Money creation is a fundamental concept in economics and finance, but its accounting mechanisms can be complex and often misunderstood. In this tutorial, we will explore how money is created, step by step, through the lens of accounting. We will use journal entries and financial statements to illustrate the process, and by the end of this tutorial, you will have a solid understanding of how money creation works in practice.
Overview: What is Money Creation?
Money creation occurs primarily through two processes:
- Central Bank Money Creation (also known as “base money” creation), where the central bank increases the supply of money in the economy.
- Commercial Bank Money Creation, where commercial banks create money by issuing loans and expanding deposits through the fractional reserve banking system.
While the central bank plays a crucial role, a significant portion of money is actually created by commercial banks through lending. Let’s dive into both processes with journal entries and examples.
Central Bank Money Creation
The central bank has the power to create money in several ways, primarily through open market operations, discount window lending, and reserve requirements. For simplicity, let’s focus on open market operations, which involve the central bank buying and selling government securities (bonds) in the open market.
Example 1: Open Market Purchase by Central Bank
The central bank buys $100 million worth of government bonds from a commercial bank. By doing so, it injects $100 million into the banking system, increasing the reserves of the commercial bank.
Journal Entries (Central Bank’s Books)
When the central bank buys government bonds:
- Debit: Government Securities (Asset) $100 million
- Credit: Bank Reserves (Liability) $100 million
These journal entries reflect that the central bank has increased its holdings of government bonds (an asset) while increasing the reserves of the banking system (a liability to the central bank).
Journal Entries (Commercial Bank’s Books)
From the perspective of the commercial bank, their reserve account at the central bank increases:
- Debit: Reserves at Central Bank (Asset) $100 million
- Credit: Government Bonds (Asset) $100 million
Notice that the commercial bank’s reserves at the central bank increased, and their government bond holdings decreased. The total assets of the commercial bank remain unchanged, but the composition of those assets shifts from bonds to cash reserves.
Impact on the Financial Statements
The increase in reserves does not directly affect the broader money supply yet. However, these increased reserves give commercial banks the ability to lend more money, which leads us to the second process—commercial bank money creation.
Commercial Bank Money Creation
Commercial banks create money primarily through lending. When a bank issues a loan, it creates a deposit in the borrower’s account. This deposit is considered money, even though it didn’t exist before the loan was made.
Example 2: Commercial Bank Issues a Loan
Let’s say a customer walks into the bank and takes out a loan of $10,000 to purchase a car. The bank approves the loan and credits the customer’s checking account with $10,000. The customer now has $10,000 available to spend, but this money didn’t exist before the loan was made.
Journal Entries (Commercial Bank’s Books)
When the bank issues the loan:
- Debit: Loans Receivable (Asset) $10,000
- Credit: Customer Deposits (Liability) $10,000
Here, the bank records an increase in loans receivable (an asset) and simultaneously creates a deposit in the customer’s account (a liability). In effect, the bank has created new money by expanding its balance sheet. The deposit, which is a liability for the bank, is also considered money from the perspective of the economy.
Impact on the Financial Statements
The balance sheet of the commercial bank expands:
- Assets:
- Loans Receivable: +$10,000
- Liabilities:
- Customer Deposits: +$10,000
Notice that while the bank’s balance sheet grows, the new deposit increases the money supply in the economy.
Fractional Reserve Banking and the Money Multiplier
In the real world, commercial banks are required to hold a fraction of their deposits as reserves. Let’s assume the reserve requirement is 10%. This means that for every $1,000 in deposits, the bank must keep $100 in reserves but can lend out the remaining $900.
The loan recipients deposit the $900 in another bank, which keeps 10% ($90) and lends out the rest ($810). This process repeats throughout the banking system, resulting in a multiplier effect.
Money Multiplier Formula
The total amount of money that can be created from an initial deposit is determined by the money multiplier, which is calculated as:
For a 10% reserve requirement, the multiplier is:
This means that for every $1 of new reserves injected into the system, up to $10 can be created in the broader money supply through lending.
Example 3: Money Creation Through the Multiplier
Suppose the central bank injects $100 million in reserves into the banking system, and the reserve requirement is 10%. The potential increase in the money supply is:
Thus, through the money multiplier effect, the $100 million in reserves can potentially result in a $1 billion increase in the money supply.
Accounting for Money Creation in the Real Economy
Now, let’s walk through a more detailed example that incorporates central bank actions, commercial bank lending, and the creation of deposits.
Scenario: Central Bank Injects Reserves, Commercial Banks Lend, and Money is Created
- Step 1: Central Bank Buys Government Bonds
The central bank buys $50 million worth of bonds from a commercial bank. This increases the bank’s reserves.
- Central Bank’s Journal Entry:
- Debit: Government Securities (Asset) $50 million
- Credit: Bank Reserves (Liability) $50 million
- Commercial Bank’s Journal Entry:
- Debit: Reserves at Central Bank (Asset) $50 million
- Credit: Government Bonds (Asset) $50 million
- Step 2: Commercial Bank Lends Out Reserves
The commercial bank lends $40 million to various businesses and individuals, creating deposits in their accounts.
- Commercial Bank’s Journal Entry:
- Debit: Loans Receivable (Asset) $40 million
- Credit: Customer Deposits (Liability) $40 million
- Step 3: Borrowers Spend Money
Borrowers spend the $40 million, transferring deposits to other banks.
- Journal Entries for Receiving Banks:
- Debit: Reserves at Central Bank (Asset) $40 million
- Credit: Customer Deposits (Liability) $40 million
- Step 4: Receiving Banks Lend Out Their Deposits
Receiving banks lend out a portion of their new deposits. Assuming a 10% reserve requirement, they keep $4 million in reserves and lend out $36 million.
- Receiving Banks’ Journal Entries:
- Debit: Loans Receivable (Asset) $36 million
- Credit: Customer Deposits (Liability) $36 million
Impact on the Economy
At this point, the initial $50 million injection of reserves by the central bank has multiplied into new deposits and loans throughout the economy. The broader money supply has expanded far beyond the initial $50 million.
In this example:
- Central bank reserves increased by $50 million.
- Commercial bank loans increased by $40 million (Step 2) + $36 million (Step 4) = $76 million.
- Customer deposits increased by an equivalent amount, $76 million.
This illustrates the money creation process: the central bank initiates the process by injecting reserves, and commercial banks multiply that injection by lending.
Risks and Considerations in Money Creation
While money creation is essential for economic growth, there are risks involved:
- Excessive Lending: If banks lend too much relative to their reserves, this can lead to an overextension of credit, creating bubbles in the economy. For example, the housing bubble of the mid-2000s was fueled in part by excessive bank lending.
- Inflation: Rapid money creation can lead to inflation. If the amount of money in the economy grows faster than the economy’s ability to produce goods and services, prices will rise.
- Liquidity Crises: If banks do not maintain enough reserves, they may struggle to meet withdrawal demands, leading to a liquidity crisis.
Conclusion
Money creation is a fundamental aspect of modern economies, and it primarily occurs through the actions of both central banks and commercial banks. Central banks inject reserves into the banking system, while commercial banks expand the money supply through lending. This process is captured through careful accounting, with journal entries and financial statements reflecting the changes in assets and liabilities for both central banks and commercial banks.
Understanding the accounting behind money creation helps to demystify how economies grow and how monetary policies impact financial systems. Through the lens of accounting, we can see how central bank actions lead to real changes in the money supply, affecting everything from inflation to economic growth.
The journal entries and financial statements serve as a clear record of this process, showing how money moves through the economy and multiplies through lending, ultimately helping us grasp the power and complexity of money creation.