How Central Banks Create Money Out Of Nothing

 

Central bank meetings over this week (Bank of Canada and European Central Bank) and next week (Bank of England and Federal Reserve) will almost certainly be centered around what approach the central banks should take regarding rising government bond yields.

Central banks can choose to continue more of the same, which is to remind markets that central bank policy rates are likely to stay low for the foreseeable future, and hope that longer-dated bonds don’t get too high. A second option is that central banks can jawbone yields back down by discussing the possibility of more asset purchases. A third option is central banks could actually purchase additional assets. In particular, they could purchase longer-dated government bonds to force yields back down.  

10 Year Government Bond Yield Graph

This all becomes quite precarious for central banks, as they have already added massive amounts to their balance sheets. Is there such a thing as too much?  And if so, how much is too much?  Furthermore, attention has turned to a post-Covid-19 world. The increase in money supplies these asset purchases have generated is coming into focus, hence the rising bond yields.

That was then, this is now!

However, there is a key difference between the quantitative easing of the Great Financial Crisis of 2008-10 and now. This time a large portion of this round of quantitative easing flowed through to consumers, not just the banks.

Below we present a refresher of how the money multiplier works. The start of which comes from central bank asset purchases. This then waterfalls into the monetary base, then the money supply. After that then on to the velocity of money and tie it all together on how this leads to inflation.

How Central Banks Creates Money

It starts with a central bank deciding to implement a quantitative easing program by purchasing assets (or through loans). The central bank then goes into the market and makes purchases and credits the counterparty dealer (consumer bank) with ‘electronic’ money. The counterparty can choose to either leave the money at the central bank as a reserve or take the money out of the central bank and use it to make loans to businesses and households, or it can use the money to purchase other assets. The money created by the central bank becomes a liability on the central bank’s balance sheet as either a reserve or currency in circulation.

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