The Truth About Money : 4 Misconceptions About Money Creation

 

There are several misconceptions about how money is created, which can lead to misunderstandings about the role of banks and central banks in the economy. Let’s clarify some of the most common ones:

 

Misconception 1: Banks as Mere Intermediaries

Belief: Banks take in deposits from savers and then lend out those same deposits to borrowers. According to this view, the amount of money that banks can lend is limited by the amount of deposits they receive.

Reality: In reality, banks do much more than just redistribute deposits. They actually create new money when they issue loans. Here’s how it works: when you take out a loan from a bank, the bank doesn’t give you money from someone else’s deposit. Instead, it creates a new deposit in your account, which you can then spend. This means that banks create new money every time they issue a loan. So, lending is not limited by the bank’s existing deposits but by the demand for loans and the creditworthiness of borrowers. This process is a key aspect of modern banking and shows that banks are essential players in money creation.​

 

Misconception 2: The Money Multiplier Theory

Belief: The money multiplier theory suggests that central banks control the amount of money in the economy by setting the quantity of reserves. According to this theory, there is a fixed ratio between reserves and the amount of loans and deposits. This implies that an increase in reserves leads to a multiplied increase in the money supply.

Reality: The actual process of money creation is more dynamic. The money supply is primarily determined by the demand for loans and the willingness of banks to lend, not by the quantity of central bank reserves. Banks decide how much to lend based on whether it is profitable, given the interest rates and the risk of lending. Central banks influence this process mainly through setting interest rates, which affects the cost of borrowing. This system, known as endogenous money supply, shows that the money supply is flexible and responds to the economic environment. Reserve requirements play a much smaller role in this process than traditionally thought.​

 

Misconception 3: Central Banks Directly Creating Money for Government Spending

Belief: Central banks can directly create money for the government to spend, effectively "printing money" to finance government projects and services.

Reality: Central banks usually don’t finance government spending directly because this can lead to hyperinflation and economic instability. Instead, they use tools like Quantitative Easing (QE) to influence the money supply indirectly. QE involves the central bank buying government bonds and other financial assets from the market. This increases the reserves of commercial banks, encouraging them to lend more and thus increasing the money supply. Central banks also manage the economy by setting interest rates, which affects borrowing and spending. By maintaining a clear separation between fiscal policy (government spending) and monetary policy (central bank actions), they help ensure economic stability and prevent runaway inflation​.

 

Misconception 4: Money is Created Only by Printing Physical Currency

Belief: New money is created only when physical currency (banknotes and coins) is printed and distributed.

Reality: In modern economies, the majority of money exists in digital form as bank deposits. Physical currency represents only a small fraction of the total money supply. Most new money is created electronically when banks issue loans. For example, if you take out a loan, the bank adds the loan amount to your account balance electronically, creating new money. Central banks manage the overall money supply using digital tools like interest rate adjustments and QE, which influence how much banks can lend. This digital money creation is far more significant than the printing of physical currency and is a fundamental aspect of how modern financial systems operate​.

Conclusion

By understanding these misconceptions, we gain a clearer picture of how money is created in the modern economy and appreciate the crucial role played by commercial banks and central banks in this process. It's important to recognize that our economic system is not fixed; it is a construct shaped by policies and choices. As citizens and humans, we have the power to influence and change how this system works. By being informed and engaged, we can advocate for economic policies that better serve the common good and create a more equitable and sustainable financial future.

 

Sources 

• Money creation in the modern economy By Michael McLeay, Amar Radia and Ryland Thomas of the Bank’s Monetary Analysis Directorate
• Explaining money creation by commercial banks: Five analogies for public education
• Notes on money creation
• The role of banks, non- banks and the central bank in the money creation process