonds). The process of money creation starts as soon as payments resulting from the additional loans or investments (in our case: $ 900) are credited to checking accounts with other banks. The second round bank(s) will keep 10 % of the deposits ($ 90) as cash reserve, too, and use the rest ($ 810) for new loans or investments. These new loans or investments will, again, lead to increased deposits with other banks in a third round. The process will continue ad infinitum with, depending on the reserve requirements, decreasing additional amounts per step. At the end of the process, the originally deposited amount of $ 1,000 will have induced a 10-fold increase in new deposits, or - in other words - will have "created" additional money of $ 9,000 and led to an increase in total money supply of $ 10,000. The following table illustrates this process.

Table 2C: Illustration of the Process of Money Creation through the Banking System

The ratio of increased bank money to increased reserves is called the money-supply multiplier and is calculated using the following formula:

where dM stands for total additional money supply, dCD for the initial additional cash deposit, and r for the share of the reserve requirements. In our example above, this gives :

The above formula indicates the maximum theoretical amount of additional money created within the banking system on the basis of an initial cash deposit. In practice, there are various factors, which restrict credit and money expansion to a smaller amount.