Money Creation and Its Process | CFA Level I Economics

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

Today, we’ll dive deep into the world of monetary and fiscal policy. Buckle up as we explore money, its functions, creation process, and how central banks define it.

What is Money, and What Does It Do?

Money is a medium of exchange that simplifies transactions, making bartering systems unnecessary. Here are its main functions:

• Means of payment: Money facilitates the exchange of goods and services.
• Unit of account: It serves as a universal measure, eliminating ambiguity in the value of goods and services.
• Store of value: Money can be saved to purchase goods later.

A Journey Through Time: From Gold to Fractional Reserve Banking

Long ago, gold and silver were used as money. People deposited their gold with early bankers and received promissory notes in return. These notes could be exchanged for gold upon demand.

Eventually, promissory notes themselves became a medium of exchange. Bankers, realizing that not all deposits would be withdrawn simultaneously, started lending a portion of deposits to earn interest. This led to the birth of fractional reserve banking.

Understanding Fractional Reserve Banking

Nowadays, in a fractional reserve banking system, a bank holds a proportion of deposits in reserve. Banks are required to hold a minimum percentage of deposits, known as the reserve requirement, and can lend out the excess.

Suppose the reserve requirement is 20%. If you deposit $100, the bank sets aside $20 as reserves and loans out the remaining $80. The bank’s balance sheet will show $100 in assets: $20 reserve + $80 loan.

If the borrower spends the $80, and the recipient deposits it into another bank, that bank can loan out another $64. This process continues until there’s no more money to be deposited and loaned out.

Calculating Money Creation and the Money Multiplier

To measure the total amount of money created by the fractional banking system, we can use a formula:

Money multiplier = 1 / Reserve requirement

For our example, the money multiplier is 5 (1 / 0.20). This means that for every dollar deposited, $5 is created in the economy. A lower reserve requirement results in more money being created.

Defining Money: Narrow and Broad Money

Under fractional reserve banking, the definition of money extends beyond notes and coins in circulation. It also includes very liquid assets like bank deposits in current accounts (narrow money) and less liquid assets that can still be used for purchases (broad money).

Money Measures: Different Strokes for Different Central Banks

Central banks around the world have different definitions of money. Let’s look at the US and European Central Bank as examples:

US Federal Reserve:

• M1: Notes and coins in circulation, travelers’ cheques of non-bank issuers, demand deposits at commercial banks, and other checkable deposits.
• M2: The broadest measure, including M1, savings and money market deposits, time deposit accounts of less than $100,000, and other balances in retail money market and mutual funds.

European Central Bank:

• M1: Notes and coins in circulation, plus all overnight deposits.
• M2: Includes M1, deposits redeemable with notice up to three months, and deposits with maturity up to two years.
• M3: The broadest definition for the euro area, including M2, repurchase agreements, money market fund units, and debt securities with up to two years maturity.

Wrapping Up: A Solid Foundation for Monetary Policy

And that’s a wrap on our introduction to money, the banking system, and the creation process! With this knowledge, you’ll be well-prepared to tackle central bank monetary policies in our upcoming lessons.