By Andrew Sheng
The Bank of England has recently published two articles in its Quarterly Bulletin on “Money in the Modern World” and “How Money is Created” (http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q102.pdf). The first should be compulsory reading in schools because it is simple and clear explanation of what money is all about. The second is a more technical explanation of how money is created — surprise, surprise — the central bank is not fully responsible! The textbooks tell us that money should have three key attributes — a store of value, unit of account and medium of exchange. The Bank says that money is really an IOU (a debt or obligation from someone). Even the cash we have in our pocket is an IOU (a promissory note from the central bank). Currency is fiat money, meaning money that is irredeemable — you can’t exchange your pound sterling for gold at the Bank of England — you will be given another banknote of the same value. Of course, the most common form of money is bank deposits, which is the IOU of your bank to the amount of money you put with it. You can use these deposits to make payments (current account) or you can save in a savings account or fixed deposits to earn interest as a store of value. Here’s where it gets really interesting. The bulk of the money created is by commercial banks, not by the central bank. When commercial banks lend money to its clients, they create deposits. Now the power to do that is not unlimited, because it depends on the banks’ willingness to lend, the willingness of the public to borrow and on legal requirements such as capital ratios and liquidity ratios.
But, the amount of money that the banks can create through giving out loans can be influenced by monetary policy. The central bank does this through setting the interest rate (the Bank Rate) on central bank reserves (the amount of money that the banks have to put with the central bank). Through changing the Bank rate, it influences a range of interest rates in the economy, including those on bank loans.
However, there is a lower limit to how much a central bank can reduce interest rates, which is zero or in practice 0.5 percent. Since the interest rate tool becomes ineffective at the lower limit, they decided to influence not just the price of money (the interest rate) but also the quantity of money. Unconventional monetary policy is unconventional, because common sense tells you that you cannot affect simultaneously both the price and the quantity. But that is exactly what the advanced country central banks are doing. The central bank can also affect the amount of money directly through purchasing assets or “quantitative easing” (QE). This is where the central banks say they are not printing money.