A typical discourse is unnecessarily complicated, without touching the essence of deposit. Money always emerges from nothing, and is always 0 sum.
Topics
About: money
The table of contents of this article
- Starting Context
- Target Context
- Orientation
- Main Body
- 1: What Is a Typical Discourse About 'Money Creation' or 'Credit Creation'?
- 2: This Is Our Explanation
- 3: Why Such an Unnecessarily Complicated Explanation?
- 4: What Is 'Deposit'?
- 5: Why Does Money Emerge from Nothing?
- 6: The Amount of Deposits Isn't Limited by the Amount of Currency
- 7: Let's Look at the Whole Picture of the Example
Starting Context
- The reader knows the background of this site.
- The reader has escaped some detrimental notions on fairness.
Target Context
- The reader will understand what 'money creation' or 'credit creation' is.
Orientation
There are some articles about that inconvertible banknotes are claims against the central bank (here and here).
Main Body
Stage DirectionHere is Special-Student-7 in a room in an old rather isolated house surrounded by some mountains in Japan.
1: What Is a Typical Discourse About 'Money Creation' or 'Credit Creation'?
Special-Student-7-Hypothesizer
A typical discourse about 'money creation' is like this.
There is a reserve requirement ratio, RR, which means that the commercial bank has to have at least deposits * RR of currency (banknotes or coins) in reserve in case depositors withdraw some of their deposits as currency. For example, RR = 0.1.
A person PA deposits 100 dollars in currency to a commercial bank BA.
BA lends 100 - 100 * 0.1 = 90 dollars in currency to a person PB.
PB deposits 90 dollars in currency to a commercial bank BB.
BB lends 90 - 90 * 0.1 = 81 dollars in currency to a person PC.
PC deposits 81 dollars in currency to a commercial bank BC.
BC lends 81 - 81 * 0.1 = 72.9 dollars in currency to a person PD.
And so on.
The sum of deposits is 100 + 100 * (1 - 0.1) + 100 * (1 - 0.1) * (1 - 0.1) + 100 * (1 - 0.1) * (1 - 0.1) * (1 - 0.1) + . . ..
It's an infinite series, and equals 100 / 0.1 = 1000.
Special-Student-7-Rebutter
Ah-ha . . .. I don't say that's incorrect, but I wonder why they have to make such an unrealistic, unnecessarily complicated explanation. It's unrealistic because loans don't have to be and in fact usually aren't made by giving currency to borrowers: borrowers get the money as deposits.
2: This Is Our Explanation
Special-Student-7-Hypothesizer
So, our explanation is this.
A person PA deposits 100 dollars in currency to a commercial bank BA.
BA lends 100 / 0.1 - 100 = 900 dollars in a deposit to PA.
Finish!
It's 900 because BA has 100 dollars in currency, the maximum deposits allowed is 100 / 0.1 = 1000 dollars, BA already had 100 dollars of deposits, and so, the 1000 - 100 dollars are the additional maximum deposits BA can create.
There is no necessity for any infinite number of depositors, any infinite number of commercial banks, any infinite number of lending, or any infinite series.
Special-Student-7-Rebutter
The maximum amount of deposits is not determined because of the infinite series, but because the reserve requirement directly dictates the maximum amount of deposits: 0.1 = 100 / 1000 is the very definition of the reserve requirement ratio, and 100 / 0.1 = 1000 is just a variation of the definition. We don't need to compute the infinite series to get the maximum amount of deposits.
3: Why Such an Unnecessarily Complicated Explanation?
Special-Student-7-Hypothesizer
Why do they make such an unnecessarily complicated explanation?
Special-Student-7-Rebutter
Well, I guess, they stand on the premise that deposits have to be created by depositors' depositing currency. However, that premise is utterly against the essence of deposit. I think, the explanation required is what clarifies the essence of deposit, not what is based on a premise against the essence of deposit.
4: What Is 'Deposit'?
Special-Student-7-Hypothesizer
So, what is 'deposit'?
Special-Student-7-Rebutter
The deposit is the depositor's claim against the bank. From the view of the bank, it's a debt to the depositor.
Special-Student-7-Hypothesizer
So, movements of currency aren't essential in creation and disappearance of deposits.
Special-Student-7-Rebutter
That's right. A typical creation of deposit happens when a bank lends money to a borrower.
For example, assume that the bank lends 100 dollars to the borrower. The bank gets a claim of 100 dollars against the borrower as a loan. On the other hand, the borrower gets a claim of 100 dollars against the bank as a deposit. Note, in such a case, no currency will be handed from either side to the other side.
Special-Student-7-Hypothesizer
I notice that the bank could lend any amount of money at once even if it had no currency at all, if there were no regulations.
Special-Student-7-Rebutter
Yes, it could.
5: Why Does Money Emerge from Nothing?
Special-Student-7-Hypothesizer
What typically confuses people will be that money seems to emerge from nothing. In the previous example, why do 100 dollars proliferate to 1100 dollars? Where did the 1000 dollars come from? Isn't it just a fraud?
Special-Student-7-Rebutter
First, let us clarify the term, 'money'. The concept of money includes currency and deposits. So, your use of the term, 'money', is correct. Deposits are money, and money proliferated from 100 (currency) dollars to 100 (currency) + 1000 (deposits) = 1100 dollars.
Special-Student-7-Hypothesizer
In fact, money is essentially something that emerges from nothing. So, if we assume that there are no regulations, any amount of money can be created from nothing if participants of transactions agree.
The 100 dollars currency didn't increase. The issue is that 0 dollar deposits became 1000 dollars deposits.
In fact, the 1000 dollars deposits emerged in this mathematical equation.
0 = +1000 - 1000
Special-Student-7-Rebutter
Yes. Not mysterious at all.
Special-Student-7-Hypothesizer
The plus amount is the claim that the depositor has against the bank and the minus amount is the debt that the bank has to the depositor; the net worth as a whole is always 0.
We just split 0 to +1000 and -1000, and counted only the plus amount. The trick is that the minus amount is forgotten. That way, we can create any amount of money from 0. To think of it, as the deposit is a claim, there is always the same amount of debt on the other side.
Currency is also a claim that the holder has against the central bank. So, its essence is the same with deposits.
6: The Amount of Deposits Isn't Limited by the Amount of Currency
Special-Student-7-Hypothesizer
There is another unrealistic explanation in the typical discourse. The typical discourse says as if the amount of currency limits the amount of deposits, but that doesn't seem to fit the reality.
Special-Student-7-Rebutter
Oh?
Special-Student-7-Hypothesizer
Currency is not mostly really held as banknotes or coins, but as a deposit of the commercial bank to the central bank, which can be increased or decreased on demand by the commercial bank by selling some assets to or buying some assets from the central bank.
Special-Student-7-Rebutter
'deposit of the commercial bank to the central bank' is not exactly currency, but as the commercial bank can anytime exchange the deposit to the central bank to currency, the commercial bank does not need to hold the reserve as currency.
Special-Student-7-Hypothesizer
Yes. And the commercial bank adjust the deposit to the central bank to meet the reserve rate.
Special-Student-7-Rebutter
I see.
Special-Student-7-Hypothesizer
The amount of deposits is determined by market forces. For example, if burrowers don't want to burrow much money, deposits can't be increased much.
Special-Student-7-Rebutter
So, the amount of reserve doesn't determine the amount of deposits, but the amount of deposits determine the amount of reserve.
Special-Student-7-Hypothesizer
It seems so.
7: Let's Look at the Whole Picture of the Example
Special-Student-7-Hypothesizer
Let us apply the above knowledge to the previous example.
First, a person PA deposits 100 dollars in currency to a commercial bank BA.
For PA, he or she lost the claim against the central bank as the currency (-100), and got the claim against BA as the deposit (+100). So, -100 +100 = 0.
For BA, it got the claim against the central bank as the currency (+100), and got the debt to PA as the deposit (-100). So, +100 -100 = 0.
Second, BA lends 900 dollars in a deposit to PA.
For PA, he or she got the debt against BA as the loan (-900), and got the claim against BA as the deposit (+900). So, -900 +900 = 0.
For BA, it got the claim against PA as the loan (+900), and got the debt against PA as the deposit (-900). So, +900 -900 = 0.
So, the net worth did not increase or decrease as a whole or for anyone.
Special-Student-7-Rebutter
Of course. As nobody did productive work, the net worth can't increase. And people usually won't do what are just losses to themselves.
Special-Student-7-Hypothesizer
Then how does the commercial bank make profits?
Special-Student-7-Rebutter
It makes profits by the split between the interest rate of the loan and the interest rate of the deposit.
Special-Student-7-Hypothesizer
Ah-ha, . . . interest also emerges from nothing, I presume?
Special-Student-7-Rebutter
Yes, interest is a claim that the lender has against the borrower and a debt that the borrower has to the lender. It can emerge from nothing because it's 0 as a whole.
References
- Michael McLeay, Amar Radia, and Ryland Thomas. (2014 Q1). Money creation in the modern economy. Retrieved from http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf
