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# System prepended metadata

title: Notes on central banking

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# Money in the modern economy
money is a type of IOU
three times of money: currency, bank deposits and central bank reserves. Most money is in the form of bank deposits.
**Money in the modern economy is just a special form of IOU, or in the language of economic accounts, a financial asset.**
**Financial assets are simply claims on someone else in the economy — an IOU to a person, company, bank or government.**
Because financial assets are claims on someone else in the economy, they are also financial liabilities — one person’s financial asset is always someone else’s debt. If everyone in the economy were to pool all of their assets and debts together as one, all of the financial assets and liabilities — including money — would cancel out, leaving only the non-financial assets.
Money is a social institution that provides a solution to the problem of a lack of trust. It is useful in exchange because it is a special kind of IOU: in particular, money in the modern economy is an IOU that everyone in the economy trusts.
evil is the root of all money.
broad money = currency + bank deposits
base money = currency + central bank reserves
![](https://hackmd.io/_uploads/ByWqzC3th.png)
Currency is made up mostly of banknotes (around 94% of the total by value as of December 2013), most of which are an IOU from the Bank of England to the rest of the economy. Fiat or ‘paper’ money is money that is not convertible to any other asset (such as gold or other commodities).
Fiat money offers advantages over linking money to gold when it comes to managing the economy. With fiat money, changes in the demand for money by the public can be matched by changes in the amount of money available to them. When the amount of money is linked to a commodity, such as gold, this places a limit on how much money there can be, since there is a limit to how much gold can be mined. And that limit is often not appropriate for the smooth functioning of the economy.
In the case of money, however, the state has generally played a role in its evolution. To bec omfortable holdingc urrency, people need to know that at some point someone would be prepared to exchange those notes for a real good or service, which the state can help guarantee. One way it can do this is to make sure that there will always be demand for the currency by accepting it as tax payments. They also need to have faith that the value of their banknotes will remain broadly stable over time if they are to hold them as a store of value and be able to use them as a medium of exchange. This generally means the state must ensure a low and stable rate of inflation.

Consumers only swap their currency for bank deposits because they are confident that they could always be repaid. Banks therefore need to ensure that they can always obtain sufficient amounts of currency to meet the expected demand from depositors
for repayment of their IOUs. For most household depositors, these deposits are guaranteed up to a certain value, to ensure that customers remain confident in them. This ensures that bank deposits are trusted to be easily convertible into currency and can act as a medium of exchange in its place.
**Far more important for the creation of bank deposits is the act of making new loans by banks. When a bank makes a loan to one of its customers it simply credits the customer’s account with a higher deposit balance. At that instant, new money is created.**
Commercial banks need to hold some currency to meet frequent deposit withdrawals and other outflows. But to use physical banknotes to carry out the large volume of transactions they do with each other would be extremely cumbersome. So banks are allowed to hold a different type of IOU from the Bank of England, known as central bank reserves and shown in green in Figure 2. Bank of England reserves are just an electronic record of the amount owed by the central bank to each individual bank. reserves accounts at the central bank can be thought of as playing a similar role for commercial banks as current accounts serve for households or firms. The Bank of England also guarantees that any amount of reserves can be swapped for currency should the commercial banks need it.
![](https://hackmd.io/_uploads/BJp7qbat3.png)
![](https://hackmd.io/_uploads/BJhiobaY3.png)

# Money creation in the modern economy
## money creation
the majority of money in the modern economy is created by commercial banks making loans.

banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits.

Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

Monetary policy acts as the ultimate limit on money creation

**rather than banks lending out deposits that are placed with them, the act of lending creates deposits.**

Rather than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the price of reserves — that is, interest rates.

The amount of bank deposits in turn influences how much central bank money banks want to hold in reserve (to meet withdrawals by the public, make payments to other banks, or meet regulatory liquidity requirements).

Banks making loans and consumers repaying them are the most significant ways in which bank deposits are created and destroyed in the modern economy. But it's not the only way.

Banks buying and selling government bonds is one particularly important way in which the purchase or sale of existing assets by banks creates and destroys money. Banks often buy and hold government bonds as part of their portfolio of liquid assets that can be sold on quickly for central bank money if, for example, depositors want to withdraw currency in large amounts.

Money can also be destroyed through the issuance of long-term debt and equity instruments by banks.
## limits to broad money creation
1. Banks themselves face limits on how much they can lend.
Banks have to be able to lend profitably in a competitive market, and ensure that they adequately manage the risks associated with making loans.
**bank will in practice seek to attract or retain new deposits (and reserves) to avoid running out of reserves.**
Interest rates on both banks’ assets and liabilities depend on the policy rate set by the Bank of England, **but how**?
Competition for loans and deposits, and the desire to make a profit, therefore limit money creation by banks.
liquidity risk, credit risk.
2. Money creation is also constrained by the behaviour of the money holders — households and businesses.
Tobin's theory, the money may quickly be destroyed if the households or companies receiving the money after the loan is spent wish to use it to repay their own outstanding bank loans. The second possible outcome is that the extra money creation by banks can lead to more spending in the economy.
3. The ultimate constraint on money creation is monetary policy.
So setting monetary policy appropriately to meet the inflation target should ultimately ensure a stable rate of credit and money creation consistent with meeting that target.(it's not true?)

implements monetary policy by setting short-term interest rates, specifically by setting the interest rate paid on central bank reserves held by commercial banks. It is able to do so because of the Bank’s position as the monopoly provider of central bank money in the United Kingdom. And it is because there is demand for central bank money—the ultimate means of settlement for banks, the creators of broad money — that the price of reserves has a meaningful impact on other interest rates in the economy.

The interest rate that commercial banks can obtain on money placed at the central bank influences the rate at which they are willing to lend on similar terms in sterling money markets — the markets in which the Bank and commercial banks lend to each other and other financial institutions. Changes in inter bank interest rates then feed through to a wider range of interest rates in different markets and at different maturities, including the interest rates that banks charge borrowers for loans and offer savers for deposits. By influencing the price of credit in this way, monetary policy affects the creation of broad money.

This demand for base money is therefore more likely to be a consequence rather than a cause of banks making loans and creating broad money.

The bank of England controls interest rates by supplying and remunerating reserves at its chosen policy rate. The supply of both reserves and currency (which together make up base money) is determined by banks’ demand for reserves both for the settlement of payments and to meet demand for currency from their customers — demand that the central bank typically accommodates.

reserve requirements are not an important aspect of monetary policy frameworks in most advanced economies today.

asset purchases(QE) are a way in which the MPC can loosen the stance of monetary policy in order to stimulate economic activity and meet its inflation target. But the role of money in the two policies is not the same.

QE involves a shift in the focus of monetary policy to the quantity of money: the central bank purchases a quantity of assets, financed by the creation of broad money and a corresponding increase in the amount of central bank reserves. The sellers of the assets will be left holding the newly created deposits in place of government bonds.

QE has a direct effect on the quantities of both base and broad money because of the way in which the Bank carries out its asset purchases. The policy aims to buy assets, government bonds, mainly from **non-bank financial companies**, such as pension funds or insurance companies.

the transmission mechanism of QE relies on the effects of the newly created broad — rather than base — money. instead, **QE works by circumventing the banking sector, aiming to increase private sector spending directly**.

The main article describes how QE works by first increasing the deposits of financial companies. **As these companies rebalance their portfolios, asset prices are likely to increase** and, with a lag, lead to an increase in households’ and companies’ spending.
![](https://hackmd.io/_uploads/SyF008222.png)
