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Anonymous

21 Jun 2019

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How does printed money enter the economy? is it used by the government in spending, or given to banks?

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Jonathan Ng

21 Jun 2019

Penultimate Economics Undergrad at Singapore Management University

Hello! From what I have learnt in school, coupled with some research, this is what I have put together:

TL;DR

Pretty sure many of us have heard our parents saying, “You think I print money one meh??’ But do you actually know who prints & creates money? Both the Central Bank and commercial banks have a role to play in this!

And how does this printed money enter the economy? There are in fact various ways to boost money supply: monetary policy, open-market operations, modifying reserve requirements, government spending & debt monetization.

In the first part of my answer, I briefly touched on who prints the physical money and creates credit. If you want to jump straight into knowing how does money enter the economy, just skip all the way to the end!

Who Prints the Physical Money?

Physical money is printed to meet the supply of cash withdrawals at commercial banks, and to replace worn out currency. In fact, printing money does not increase the money supply. Printed money has no effect on the economy as long as it remains in the print shop.

In SG, the Monetary Authority of Singapore (MAS) produces notes and coins.

In the US, the Bureau of Engraving & Printing prints notes while the US Mint produces coins. Both of them come under the Treasury Department.

Who Creates Money (Credit)?

When you take up a $100 loan from a bank, it credits your account with $100 and thus ‘new money’ has been created. This money did not exist until it was credited to your account.

In the UK, commercial banks create 79% of the money in the economy through credit. This shows that credit creates much of the money in an economy.

Source: Bank of England

Commercial banks have accounts with the Central Bank called reserves account. A commercial bank’s reserves are the same as its reserve account, vault cash, and savings account deposits.

Commercial Bank’s Reserves = Reserve Account = Vault Cash = Savings Account Deposits

Therefore, when most of our friends say the Central Bank ‘prints money’, they usually mean the Central Bank adding credit to the commercial banks’ reserves.

Then… you may be thinking: Can the commercial banks create as much money as they like by giving out more loans? This leads us to the next part.

Why Commercial Banks Can Create Money?

This is because of fractional reserve banking which has been around for centuries. As most people are not going to need their money in the form of cash at the same time, commercial banks practice fractional reserve banking where only a fraction of deposits is backed by actual cash and available for withdrawal.

This fraction of deposits is dictated by the reserve requirements set by the Central Bank. If the required reserve ratio is 10%, then the commercial bank is obliged to keep at least 10% of its total deposits as reserves and not loan it out.

How Exactly Does Printed Money Enter the Economy?

Money gets injected into the economy mainly through these ways:

  • Monetary Policy
  • Open-Market Operations
  • Modifying Reserve Requirements
  • Government Spending
  • Debt Monetisation

Monetary Policy

When the Central Bank uses expansionary monetary policy, it lowers the short-term interest rates. This makes borrowing cheaper and boosts economic activity. Therefore, money supply is increased by injecting the printed money into the economy.

However, Singapore’s monetary policy does not target interest rates but instead focuses on the exchange rate.

Open-Market Operations

When the Central Bank purchases government securities in the open market, usually held by commercial banks and private companies, they get cash in exchange for the bonds, increasing the money supply in the economy.

Modifying Reserve Requirements

The Central Bank can lower the reserve requirements so that commercial banks are able to issue more loans, increasing the money supply in the economy.

Government Spending

The government can increase the supply of money in the economy by implementing a stimulus package. This is usually done during a recession. An example is the Resilience Package launched during Singapore Budget 2009 in light of the 2008 Sub-Prime Mortgage Crisis.

Debt Monetisation

With a government deficit, the government can finance it by issuing new bonds. The Central Bank can then buy these bonds through open-market operations, increasing the money supply in the economy. When the government bonds held by the Central Bank are due, the Central Bank will return the interest it has gained back to the government and the government does not need to repay the Central Bank.

This process of financing government spending by the Central Bank is called ‘monetising the debt’. This option is only possible if the country creates its own money, so countries in the European Union are unable to monetise debt.

An example of a country that engages in debt monetization is the US. The US Federal Reserve frequently purchases US Treasury bills. This decreases the supply of bills and make the remaining bills more valuable, attracting buyers. Therefore, the US Treasury does not have to pay high interest on its bills to attract buyers due to its scarcity, driving down interest rates on the US government’s debt. The Fed is willing to buy the bills only if its purpose was to lower interest rates and spur economic growth (this process is otherwise known as quantitative easing).

However, debt monetisation results in inflation as when more money is created, the value of each unit of currency will be worth less.

Similarly, money can be removed from the economy by decreasing money supply through contractionary monetary policy, the Central Bank selling government securities and increasing reserve requirements.

Source: Wikipedia

Hope this helps!

View 2 replies
  1. Existing money have a life span and they'll be replaced with newer currency (replacing)
  2. Reserve can use the money to buy back T-bills from investors (increasing amount in circulation)

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