Thursday, November 11, 2010

Money Creation - Simplified

Well, I'm not here to talk about history of the invention of money but to talk about how money is created today. Yes, money creation. Perhaps some of you might have know this, for those who doesn't, you probably should continue reading this. No, this is not quantitative easing or 'money printing', this is different.

Money creation?...Today?....What?
Yes, today, everyday. When? Every time you swipe your credit cards, every time you take loan from banks to buy car or house, just about every loan you just help to create money in the economy.
WTH?

That's how the economy works today - partly.

How?
It is quite simple. Ever heard of Fractional Reserve Ratio? You can find the explanation from wikipedia if you interested in the details, if not this is the simplified one. Basically what it means is that the minimum amount ratio of deposit  the bank must hold in order to lend money to its borrowers. Lets say if the minimum amount ratio is 10%, 90% of the deposited amount can be lend out. Take for example:

Bank A, a car seller and a car buyer. 
Imagine both car seller and car buyer has an account in Bank A. The car buyer deposited RM100,000 in bank A. Somehow he decided to borrow money from the bank to buy a car worth RM90K. So he borrows from bank A. With the fractional reserve ratio of 10%, Bank A is allow to lend out RM90K which is 90% of the amount of cash it has in its deposit. When the car buyer pays the car seller RM90K, Bank A will key in that amount of money to the car seller account which happens to in Bank A. See here, no real cash movement are involved and the bank has now RM190K in its deposit and thus RM90K has been created. Now the bank has RM100K in cash and RM190K in liabilities.



Now, when the bank key in RM90K into the the car seller's account it also means the car seller has deposited  RM90K into its account. This will give the chance for Bank A to lend out another RM81K (90% of RM90K). If this cycle continues, Bank A can expand its reserve to the maximum amount of RM1mil or create RM900K (RM100K + RM90K + RM81K + RM72.9K +.......= RM1mil). The multiplier can be calculated by this simple equation:

multiplier = 1/ratio = 1/10% = 10

Means if the ratio is 10%, 10 times of the amount deposited can be created, 20% means 5 times and so on. The ratio differs from country to country. Of course in the real world, it would not be just one bank, but this is regulated by the central bank. Even if the money is deposited in Bank B, Bank A could still loan out 90% of it as long as the total for both does not exceed 90%.

Does Malaysia has this?
Yes, of course. The only difference is that we call it Statutory Reserve Policy (SRP). What is the ratio then? Erm....1% as of the day I wrote this. This would mean, every RM1 deposited in our banks RM100 can be created. From 2008 till today, our statutory reserve requirement has been cut from 4% to 1%. Well, normally when a central reduce the requirement it is to increase money supply to the market or in other words to get the economy going. If the economy is improving, why is there a need to increase money supply? Or is it? Hmmm..... I don't know. But....GDP can be improved by incurring more debt. How? Maybe next time.

Well that is how it works for now. Unless any reform takes place which is still in discussion now. We'll see.

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