How is money created?

Modern money is created by using three primary methods. These methods are called seigniorage, fraction reserve banking, and quantitative easing. This article will explain these methods with real-world examples.

What is Seigniorage?

The profit earned by the government while issuing a currency is known as seigniorage. The profit is derived from the difference between the currency’s value and the cost of production.
For example, if the central government bank prints a $100 bill and a $1 coin at a cost of $1 for the bill and $0.01 for the coin, the seigniorage is $99 for the bill and $0.99 for the coin.
Seigniorage is a way for the government to create money by minting currency. Money costs are usually (but not always) lower than the face value of the created currency. Economic profit will arise from positive seigniorage, while an economic loss will result from negative seigniorage. The difference is invested by central banks and governments in order to earn interest.

Base Money

Base money is the money that is issued by the country’s central bank. The central bank raises base money by operating directly in the open market. Commercial banks that practice fractional reserve banking play a significantly larger role in extending the quantity of broad money created by the central bank than the central bank does. Authorities restrict commercial bank’s creation of broad money through policies such as reserve requirements and capital adequacy ratios.

What is Fractional Reserve Banking?

Simply put, fractional reserve banking is the process of commercial banks producing money out of thin air. Central banks not only create new money in the form of debt but also regulate the deposit ratio of commercial banks. Fractional reserve banking is the term for this ratio. The approach allows banks to lend large sums of money that they do not have. Commercial banks are required by fractional reserve banking to hold a portion of deposits in reserve and lend the rest.

A short example will help to clarify the concept. For example, if the reserve is set at 20%, borrowers will receive $1,600 out of a $2,000 loan. The $1,600 will be put into a different bank account. This second bank will set aside $320 of the $1600 as a 20% reserve. This cycle will repeat itself until the money supply reaches its maximum level. The entire amount of deposits produced in this manner, i.e. at a rate of 20%, is $10,000, whereas the maximum increase in money supply is $8,000. Banks were able to generate an additional $8,000 from $2,000 in deposits in this fashion. Banks can create a lot more if interest rates are lower.

There are some fixed constraints on fractional reserves in the United States. If the bank’s assets are less than $16.3 million, there is no requirement to keep a reserve. A 3% reserve is required if the assets are more than $16.3 million but less than $124.2 million. If the bank’s assets exceed $124.2 million, a 10% reserve requirement is required.

Monetary Policy

The Federal Reserve defines Monetary policy as “The term ‘monetary policy’ refers to what the Federal Reserve, the nation’s central bank, does to influence the amount of money and credit in the U.S. economy. What happens to money and credit affects interest rates (the cost of credit) and the performance of the U.S. economy.”
The central bank implements monetary policy through open market operations, in which debt is purchased and bank reserves are increased. Unconventional monetary policy is involved in the process.

What is Quantitative Easing (QE)?

The process of quantitative easing (QE) is when a central bank purchases long-term securities from commercial banks. As a result, the central bank injects additional money into the economy, lowering interest rates and making it easier for people to borrow. Quantitative easing is a monetary policy that involves the Fed expanding its open market operation and therefore influencing the money supply. As a result of buying from commercial banks, money is transferred to commercial banks’ balance sheets, lowering interest rates. In laymond’s terms it allows the Federal Reserve to print money from thin air.

Jerome Powell using the Money Printer

How does Quantitative Easing Works?

When the Federal Reserve purchases securities from member banks, it gives them cash in return for assets like bonds. Commercial banks then lend the money to the wider population. The Reserve Requirements, which determine how much of the available cash the banks must maintain on hand and how much it must give out, are also examined by the Fed. If the reserve requirements are lowered, member banks will be able to lend more to individuals. Lowering reserve requirements lowers interest rates and encourages customers to take out more loans and spend more. The greater the amount of money spent, the more the economy will grow.

Following the Great Financial Crisis of 2008, the Federal Reserve utilized quantitative easing to restore financial market stability. In response to the financial consequences from the COVID-19 pandemic in 2020, the Fed utilized quantitative easing to expand its balance sheet to $7 trillion.