May 13, 2020
Can social objectives be financed by money creation?
Part 2: Central banks
We showed in Part 1 that commercial banks create money. We considered a banking sector with balance sheet:
Let us now introduce the government and the central bank. The government wants to hire Carole as a school teacher and borrows money to pay for her wage, which is 20 euros. The government issues a bond, which is purchased by the bank. The government uses the money to pay Carole, who deposits her wage at the bank. The balance sheet of the banking sector is now:
The issuance of government debt leads to money creation in this example, because bank deposits are money as we showed in Part 1.
Let us now turn to the central bank. The central bank is the bank of commercial banks. Commercial banks have an account at the central bank where they hold deposits. Therefore, households hold deposits with commercial banks, which in turn holds deposits with the central bank! To avoid confusion, we use the term "deposits" to refer to households' deposits at commercial banks and "central bank money" (CB money in short) to refer to commercial banks' deposits at the central bank.
Central banks create CB money in two ways: asset purchases and lending to banks. Let us start with the former. The central bank purchases assets from commercial banks and pay using newly created CB money. For instance, the central bank can buy 10 euros worth of government debt by creating 10 euros of CB money. The balance sheets of the central bank and the banking sector are then:
In normal times, central banks purchase risk-free government debt. During recessions, central banks can also buy risky debt as the ECB and the Fed recently did during the Covid crisis as we studied in a previous post.
The second way central banks create CB money is by lending to banks. The central bank make loans to commercial banks by crediting their account at the central bank with CB money. For instance, if the central bank lends 10 euros to banks, 10 euros of CB money is created as shown below:
A recent example is the ECB's programme of loans to banks during the Covid crisis as described in this article in the FT ECB launches fresh push to lend to banks at ultra-low rates.
The process to reduce the quantity of CB money is exactly symmetric: the central bank sells assets or asks banks to repay their loans, which pulls CB money out of the banking sector.
We explained the how, let us now allude to the why. Central banks create CB money because it is used by commercial banks to make payments to each others. CB money is therefore an essential part of the payment system. Central banks also change the quantity of CB money over the business cycle to accommodate the needs of the payment system and to affect the interest rate.
Let us summarize what we learned:
Fact 3: Central banks create CB money by buying assets from, and making loans to, commercial banks.
Fact 4: There exist two types of (electronic) money: bank deposits created by commercial banks and used by households and businesses to make transactions; CB money created by the central bank and used by commercial banks to make transactions between themselves.
We focused on electronic money and did not mention bills and coins – aren't they money? Yes, they are money because they can be used to make transaction. And because bills and coins are created by the central bank, they are (physical) CB money. Therefore, households have access to physical CB money but not to electronic CB money.
This state of affair may change in the future if proposals to create central bank digital currencies materialize (see for instance this article in The Economist China aims to launch the world’s first official digital currency). CB digital currencies would allow households to use electronic CB money without the intermediation of commercial banks, which would deeply transform the functioning of the banking sector.
Tomorrow, we will see how the government can finance social objectives by having the central bank create CB money. To be continued...