Introduction
Currency creation, or issuance, is the process by which the money supply of an economic area is increased.
Indeed, it is the central banks that have been tasked with organizing currency creation. They have often obtained the monopoly of monetary creation in fiduciary money, metallic currencies and bank notes, insofar as the currency is a public monopoly issued by the State.
I – The role of central banks in creating currency
In general, the central bank manages the country’s monetary system and also plays a key role in moderating the economy.
Thus, as part of its mission to contribute to the implementation of the state’s macroeconomic policy, the central bank, through monetary policy, seeks monetary and financial stability to promote economic prosperity.
The central bank acts through decisions and actions aimed at regulating the amount of money circulating in the economy while ensuring control of inflation within sustainable and stable limits over time to avoid the danger of an inflation that can be either:
A – Inflation too high, which is harmful to the entire economy, leading ultimately to a decline in the value of the currency and complicates price expectations and investment and purchasing decisions;
B – Inflation is too low, or even there is a risk of deflation, which would encourage businesses and households to postpone their purchases and thus lead to lower consumption, slower growth and higher unemployment.
Moreover, the central bank’s decisions are carried out through monetary policies, which fall into two categories:
A – Conventional monetary policies: temporary interventions in markets based on policy interest rates. Economic and financial variables are influenced indirectly;
B – Unconventional monetary policies: interventions in crisis situations, sometimes over the long term, using other tools such as quantitative easing. The central bank tries to influence certain economic and financial variables more directly.
Thus, to achieve the objectives of monetary policy, the central bank has three instruments:
- The refinancing policy,
- Minimum reserves
- Interventions in the money market.
1 – The refinancing policy
The central bank has several tools at its disposal to achieve monetary policy objectives, the main one being refinancing policy through steering the key rate.
Indeed, the policy rate is the interest rate that the central bank applies to commercial banks when they deposit cash with it or request loans.
This latter operation corresponds to the refinancing of commercial banks by the central bank. The central bank can thus vary the cost of money according to threats to monetary stability and economic conditions.
The policy rate is overtaken by other bank rates, particularly those at which commercial banks grant credit to economic agents (State, households, enterprises, etc.).
By varying this rate, the central bank influences the demand for credit, and thus the creation of money by commercial banks, that is to say the currency in circulation in the economy. This has a direct impact on price developments and economic activity.
2 – Minimum reserves
The reserve requirements correspond to the non-interest-bearing deposits that commercial banks must make with the central bank.
They concern a share of the total deposits collected from their clients. The amount of required reserves is a constraint on banks’ liquidity and weighs on their profitability.
For this reason, an increase in these reserves reduces the supply of loans, while a decrease increases it.
3 – Interventions in the money market
In principle, the central bank acts on the money market through open market operations, which consist of providing or withdrawing liquidity to financial institutions through purchases or sales of assets (treasury bills held by commercial banks).
Money creation then moves from the credit market to financial markets.
These open market operations cause money market rates to rise or fall depending on the objective pursued.
The central bank may also adjust lending or deposit terms that allow commercial banks to borrow from or deposit liquidity with the central bank (for a duration of one day to one week).
II – How do commercial banks create currency?
Generally, the main mechanism of money creation is based on bank credit. Money is thus created when a bank grants credit to a client, by a simple set of accounting entries, without having to draw on prior savings.
1 – Bank credits and the currency creation
Thus, when a bank grants credit, it creates the corresponding currency by crediting its customer’s account. This monetary creation is scriptural, that is to say it is done through accounting entries and not by the printing of new notes.
Moreover, the creation of banknotes and coins corresponds to the physical manufacture of money.
For this, when a private individual withdraws money from the ATM, the amount withdrawn in notes is deducted from his bank account. The money supply therefore remains the same even though its composition has changed.
It should be noted that 90% of the money supply consists of scriptural currency, while notes and coins represent only a small fraction of the currency in circulation, namely the remaining 10%.
This is why the central bank, at the helm of the so-called “money printing press”, and the state, at the heart of which coins are minted, are not the main issuers of currency. It is the banks that create it.
2 – The role of bank deposits
In fact, deposits are not a prerequisite for the granting of credit. Thus, when a bank creates money by granting credit, it also creates a bank deposit by making the created money available to its customer.
It should be noted that, contrary to the widespread popular belief that deposits are the ones making loans, it is rather credits that make deposits.
3 – Monetary destruction during the repayment of credits
In principle, each credit granted increases the money supply and each repayment reduces it, and on the occasion of each loan repayment operation a quantity of money is destroyed.
Thus, if more credit is extended than repaid over a period of time, the money supply increases.
On the other hand, this mass will decrease if repayments are greater than the credits granted.
Therefore, the quantity of money in circulation thus depends on the permanent flow between new credits and repayments.
This structural characteristic implies that the stability of the money supply presupposes a continuous expansion of credit: to compensate for the monetary destruction linked to repayments, new loans must be taken out.
Modern money is therefore based on a dynamic of permanent debt that accompanies economic growth.
Moreover, banks’ capacity to create money is not unlimited, as they are constrained by central bank-set refinancing requirements.
It is therefore the central bank that, by varying its refinancing rate, which is the key interest rate, can thus steer money creation.
Conclusion
Currency has gradually detached itself from its materiality to become a credit currency, based on debt relations between economic agents.
It is no longer a reflection of past wealth, like gold extracted from mines, but an anticipation of future wealth linked to investment, production and trade.
Thus, bank currency was a decisive lever in the development of industrial capitalism. By enabling firms to obtain financing even before production is completed, bank credit facilitates investment and the accumulation of productive capital.
Money creation thus becomes a central instrument for financing the economy.