How Is Money Made?

CENTRAL BANK OF SAMOA FACT SHEETS How is money made? c. Regulatory policy acts as a limit on Money creation banks’ activities in order to lessen a build-up of risks that could pose a In the modern economy, most money threat to the stability of the financial takes the form of bank deposits. When- system. ever a bank makes a loan, it simultane- ously creates a matching deposit in the 2. Money creation is also controlled by borrower’s bank account, thereby cre- the behaviour of the money holders ating new money. – households and businesses. House- holds and companies who receive the Although commercial banks create newly created money might respond money through lending, they cannot by carrying out transactions that im- do so freely without limit. mediately destroy it, for example by repaying outstanding loans. In the modern economy there are three main sets of limitations that re- 3. The ultimate limit on money creation strict the amount of money that banks is monetary policy. By influencing the can create: level of interest rates in the economy, the Central Bank of Samoa’s monetary 1. Banks themselves face limits on how policy affects how much households much they can lend. In particular: and companies want to borrow. This a. Market forces limit lending be- occurs both directly, through influenc- cause individual banks have to be ing the loan rates charged by banks, able to lend profitably in a compet- but also indirectly through the overall itive market. effect of monetary policy on econom- b. Lending is also constrained be- ic activity. As a result, the Central Bank cause banks have to take steps to of Samoa is able to ensure that money lessen the risks associated with growth is consistent with its objective making additional loans. of low and stable inflation. CENTRAL BANK OF SAMOA FACT SHEETS loans. For example the risk that people Bank lending limits will want to withdraw their deposits in large sums and the bank will need to Banks receive interest payments on have that currency on call. their assets, such as loans, but they also generally have to pay interest on their One way the banks do this is by making liabilities, such as savings accounts. sure that they attract relatively stable deposits to match their new loans. That A bank’s business model relies on re- is, deposits that are unlikely or unable ceiving a higher interest rate on the to be withdrawn in large amounts, such loans (or other assets) than the rate as term deposits. it pays out on its deposits (or other liabilities). The commercial bank uses Consumers are likely to require com- the difference between the two, or the pensation for the inconvenience of “spread”, to cover its operating costs holding longer-term deposits. So these and to make a profit. are likely to be more costly for the banks, limiting the amount of lending By attracting new deposits, the bank they wish to do. can increase its lending without run- ning down its reserves. But it must An individual bank’s lending is also lim- balance the interest it is paying out on ited by considerations of credit risk. deposits with the interest it is receiving This is the risk to the bank of lending to on loans. borrowers who turn out to be unable to repay their loans. This means that competition for loans and deposits, and the desire to make a In part, banks can guard against credit profit, therefore limit money creation risk by having sufficient capital to ab- by banks. sorb any unexpected losses on their loans. But since loans will always in- volve some risk, the cost of these po- Managing risks tential losses will be taken into account when the bank process loans. Banks also need to manage the liquid- ity1 risks associated with making new However market forces do not always 1 Liquidity - A measure of the extent to which a debtor has the cash to meet short-term debts. lead individual banks to sufficiently pro- need be no further effects on the econ- tect themselves against liquidity and omy. credit risks. Because of this, prudential regulation (carried out by CBS) aims to ensure that banks do not take excessive Monetary policy risks when making new loans, including via requirements for banks’ capital and One of the Central Bank’s primary ob- liquidity positions. These include rules jectives is to ensure monetary stability set out under the Financial Institutions by keeping consumer price inflation on Act 1996. track to meet the three percent target set by the Government. Consumer Setting monetary policy appropriate- ly ensures a stable rate of credit and constraints money creation to meets this target. When new money is created, house- The Central Bank of Samoa implements holds or companies either pass it on monetary policy by setting short-term through spending, or destroy it by pay- interest rates, specifically by setting ing off debts. the interest rate paid on central bank reserves held by the commercial banks. Each scenario has a very different im- plication for economic activity. It is because there is demand for central bank money – the ultimate means If the new money is spent then it may of settlement for banks – that the price continue to be passed between differ- of reserves has a meaningful impact on ent households and companies, each other interest rates in the economy. of whom may, in turn, increase their spending. This process can lead to in- The interest rate that commercial creased inflationary2 pressure on the banks can obtain on money placed at economy. the central bank influences the rate at which they are willing to lend on simi- In contrast, if the money is quickly de- lar terms to their customers. stroyed (by paying back a debt) there 3 Inflation - A sustained increase in the general level of prices for goods and services. For more on this topic see the CBS Factsheet “Inflation”. CENTRAL BANK OF SAMOA FACT SHEETS Changes in inter-bank interest rates The commercial bank’s balance sheet then feed through to a wider range of expands: new deposit liabilities are interest rates in different markets and matched with an asset in the form of at different maturities, including the new reserves. interest rates that banks charge bor- QE works by circumventing the bank- rowers for loans and offer savers for ing sector, aiming to increase private deposits. This then influences how spending directly. much money is created. However once short-term interest Conclusion rates reach their effective lower bound, it is not possible for the central bank to Most of the money in circulation is cre- provide further stimulus to the econ- ated, not by the printing of banknotes omy by lowering the rate at which re- by the Central Bank of Samoa, but by serves are remunerated. the commercial banks themselves. One possible way of providing further The Central Bank is nevertheless still monetary stimulus to the economy is able to influence the amount of money through a programme of asset purchas- in the economy. es known as “quantative easing” (QE). It does so in normal times by setting The policy aims to buy assets, govern- monetary policy – through the inter- ment bonds, mainly from non-bank est rate that it pays on reserves held financial companies, such as pension by commercial banks with the Central funds or insurance companies. Bank of Samoa. Consider, for example, the purchase of But when interest rates reach their ef- $1 million of government bonds from a fective lower bound, the Central Bank pension fund. The pension fund’s bank can use an asset purchase programme credits the pension fund’s account with to raise the amount of money in public $1 million of deposits in exchange for circulation. This in turn affects the pric- the government bonds. The Central es and quantities of a range of assets in Bank finances its purchase by crediting the economy, including money. reserves to the pension fund’s bank. For more CBS Fact Sheets, visit www.cbs.gov.ws.

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