Commercial Banks and the Money Creation Process

One problem that arises when governments increase spending or cut taxes to stimulate demand is that these measures create budget deficits. In contrast, contractionary fiscal policy, through cutting government spending or raising taxes to control inflation, reduces the budget deficit. However, proactive fiscal policy to stabilize the economy is not the only factor that affects a country's budget balance at any given time. In reality, the budget balance can change for reasons that have nothing to do with fiscal policy. For example, with a fixed level of spending of $250 and taxes of 25% of income, the government budget will be in balance when income is $1000, as illustrated in Figure 3.23. At incomes below $1000, the budget will be in deficit, and at incomes above $1000, the budget will be in surplus.

The above analysis shows that the budget balance itself is not a good indicator of fiscal policy. When we see a government budget deficit, we do not rush to conclude that fiscal policy is too expansionary and therefore assume that the government should tighten its fiscal policy first. If, in fact, the budget deficit is due to the economy falling into a recession, then implementing a tightening fiscal policy will reduce aggregate spending and thus push the economy deeper into recession.

A better measure of fiscal policy than the actual budget balance is the full-employment budget , or structural budget , which we will denote by BB*. This is based on estimates of spending and tax revenues assuming the economy operates at its potential output. The resulting outcome depends only on the choice of fiscal policy and is not affected by short-run economic fluctuations.

BB* = tY - G

Now we will consider the difference between the actual budget balance and the structural budget balance:

Maybe you are interested!

BB-BB* = (tY-G)-(tY*-G) = t(YY*)

Thus, the actual budget balance and the structural budget balance differ only in the net tax amount. Specifically, if output is below the natural level, the actual budget deficit will be larger than the structural budget deficit. Conversely, if output is above the natural level, the actual budget surplus will be larger than the structural budget surplus. The difference between the actual budget balance and the structural budget balance reflects the cyclical component of the budget and is often referred to as the cyclical budget balance. The cyclical budget reflects the short-term economic impact on government revenue and expenditure. When the economy falls into a recession, the budget will automatically deteriorate because tax revenue decreases while some transfer items increase. Conversely, in

The cyclical budget deficit is automatically improved during boom periods. The above formula shows that the cyclical budget will be in deficit when output is below the natural level and in surplus when output is above the natural level.

Another reason why the real budget balance is not a good measure of fiscal policy involves the distinction between nominal and real interest rates. In practice, published government budget figures treat all nominal interest payments by the government on its outstanding debt as a line item in government spending. However, when inflation is quite high, nominal and real interest rates differ significantly, so it makes more sense to treat the real interest rate multiplied by the government's outstanding debt as a line item in deficit spending. For example, if inflation is 8 percent and the nominal interest rate is 10 percent, the real interest rate is only 2 percent. In fact, the real cost of the government's outstanding debt is only 2% because although the government must pay 10% interest on the original loan, tax revenues appear to increase with inflation even if the tax rate remains unchanged, which creates the revenue needed to cover the higher nominal interest. Similarly, from the private sector's perspective, although the holders of government bonds receive a nominal return of 10% on the original loan, this actually yields only 2% in real terms, and it is the real return that measures the real return on lending and determines the private sector's behavior in choosing the optimal investment portfolio.

3.4. CURRENCY AND MONETARY POLICY

3.4.1. Currency

3.4.1.1. Concept of money

In the modern economy, in addition to using cash, people also use checks or credit cards for payment. So are checks or credit cards money? To answer this question, we need to understand what money is. Understanding the concept of money is important to grasp the principles of macroeconomics, but it is not a simple task.

In the most general sense, money is defined as “Anything that is generally accepted in payment for goods or services or in the repayment of debts.”

3.4.1.2. Functions of money

To be generally accepted as a means of payment, money must have specific functions. In general, modern monetary theories emphasize three basic functions of money: medium of exchange, unit of account, and store of value. These three functions distinguish money from other assets, such as stocks, bonds, real estate, and other assets.

real estate, works of art.... Next we will consider each function of money in turn:

- Medium of exchange

A medium of exchange is something that is accepted by people in exchange for goods and services. Money is a medium of exchange. When you buy a commodity, such as a shirt, the shopkeeper gives you the shirt, and you give him money. It is through the transfer of money from the buyer to the seller that the transaction takes place. Without money, the exchange of goods becomes much more complicated and costly. Let us imagine that in an economy without money, an economics professor wants to drink beer, but can only exchange beer for his lecture. Will this professor satisfy his desire? However, in a monetary economy, the professor can teach economics and drink beer whenever he wants, because he will receive payment in money and can use the money to buy drinks and other things that the professor needs. The beer house will accept pieces of paper that are designated as money because they trust that other people will accept them. So money has value because people think it has value.

- Means of storing value

Money’s role as a medium of exchange goes hand in hand with its role as a store of value. People will only hold money if they believe that it will continue to have value in the future, so money can function as a medium of exchange only if it also serves as a store of value. In this function, people may choose to hold some of their wealth directly in money. Of course, money is not the only store of value in the economy, because a person can transfer purchasing power from the present to the future by holding other assets. The term “asset” is used to refer to stores of value, including money and non-money assets. However, under conditions of inflation, the value of money decreases over time. This makes money a weaker store of value than other assets.

- Accounting unit

With these two functions, money becomes a very convenient and efficient unit of account because it is widely accepted in all transactions. People use a common currency “like the Vietnamese currency or the US dollar” to list prices and record debts. When you go shopping, you may see that the price of a shirt is 120,000 VND and a bowl of pho costs 10,000 VND. Although it is possible to accurately say that the price of the shirt is equal to 12 bowls of pho and the price of a bowl of pho is 1/12 of a shirt, the prices are never recorded in this way. Similarly, if you borrow money from a bank, the amount you have to repay in the future will be calculated in VND or dollars, not in the quantity of goods and

services. When we want to calculate and record economic value, we use money as the unit of account.

3.4.1.3. Types of money

Throughout history, many things have served as money, including seashells, tobacco, precious metals, as well as paper money and bank transfers. Galbraith and Salinger in “Everybody’s Guide to Economics” divide the history of money into three periods:

In the early stages, humans used original or basic money. These were salt, seashells, precious metals, or other basic commodities. When money existed in the form of a commodity with inherent value , it was called commodity money . The term inherent value implies that the commodity had value even if it was not used as money. An example of commodity money is gold. Gold has inherent value because it is used in industry and in making jewelry. Another example of commodity money is cigarettes. During World War II, prisoners in prison camps exchanged goods and services with each other using cigarettes as a store of value, unit of account, and medium of exchange. Similarly, when the Soviet Union collapsed in the late 1980s, cigarettes replaced the ruble as the preferred currency in Moscow. In both cases, even non-smokers are willing to accept cigarettes in exchange, because they know that cigarettes can be used to purchase other goods and services.

In the second stage, governments and banks became the main players in the money supply. But at this stage, some basic goods were still used to quantify the exchange for money. Therefore, this was the pre-standard stage, mainly the “gold standard” or “silver standard”. In the gold standard, the government of each country fixed the price of gold in terms of its domestic currency. The government was always ready to buy and sell the exact amount of gold that the population wanted to trade at this fixed price. The government’s ability to supply money was then severely limited by the requirement that the government hold an equivalent amount of gold in its treasury.

In the third and final stage, the metal standard disappeared, and money became a creation of banks and governments. Money that has no real value – like the Vietnamese dong – is called fiat money . The concept of fiat refers to a legal decision of the State, and fiat money is money created by a government decree. Why can you use banknotes issued by the State Bank of Vietnam to pay your bills? The answer is that the Vietnamese government has stipulated by a decree that those banknotes are legal money.

Although the government is the central agency in establishing and operating the fiat money system (for example, prosecuting counterfeiters), it is the

For a currency to function successfully, other factors are needed as well. More broadly, the acceptance of fiat money depends as much on social expectations and customs as on a government decree. In the 1980s, the Soviet government never abolished the ruble, because it was the official currency that the government had established. But Muscovites preferred to accept cigarettes (or US dollars) over rubles in exchange for goods and services, because they believed that the latter would be accepted by others in the future.

3.4.1.4. Measuring money volume

According to the three functions of money and with the development of financial assets, determining which type of asset is money is becoming more and more complicated. Is money just paper money, coins or something else? Currently, in textbooks and in practice, there are 3 main ways to measure the amount of money: cash (M 0 ), transaction money (M 1 ), and broad money (M 2 ). However, the structure of the components that make up M 1 or M 2 is not uniform among countries. This difference is mainly due to the different levels of development of the financial systems in these countries. Despite such differences, the components that make up M 1 or M 2 must meet the functions of money as stated. In the scope of this lecture series, we understand the concepts of money M 0 , M 1 , M 2 as follows:

- M 0 or cash: Includes paper money and coins in circulation.

- M 1 : Includes cash, deposit accounts that can be withdrawn on demand (non-term deposit accounts).

- M2 : Includes M1 and term deposit accounts.

Money is divided into M 0 , M 1 and M 2 based on the liquidity of the components that make them up, and the liquidity of financial assets depends on the characteristics and level of development of the financial system. The liquidity or convertibility of an asset refers to the ease with which it can be converted into the medium of exchange of the economy.

Let us consider in turn why M 0 , M 1 and M 2 are considered measures of the money stock of the economy. In general, cash can be used directly, immediately and without restriction for payments. Therefore, cash is known as the most liquid asset. Demand deposit accounts are also considered money. Why? First, we get acquainted with two basic financial instruments (assets) that have a direct impact on measuring the money stock: demand deposit accounts (referred to as demand accounts) and time deposit accounts (referred to as time accounts). With demand accounts we can “withdraw money” at any time without incurring any costs. In addition, with demand accounts, we can write checks and use them to pay for our expenses.

For term accounts, in principle, we can only withdraw cash when the term is due, or we must notify in advance and pay interest penalties. Previously, only term accounts were entitled to interest. However, currently, non-term accounts also receive interest, but at a lower rate than term accounts.

3.4.2. Banking system

3.4.2.1. Monetary base and money supply

If we ignore the differences between types of deposits (i.e. different definitions of the money stock) and consider only one unified type of deposit denoted by D , then the money supply or money supply ( MS ) includes cash outside the banking system ( Cu ) plus deposits ( D ):

MS = Cu + D

We need to distinguish the money supply from the monetary base ( B ), which is the amount of money issued by the central bank. The monetary base exists in two forms: currency outside the banking system ( Cu) and reserves of commercial banks ( Reserve – R). Therefore, we can write:

B = Cu + R

In modern economies, the money supply is always larger than the monetary base. This is due to the money creation process by commercial banks. In the next section, we will examine how the behavior of commercial banks affects the money supply.

3.4.2.2. Commercial banks and the money creation process

Commercial banks are the most familiar type of financial intermediary. The most basic function of a bank is to accept deposits from savers and lend them out. Banks also have a second important role: they facilitate buying and selling by allowing people to write checks against their deposits. In other words, banks help create a special asset that people can use as a medium of exchange. The role of providing a medium of exchange is what distinguishes banks from other financial intermediaries. Along with the central bank, the commercial banking system provides payment services and plays an important role in determining the money supply in the economy.

To see the money-creating role of the commercial banking system, we will consider the following two situations in turn:

- Banks operate on the principle of 100% reserve

To consider the impact of commercial banking activities on the money supply, let us first imagine a world in which no banks exist. Without banks in the economy, there would be no deposits and therefore no money supply.

money simply equals the quantity of cash. The exact same thing happens if there are banks and they operate on a 100% reserve basis. In other words, banks only accept deposits and simply hold them as reserves, without lending them out. If the public deposited all their cash in the banking system, there would be no cash in the hands of the public—all their notes and coins would be held as reserves—but the quantity of deposits would be exactly equal to the quantity of cash. Under 100% reserve conditions, banks have no role in changing the money supply.

- Banks operate on the principle of fractional reserve and money creation.

In practice, banks always lend money. Because banks anticipate that not all depositors will withdraw all their deposits at once, they do not need to hold reserves equal to the deposits. Instead, they hold only a portion of the deposits and lend out the rest. Such a banking system is called a fractional reserve banking system.

To see how the banking system creates money, first assume that the public does not hold cash and so the amount of cash outside the banking system is zero. Next, assume that when banks receive a deposit, they keep 10% in reserve and lend out the remaining 90%. In this case, the bank 's reserve ratio is 10%. In the general case with a reserve ratio of rr, the amount of reserves (R) will be rr times the amount of deposits (D).

Next, we use a T-account table to examine the changes in assets and liabilities of a bank (bank number one) after receiving a new deposit of VND 1,000 million issued by the Central Bank. Before the first bank made the loan, the money supply increased by VND 1,000 million. But after the bank made the loan, the account of this bank changed as follows:

First Bank

Assets Liabilities

Reserves: 100 Loans: 900

Deposit: 1000

On the right side of the account, the liabilities increased by 1,000 million VND (the amount that the bank owes depositors increased). On the left side of the account, the assets also increased by 1,000 million VND, in which the bank added 100 million VND in reserves and lent out 900 million VND. The assets and liabilities of the bank are always equal. Thus, the money supply now increases by 1,900 million VND because the depositors in the bank hold 1,000 million VND in demand deposits and the borrowers of the bank hold 900 million VND in cash. Thus, when the bank only holds a part of the mobilized deposits as reserves, it has increased the total means of payment.

Money creation does not stop at Bank 1. Suppose the borrowers from Bank 1 use 900 million VND to buy some items from some other people, who, after receiving the money, decide to deposit all their cash in Bank 2. This bank keeps 10% (90 million VND) as a reserve and lends out the remaining 90% (810 million VND), increasing the money supply by 810 million VND.

Second Bank

Assets Liabilities

Reserve : 90

Deposit:900

Loan :810

The process continues: each time money is deposited in a bank, the bank lends out some of it. This increases the amount of money in the economy. So how much money is created in the economy? Now let's add all the deposits together:

Initial deposit = 1000

The loan amount of the 1st bank = 900 [= 1000] The loan amount of the 2nd bank = 810 [= 900]

……………

Total amount of money increased = 10,000

Thus, this process of money creation cannot continue indefinitely: the amount of additional money is gradually decreasing. If we add up all the numbers in the above example, we will see that with the 1,000 million VND that the Central Bank has just injected into circulation, the amount of money in the economy increases by 10,000 million VND. The amount of money in the economy that increases due to the activities of the banking system from the one VND that the Central Bank injected into circulation is called the money multiplier. Thus, in the case of a 10% reserve ratio and no one holds cash, when the monetary base increases by 1,000 million VND, it increases the money supply by 10,000 million VND, and thus the money multiplier is 10 (equal to 1 divided by the reserve ratio).

3.4.2.3. Money supply model

Let us now consider the phenomenon of expansion of the money supply relative to the monetary base due to the operations of fractional reserve banks more carefully. Starting from the equations defining the money supply and the monetary base that we mentioned above:

B = Cu + R MS = Cu + D

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