Money Demand and How Banks Create Money
Money Demand
People demand money to meet expenses and are also interested in holding some of their wealth in the form of money because of its purchasing power, i.e., the amount of goods that can be bought with it.
The public is not interested in the *amount* of coins and notes held, but rather the *amount of goods* they can buy with them (purchasing power).
The reasons why money is demanded are:
- To purchase goods and services (individuals).
- To pay for raw materials and salaries (companies).
Several factors influence money demand:
- If real income increases, a person’s consumption will likely increase, leading people to keep more cash to pay for purchases.
- The frequency or period people are paid also influences money demand, often affecting the demand for transaction balances.
- Money demand is primarily for transactions; you must have money to pay for goods and bills.
- If income increases and the monetary value of goods rises, more money is needed for transactions.
- Money demand is also affected by interest rates; if rates rise, the quantity of money demanded decreases as holding money becomes more costly relative to earning interest.
Banks and Money Creation
Commercial banks are financial institutions authorized by the state to provide credit and accept deposits.
They are required to maintain a reserve system.
Banks must keep a fraction of the funds deposited by their customers in their vault or as a deposit held at the central bank (like the Bank of Spain) for two main reasons:
- To address potential withdrawal of client funds.
- To meet requirements set by monetary authorities.
The fraction of deposits banks must keep as cash or on deposit at the central bank is called the reserve ratio. Its function is to ensure the liquidity of deposits and control the money supply.
Operations of Banks
Banks are for-profit companies whose activity involves two main classes of operations:
- Passive Operations: Recorded on the liabilities side of the balance sheet, representing the bank’s obligations to clients (e.g., deposits). When a client wants to withdraw money, the bank must provide it.
- Active Operations: Recorded on the assets side of the balance sheet, representing the bank’s claims (e.g., loans and credits). These are assets owned by the bank.
Deposits and Credits
When a person opens an account at a bank, they are making a bank deposit. The bank incurs a debt to the client (a passive operation). The bank must return the money upon demand or by the agreed deadline and may pay interest.
The bank can use the deposited money to lend out. When the bank lends money to an individual or company (a loan or credit), this is an active operation. The client’s obligation is to repay the principal amount and pay interest on the money received.
This process allows the bank to earn interest on loans, which covers the interest paid to depositors and generates profit for the bank.
Banks and Bank Money
The fractional reserve system allows banks to create money. By being required to hold only a fraction of deposits in reserve, banks can lend out the rest, contributing to credit expansion and money creation.
For example, if the reserve ratio is 20%, it means the bank is only required to keep 20% of deposits received in reserve.
If a bank receives a deposit of €1,000, it can lend out €800 (assuming no excess reserves). This €800 may be deposited in another bank, which can then lend out 80% of that (€640), and so on. This process, known as money creation or the money multiplier effect, can theoretically lead to the banking system creating a total of €1,000 / 0.2 = €5,000 in new money based on the initial €1,000 deposit.
In the creation of money, there are three main agents:
- Monetary Authority (e.g., European Central Bank): Creates base money (notes and coins) and influences the money supply through policy tools.
- Banking System: Expands the money supply through lending based on the fractional reserve system.
- Public: Individuals and companies who decide how to hold their assets (as cash or deposits), affecting the amount of reserves available to banks.