Money Creation

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In economics, money creation is the process by which the money supply of a country or a monetary region (such as the Eurozone) is increased. There are two principal stages of money creation. First, the central bank introduces new money into the economy (termed 'expansionary monetary policy') by purchasing financial assets or lending money to financial institutions. Second, the new money introduced by the central bank is multiplied by commercial banks through fractional reserve banking; this expands the amount of broad money (i.e. cash plus demand deposits) in the economy so that it is a multiple (known as the money multiplier) of the amount originally created by the central bank.


Central banks monitor the amount of money in the economy by measuring monetary aggregates such as M2. The effect of monetary policy on the money supply is indicated by comparing these measurements on various dates. For example, in the United States, money supply measured as M2 grew from $6407.3bn in January 2005, to $8318.9bn in January 2009.

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Within almost all modern nations, special institutions exist (such as the Federal Reserve System in the United States, the European Central Bank (ECB), and the People's Bank of China) which have the task of executing the monetary policy and often acting independently of the executive. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system. There are several monetary policy tools available to a central bank to expand the money supply of a country: decreasing interest rates by fiat; increasing the monetary base; and decreasing reserve requirements. All have the effect of expanding the money supply.


The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various financial assets, such as treasury bills, government bonds, or foreign currencies. Purchases of these assets result in currency entering market circulation (while sales of these assets remove money from circulation).


Usually, the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency, the price of gold, or indices such as Consumer Price Index. For example, in the case of the USA the Federal Reserve targets the federal funds rate, the rate at which member banks lend to one another overnight. The other primary means of conducting monetary policy include: (i) Discount window lending (as lender of last resort); (ii) Fractional deposit lending (changes in the reserve requirement); (iii) Moral suasion (cajoling certain market players to achieve specified outcomes); (iv) "Open mouth operations" (talking monetary policy with the market). The conduct and effects of monetary policy and the regulation of the banking system are of central concern to monetary economics.

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