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The Central Bank

The Central Bank

The Central Bank is an agency having an exclusive right to issue national currency in its most basic form, currency notes. While its name and establishment history varies from country to country, its main functions are more or less similar. It is called a bank, but it does not work with physical persons and nonfinancial corporations. It is a bank made for other banks.

At the same time, the CB is a governmental entity separated from other state authorities. The Central Bank is granted independence in order to be able to screen the government from the temptation to issue money directly to pay its bills. Ideally, the Treasury, having no right to issue money, will have to fund governmental spending with the revenues it collects. The Central Bank ensures stability of the monetary system by managing the amount of produced money based not on the government’s momentary need of money, but rather on the strategic macroeconomic tasks assigned to it.

But in this idealized scenario, how does the Central Bank’s money-issuing mechanism function? What does the bank spend the issued money on, if not on financing government expenditures?

The money issued by the CB is called its liabilities. That is, it is its “debt” to holders of currency notes and accounts opened at the CB. Yet a man holding a CB-issued note issued in his hand probably does not feel that it represents someone owing him something—he would simply believe that he has money. So, why is it called a “liability” or “debt”?

At one time, calling such a note a “debt” did make sense. Notes issued in the times of the gold standard represented an obligation to pay a certain weight of gold upon first demand. Bank clients placed their gold in vaults, getting a receipt in exchange—a note acknowledging their right to withdraw the gold. Those notes represented the bank’s real liability. The same was true for bank accounts: they represented records of the amount of gold placed in the bank and acknowledged its owner’s right to withdraw the gold.

As a matter of convenience, bank notes and accounts simplified currency circulation; in order to pay, one did not need to carry along precious metals. Instead, a buyer could pass over to the seller the bank note, which the seller could use to claim gold at the bank. Alternatively, the buyer could write the seller a check authorizing the bank to make a record in its books certifying that the gold in the vault now belonged to the seller.

Such a transaction can still occur today, with several exceptions:

  • The right to issue bank notes exclusively belongs to the one bank with issuing status: the Central Bank.
  • The Central Bank works exclusively with other financial institutions and the government.
  • Ever since the gold standard was abolished, the Central Bank no longer has to return the gold it receives, and the notes it issues and the entries made in its books are legally irredeemable.
  • The Central Bank may issue bank notes and put money in accounts not only by buying gold, but also by using other methods that will be discussed later.

 

For now, let us get back to our example with gold. In order to illustrate it, let us assume that a modern Central Bank has decided to purchase gold to replenish its reserves. Buying gold from commercial Bank A, the CB will record the transaction in its books:

Gold in vault Account of Bank A opened at CB

Valued at 100 units

100 units

 

In order to better understand bank records, imagine what your own personal financial books would look like. Take a sheet of paper and draw a vertical line on it. On the right-hand side, write all of your debts—credit card, mortgage, etc., and on the left-hand side write all of your property such as cash, bank accounts, real estate, etc. All of your records on the right are your liabilities, and records on the left are your assets. The difference between the amounts on the right and on the left is your capital or negative net worth.

The record on the left in the examples above means assets obtained by the bank at the time of issuing the money; the record on the right means the Central Bank’s liability—which in effect has become newly created money. Please note that no subsequent changes in gold prices will affect the amount of cash issued by the bank: its nominal value is not tied to gold prices, and the amount in the account will remain unchanged. Thus, the economy will be injected with the Central Bank’s irredeemable money.

You may be wondering why we have started talking about records in the CB books and bank accounts when speaking about creating money. This question is important for understanding how the money-creation process works. Money creation is mostly not about printing new notes; it is about those new records in bank accounts. Moreover, newly printed notes may not even increase money stock; they may, for example, simply change its structure by entering circulation if the gold-selling Bank A from our example decides to convert the money from its account into cash.

In order to better understand this, let us further expand our example. What happens if the gold seller wants to get thirty units in cash bills? In this case, cash will be taken out of the vault and the following changes will be made in the CB books:

 

Gold in vault Account of Bank A opened at CB
Valued at 100 units 70 units
Cash issued
  30 units

 

The CB gives away thirty cash units from its vault, but the amount of its issued money remains unchanged since the bank will decrease the amount of its cashless debt by the same amount. The CB does not care about what happens to its liabilities; subsequently, the currency notes may change hundreds of hands, but both the record and the amount in the CB’s balance will remain the same.

If Bank A decides to remit part of the money to Bank B using a wire transfer, the CB will simply make changes in its entries; this is what the bank payments principle is all about.

Gold in vault Account of Bank A opened at CB
Valued at 100 units 50 units
Account of Bank B opened at CB
  20 units
Cash issued
  30 units

 

Thus, the basic money of a modern economy consists of the CB’s liabilities represented by records in its bank books. These records may take into account both the amounts that the bank released into circulation and the amounts that it posts on its accounts.

If the CB does not change the amount of its liabilities, the money stock will be fixed. Any money movements will only change the structure of the money stock and money owners, but no financial transactions will change the total amount of money.

It should be noted that the CB may then sell some of its purchased gold. In this case, money disappears in the CB’s books because the amount of the bank’s liabilities will decrease after the CB debits the account of the buyer of the gold. Accounts entered in the CB’s books can both increase (money emission) and decrease (money clearance). The money stock management process works both ways, and the CB can actively manage it to attain its goals.

We have studied the example with gold to clarify the technical principle of how money is created. However, you may justly note that the times of the gold standard are over, and money creation through purchase of gold is an exception rather than a rule.

In addition to the purchase of gold by the Central Bank, there are different ways of creating money. Any specific Central Bank’s preferred way depends on its country’s history, economic development, and monetary policies.

The main methods are as follows:

  • purchase of foreign currency by the Central Bank
  • credit disbursement to commercial banks by the Central Bank
  • purchase of government debt instruments by the Central Bank

 

The first method is widely spread among the developing countries and exporting nations that have a positive balance of payments (that is, countries that get more money from exporting their products than spend on purchase of imported products). According to this method, the CB buys a foreign currency while issuing a currency of its own; in other words, the foreign state’s currency plays the role of gold in this case.

Creating money by purchasing foreign currency will be recorded in the CB books as follows:

Foreign currency Account of Bank opened with CB

Valued at 100 units

100 units

 

Just like in the case with gold, the CB can sell its previously purchased currency, and during the foreign currency sale process, money disappearance will occur.

The second way to create money is by granting loans to commercial banks. In this scenario, the CB registers its liabilities (i.e., the money created by it) and its rights to receive back the credit disbursed to the bank. It looks as follows:

Loan to Bank A Account of Bank А opened with CB

100 units

100 units

 

With this method of creating money, money disappearance is not only possible as with the first two, but is mandatory, since, unlike gold and foreign cash, disbursed credits have a repayment period. As soon as a credit matures, the money created on its basis must be repaid. This method of issuing “temporary” money is referred to as credit emission.

Finally, the third method of creating money through purchasing government debt instruments is the most demonstrative of the fundamental nature of modern money. If the CB acquires the government’s debt instruments, the following record is made:

Government Bonds Treasury’s Account at the CB

100 units

100 units

 

Similar to credits, any government’s debt has a repayment period. However, the peculiarity of this method is that the government lends money to itself. Both the CB and the Treasury are governmental agencies. Money created by the CB by purchasing government bonds is the purest form of modern money. Yes, the government says it only issued the money temporarily. Later on, it will collect the taxes and give everything back. But, since it owes to itself, it actually owes to nobody! We will come back to this issue when discussing government bonds.

As for now, let us review the process of creating money within the banking system. As mentioned before, the CB is not a monopoly in this. Money can be created by other “ordinary” banks that we deal with in our everyday lives. Such banks do not have a “central” status, they may not issue bank notes, they are not always owned by the government, but the modern banking system allows them to create money out of thin air, too. How?

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