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The Financial Express
Swasti Lankabangla Swasti Lankabangla

Understanding money creation process: RM to MS


Understanding money creation process: RM to MS

Money is the lifeblood of an economy. It moves into various economic steams to keep the economy alive. Depending on the degree of liquidibility, the money can be defined as M0, M1, M2, M3, M4, and so on. The lower the number, the higher the degree of liquidibility. The most liquid form of the money is M0, it is nothing but mere cash and we call it Reserve Money (RM). It is also known as High-Powered Money, Monetary Base, Base Money, Central Bank Money etc. The other forms of money, i.e., M1 is M0 + Demand Deposit, a form of money which is less liquid than M0, while M2 is M1 + Time Deposit, another form of money which is less liquid than M0 and M1.

The form of money keeps expanding based on the depth and breadth of the financial sector of an economy. In Bangladesh, as we calculate, the highest form of money is M3. It is M2 plus monetary data of other non-bank deposit-taking institutions including national saving certificates, prize bonds etc.

WHAT IS RM? : RM is nothing but the 'currency in circulation + banks' and other deposits with Bangladesh Bank (BB)'. The currency and deposits are the two important components of money. To understand the money supply process, we need to know the interaction between them, and how the regulator's policy influences these two components of the money. We also need to be mindful about the behaviours of three money market players: (i) the regulator (the central bank); (ii) the users (individuals and institutions that hold deposits in banks and borrow from banks); and (iii) the banks (financial intermediaries that accept deposits from individuals and institutions and make loans).

It is customarily a standard practice for banks to keep a certain part of its deposit liability as reserve with the central bank depending on the rule set by the regulator. Now, let us look into this issue with three possible reserve keeping options. Consider a situation where the required reserve is 100 per cent, which means that all deposits are required to hold as reserve. Banks accept deposits, place that as reserve with the central bank, and leave the money there until the depositor makes a withdrawal or writes a check against his balance with the bank. This 100-per cent-reserve banking system, where all deposits are held in reserve has zero or no effect on the money supply.

Another possible option could be fractional reserve banking where banks keep only a fraction of their deposits in reserve. Under this option, banks keep a certain fraction of their deposits as reserves required by the regulator. In a system of fractional-reserve banking, banks create money. Let us assume that an initial deposit of Tk 1000 has been made under a fractional reserve banking system. Say, the required reserve ratio (RRR) is 10.0 per cent. This could trigger a chain effect on deposits and money supply process. After receiving the initial deposits of Tk 1000, the bank is required to keep Tk 100 as reserve and could make a loan of remaining Tk 900 which will be deposited to another bank by the person who received the loan. Again, the second bank can make a loan of Tk 810 by keeping the required reserve Tk 90 out of deposited Tk 900. Here, we can easily observe that deposits create loans and then loans are reappearing as deposits and so on. If the process continues, it will be creating more deposits and more loans over time. Here, the speed of deposits and loan creation process directly depends on the value of RRR. The smaller the value of RRR, the faster the money creation process. Mathematically, it can be shown that the amount of money that the original Tk 1000 deposit will create in this process is: (1/RRR)x1000 = (1/0.1)x1000 = Tk 10,000. That's why, with the fractional reserve banking, it is said that deposit creates money.

The third possible option could be no-reserve banking. In this case, banks are not required to keep any reserve against the deposits they received. Here, the money creation process would be lightning-fast, as we can visualise that the same amount of loan and deposit will keep reappearing from the initial amount of deposit. In this process, the amount of money that the original deposit of Tk 1000 will be unlimited.

MONEY MULTIPLIER: Looking at the three possible options discussed above, we can come to a decision that only fractional reserve keeping is plausible. Taking the fractional reserve banking as a workable practice, we can define a process known as a simple deposit multiplier to see how multiple deposits could be created from a change in reserves. A simple deposit multiplier is defined as  ?D/?R or (1/RRR). Where, ?D = the change in checkable deposits, ?R = the change in reserves, RRR = the required reserve ratio. If RRR=10.0 per cent, the simple deposit multiplier would be 10. This means for every Tk 100 increase in reserve, there will be a 100x10 = Tk 1000 increase in deposits. 

There are, however, a few practical problems with this simple model of deposit creation. Just think, if the people do not deposit the entire amount of their money with banks, then the simple model overestimates the amount of checkable deposits created. Suppose that after receiving the loan of Tk 900 from the first bank (as mentioned earlier), someone may like to keep some cash (say Tk. 100) with him and deposit the rest, i.e., Tk. 800 in the second bank. This means that the second bank now can only loan out Tk 720 instead of Tk 810 as mentioned before since it has to keep 10.0 per cent of Tk 800 or Tk 80 as a reserve. Likewise, the banks may also like to keep some cash in tills before loaning out the whole deposited amount. In this way, the multiplier effect on the deposit creation process will be slower than the amount calculated above. When people do not deposit the entire amount, this is known as currency leakage. If banks decide to hold some cash, the simple model overestimates the amount of deposits created as well. What the simple model shows us is the maximum amount of deposits that can be created, if we start with very strict assumptions about what people and banks actually do.

Therefore, some adjustments are essential to reconcile the above limitations of the simple deposit multiplier model. For that, we need to introduce two terms into the simple model to make it a plausible and regular multiplier. These two terms are currency-deposits ratio (C/D) and excess reserves-deposits ratio (ER/D). By introducing C/D and ER/D into the simple deposit multiplier, it can be shown that the regular money multiplier (mm) is = (1 + (C/D)) / (RRR + (ER/D) + (C/D)). Interestingly, this transformation of the money multiplier relates the change in the money supply (MS) to a given change in the reserve money (RM) where MS = mm x RM. It explains how a change in the reserve money inflicts a change in the money supply. If mm is 5 and the amount of reserve money increase by Tk 100 then the amount of money supply will be increased by Tk 500.

Now, it is imperative to look at the factors that affect both the reserve money and the money multiplier to depicts the whole money creation process. Let us first look at the components of reserve money that constitute the balance sheet of the regulator. Looking at the simplest form of the balance sheet of a regulator, thinking  Bangladesh Bank (BB) in this case, we can see net foreign asset (NFA) comprising foreign currency, gold, and reserve holding and net domestic asset mainly comprising claims on government, claims on other public, claims on deposit money banks (DMBs) in the form of securities, discount loans (including refinance loans) etc., are in the asset side while currency in circulation (currency outside banks + cash in tills) and deposits held with BB (required + excess reserves) are in the liability side.

Any increase in the above-listed items on the asset side will increase the RM and size of the BB's balance sheet. For example, any inflows of foreign currencies, the holding of more gold or SDR (Special Drawing Rights) will increase the RM. Likewise, holding more government securities, disbursing more loans through a discount window, or through refinance credit lines will also increase the volume of RM. All of these changes will bring a consequential impact on the money supply through money multiplier (e.g., MS = mm x RM). For example, considering mm as 5, Tk 100 increase in discount or refinance loan will inflate the BB's balance sheet by Tk 100 and, thereby, the money supply will increase by Tk. 500.

Now, let us examine how each of the components of mm, namely RRR, C/D, and ER/D contributes to the money supply process. It is noteworthy to mention that all of the three ratios of the money multiplier (mm) are inversely related to mm. That means a higher value of RRR, or C/D or ER/D will reduce the magnitude of mm. So, if there is an increase in RRR, the value of mm will decrease and the money supply process will slow down because banks are now legally obligated to hold more cash as reserves and, as a result, banks will be able to loan out less funds to individuals. If less loans are being made, then there is less money that can be deposited into other banks, and, thus, less of an expansion of money can occur.

What if C/D increases? This means that people are now holding a higher fraction of their income as cash instead of deposits where the currency leakage problem is appearing, leading to a smaller value of money multiplier. That is why when money demand for cash increases, the value of mm tends to decrease and the process of money supply becomes slower. What we saw during the last March-June 2020 is that people were withdrawing and holding relatively more cash due to on-going coronavirus pandemic related uncertainties resulting in lower value of mm and, thereby, slower money creation process.

Likewise, an increase in the excess reserve-deposits (ER/D) ratio will also have a similar impact on the money multiplier and money creation process. The intuition is that if the excess reserve ratio increases, then banks are not optimally using its loanable funds. If they loan out less of their funds, then there would be less money that individuals can deposit in banks. The reasons why banks would be unable to use their funds optimally depend on numerous factors ranging from the managerial inefficiency to the prevailing market conditions. For example, if market interest rates increase, then banks will be less likely to hold excess reserves. This is because they would be missing out on a bigger profit opportunity. Secondly, if there is a possibility of deposit outflow to increase, then banks will be holding excess reserves to protect against the outflows, otherwise, it must call in loans to cover these deposit outflows. Therefore, if banks expect the deposit outflows to increase, they will increase the excess reserve ratio accordingly.

CONCLUSION: Now, in concluding the discussion, it is a million-dollar question to ask - how much control a central bank has over the RM? From our discussion we can safely assume that the central bank has reasonable control over the RM. However, it is not necessarily true that only the central bank's decisions affect the RM. When making an open market sale or purchase through auction, repo, and reverse repo, the central bank merely directs a bank to make a sale or purchase. In this case, the central bank has complete control. Nonetheless, the central bank cannot determine the amount of borrowing that commercial banks will do when the central bank sets a refinance line where it only can expect how much borrowing commercial banks will do, but it cannot be sure about the amount that the banks will borrow. Thus, the central bank lacks complete control over the RM to some extent because the commercial banks have decisions to make. It may then be appropriate to break the components of the RM into two parts, the one that the central bank completely controls, the non-borrowed RM, and the other one that it cannot control with 100 per cent certainty.

In sum, it could be said that the money multiplier plays an important role in establishing monetary authority's precise control over reserve money and, thereby, money supply. Various factors could affect the magnitude of money multiplier directly, such as changes in the required reserve ratio (RRR), changes in the currency deposit ratio (C/D), and the changes in the excess reserve deposit ratio (ER/D). An increase in any of these ratios will reduce the magnitude of money multiplier and, thus, dawdle the money creation process. Some other factors, such as market interest rates and expected deposit outflows could affect money multiplier indirectly. A decrease in the market interest rate tends to increase the excess reserve deposit ratio for which money multiplier and the money creation process could be moderated to some extent. Similarly, an increase in the expected outflow of deposit will also increase the excess reserve deposit ratio and hence reduce money multiplier marginally. Besides, an increase in foreign currency inflows (like foreign aid, remittances etc.), holding of additional gold or SDR, acquiring more government securities, facilitating more discount/refinance loans would enhance the volume of reserve money and so to the balance sheet of the central bank resulting in increased volume of the money supply through the multiplier effect.

Dr Md Habibur Rahman is a banker and a macroeconomist. habiburr@yahoo.com

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