ECX3550 Chap.9 Money Creation and the International Monetary System
Money Creation and the International Monetary System
Week 7 is the technical hinge of the unit, and everything in Weeks 8, 9 and 11 is an application of it. It covers what money is by function, how money is created in two directions - vertically by government deficit spending and central-bank lending, horizontally by commercial banks lending - and why, on the credit creation theory, a bank loan expands the balance sheet while a non-bank lender's does not. It then covers the monetary aggregates, the three competing theories of banking and the accounting test that discriminates them, inside versus outside money, the link from credit expansion to financial crisis, and a short history of the international monetary system. Get this chapter right and the three crisis chapters become one model applied three times; get it wrong and they become three unrelated stories.
What this chapter covers
- 01Money as a generally accepted means of payment, and its three functions: medium of exchange, unit of account and store of value - the most liquid asset
- 02Vertical operations: government deficit spending and central-bank lending inject money, taxes drain it, and the non-government sector's stock of net financial assets is the cumulative record of past fiscal deficits
- 03Horizontal operations: commercial banks create money by lending - loans create deposits - and net to zero in aggregate financial-asset terms, since every new deposit is matched by a new loan
- 04The life cycle of money: born when a bank loan is granted, working as it circulates, retiring on deposit and reactivating on withdrawal, and dying when the loan is repaid - so simultaneous deleveraging contracts the money supply
- 05Inside versus outside money: in the three-sector balance sheet only gold is an asset that is nobody's liability, while bank-created inside money is simultaneously someone's asset and someone else's liability
- 06The monetary aggregates M0 to M4 as a ladder of decreasing liquidity, and the exhibit that broad money is roughly nineteen times the money base (Australia, July 2018)
- 07The three theories of banking - financial intermediation, fractional reserve, credit creation - the regulatory tool each implies, and the accounting test that discriminates them
- 08Good versus bad credit creation, and the six regimes of the international monetary system: the classical gold standard 1815-1914, war and its aftermath 1914-26, the gold exchange standard 1926-31, fluctuating fiat 1931-45, Bretton Woods 1945-71 with its rules and unravelling, and floating rates from 1973
The balance-sheet test: which lender actually creates money?
- +1The manufacturing firm (a non-financial corporation) must fund the loan from resources it already holds. Its assets change composition - 'loan receivable' rises by 50 while 'deposits' fall by 50 - but total assets are unchanged. The balance sheet does not grow, and no new money exists.
- +1The non-bank finance company gets the same result. It lends money it has raised or holds: loan +50, deposits −50, total assets unchanged. Having a financial business model is not what matters; having a banking licence is.
- +1The licensed bank books the loan as a new asset (+50) and simultaneously credits the borrower's account, creating a new customer deposit as a new liability (+50). Total assets and total liabilities both rise by 50: the balance sheet expands, and $50 million of new money now exists. In accounting terms the bank re-classifies a liability from 'accounts payable' into 'customer deposits' - it does not withdraw the funds from anywhere.
- +1Read the results against the three theories. Financial intermediation theory says banks lend out deposits they have taken in, and fractional reserve theory says an individual bank lends out what is left after required reserves - both predict a withdrawal from somewhere else. Only credit creation theory predicts an expanding balance sheet with no withdrawal, and that is what the accounting shows; the empirical tests the unit reports (a real loan documented in 2014 and a banking-software simulation in 2016) found no withdrawal, and the Bank of England acknowledges that most money in the economy is created by banks when they lend. The policy implication is what carries into the rest of the unit: if banks create credit, the effective lever is the quantity and direction of credit - window guidance or credit control - rather than the reserve ratio or the interest rate.
Key terms
- Inside and outside money
- Outside money is an asset that is nobody's liability - in the unit's three-sector balance sheet, gold. Inside money is money created by the banking system, where every unit is simultaneously someone's asset and someone else's liability. Because broad money is roughly nineteen times the money base, bank-created inside money is the overwhelming bulk of the money supply.
- Credit creation theory of banking
- The theory that individual banks create money when they lend, expanding their balance sheets rather than transferring existing funds. It implies that the correct policy instrument is direct window guidance or credit control, rather than the reserve ratio implied by fractional reserve theory or the capital requirements implied by financial intermediation theory.
- Monetary base (M0)
- Circulating notes and coins plus reserves - also called high-powered money. It is the narrowest aggregate, and the ladder M1 to M4 adds progressively less liquid claims. Definitions differ by country, which is why an Australian aggregate does not map one-to-one onto a US definition.
- Quantity theory of credit
- The disaggregation of the quantity equation by the use of credit: for real transactions C_R · V_R = P_R · Q_R = P_R · Y, and for financial transactions C_F · V_F = P_F · Q_F. Growth in credit for real transactions that does not raise output shows up in consumer prices; growth in credit used to purchase existing assets shows up in asset prices. This is why an economy can run large credit growth with quiet consumer-price inflation while asset prices explode.
- Minsky's financial instability hypothesis
- The proposition that a financial structure evolves from robust to fragile: hedge positions, where expected income covers principal and interest (R ≥ i + A), give way to speculative positions covering interest only (i ≤ R < i + A) and then to Ponzi positions where income does not even cover interest (R < i). Stability itself breeds the risk-taking that produces instability.
- Bretton Woods and exorbitant privilege
- The 1944-45 system of gold convertibility at US$35 an ounce, other currencies fixed against the dollar and changeable with IMF approval in cases of fundamental disequilibrium, the dollar as reserve currency, IMF credit with conditionality criteria, and Special Drawing Rights from 1969. Exorbitant privilege is the advantage of issuing the reserve currency, whose external deficits are financed automatically by foreigners' willingness to hold it - one of the two European criticisms that led to the system's end in August 1971.
Money Creation and the International Monetary System FAQ
Do banks lend out deposits, or create them?
On the theory the unit teaches, they create them. Compare three lenders making the same loan: a non-financial corporation and a non-bank financial intermediary both have to take the funds from elsewhere within the firm, so their balance sheets do not grow; a bank books the loan as an asset and simultaneously credits the borrower's account, creating a deposit as a liability, so its balance sheet lengthens and credit is created. The discriminating test is whether the bank withdraws the loan amount from another account, and the empirical work the unit reports - a real loan documented in 2014 and a simulation using banking software in 2016 - found that it does not, which refutes both the financial intermediation and the fractional reserve theories. The Bank of England is cited as acknowledging the same point. The consequence is not academic: it means that if firms will not borrow, expanding the monetary base cannot expand broad money, which is exactly what Week 8 shows happening in Japan.
What is the difference between good and bad credit creation?
It is a criterion about what the credit finances, not how much of it there is. Credit matched by value creation - financing the capital needs of businesses producing real goods and services, real infrastructure, new businesses creating jobs, or technologies that raise productivity - supports value creation. Credit not matched by value creation is inflationary: consumption credit that does not increase output pushes up consumer prices, while financial credit used to purchase existing assets such as land, second-hand housing or shares pushes up asset prices. The quantity theory of credit puts algebra on that distinction by splitting the quantity equation into real and financial transactions, and the payoff is that excessive financial credit produces asset bubbles which eventually burst. Every crisis chapter in the unit is an instance of the same statement.
Why must asset bubbles burst?
The unit gives a four-line answer worth memorising. Financial transactions are not productive, so unproductive activity creates no net income. In aggregate, bank lending for financial transactions therefore cannot be recovered, because there is no net income with which to service the loans. Speculators rely instead on asset price rises - that is, on someone else being willing to pay more - to service their borrowing. So bubbles are driven by the false expectation that prices will keep rising and facilitated by easy credit; when reality bites, expectations change and credit tightens, and the bubble bursts. The formal version is the step recursion in which each buyer borrows the full purchase price and the process stops when the expected capital gain no longer covers the expected finance cost, after which forced selling drives prices down and contagion spreads across assets.
Can AI help me with the money and banking material in ECX3550?
Yes, as a step-by-step study aid. Sia can draw the three T-accounts with you, quiz you on the monetary aggregate ladder, walk through the quantity theory of credit and Minsky's three positions, and rehearse the five monetary regimes as a timeline with the mechanism that ended each one. It does not do graded assessment for you - not the tutorial presentation, the forum posts or any part of the Project - and Monash University academic-integrity rules still apply. Confirm every assessment detail on Moodle.
Assessment move
This is the chapter to over-prepare, because Weeks 8, 9 and 11 all draw on it and you only have to learn the machinery once. Start with the three T-accounts and be able to draw them from memory: a non-financial corporation, a non-bank lender and a bank, each making the same loan, with only the bank's balance sheet expanding. Then attach the three theories of banking to those pictures, together with the regulatory tool each implies - capital requirements, the reserve ratio, or direct credit guidance - because that mapping is what makes the Japanese and Thai chapters intelligible. Next, learn the credit-bubble engine as one diagram and refuse to re-derive it later: credit extended to finance unproductive assets raises asset prices, which finances more credit-financed investment, which raises prices further; then credit tightening forces sales, prices fall, and more sales follow. Week 9 adds a foreign-credit and reserves layer to the same diagram and Week 11 adds a securitisation layer, so annotate one figure three times rather than drawing three figures. For the international monetary system, hold six regimes with one sentence each on what ended them, and be able to state the Bretton Woods rules of the game. Finally, practise the aggregates as a ladder of decreasing liquidity rather than as definitions to recite - and remember that the definitions differ by country. Confirm assessment details on Moodle.
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