Question

A columnist in the New York Times noted, "Normally when we say that a central bank like the Federal Reserve or European Central Bank creates money from thin air, it does so by buying up bonds." How can a central bank "create money" by buying bonds? Doesn't the government create money by printing currency? Briefly explain.

Short answer

Central banks can 'create money' by buying bonds, which increases bank reserves, allowing them to lend more. This shows that most of the money is digital and exists in bank accounts. Meanwhile, the government can physically print currency, but this only forms a small part of the total money supply.

Step-by-step solution

Understanding Bond Buying by Central Banks

Central Banks, such as the Federal Reserve or European Central Bank, can create money by buying government and corporate bonds from banks or other financial institutions. They do this by simply creating a deposit in the seller's bank account, which increases the reserves of the bank.

Impact on Money Supply

When a central bank buys bonds, it credits the account of the selling bank thereby increasing the reserves of the bank. The increased reserves allow the bank to lend more, creating new deposits for those who borrow and thus 'creating money' in the economy.

Difference between Currency Creation and Money Creation

Creating money doesn't necessarily mean printing more currency. While the government does have the power to print physical currency, this is a small part of the total money supply. Most of the money exists in digital form as balances in bank accounts. Since central banks have the ability to change the amount of money banks have to lend, they can effectively 'create money'.

Key concepts

Central Banks

Central banks are essential institutions in a country's economy. They play a pivotal role in overseeing financial systems and implementing monetary policies. A central bank, such as the Federal Reserve in the United States or the European Central Bank in Europe, manages the country's currency, money supply, and interest rates. These banks don't operate like commercial banks, they typically serve the government's banking needs and have the power to influence the financial environment.
They utilize various tools to maintain economic stability and growth. One of their primary methods is through manipulating the money supply, which can directly affect inflation and economic activity.

• They control national interest rates to ensure price stability.
• They regulate and supervise financial institutions to enhance the safety and soundness of the financial system.
• They serve as a lender of last resort in financial crises.

By doing so, central banks influence the broader economy, including employment levels and growth rates.

Money Supply

The money supply is the total amount of money available in an economy at a particular time. It includes various forms of money, such as coins, notes, and digital balances in bank accounts. Central banks control the money supply through monetary policy tools. This control is crucial as it influences interest rates, inflation, and ultimately the economy's health.
When central banks increase or decrease the money supply, they are influencing the ability of money to move through the economy efficiently. An increase in the money supply typically results from actions such as lowering interest rates or purchasing financial securities like bonds.
There are different measures of money supply, including:

• M1: Liquid forms of money such as cash and checking deposits.
• M2: Includes M1 plus savings accounts, time deposits, and other near-money.

In a digital age, much of the focus is on bank reserves and account balances rather than physical cash, as these represent significant portions of an economy's money supply.

Bond Purchases

Bond purchases are a key instrument used by central banks to influence the money supply and economic activity. When a central bank buys bonds, it pays for them by increasing the reserve balances of the banks that sell these bonds. This process is known as open market operations.

• This activity essentially injects money into the economy, as banks receive money in exchange for their securities.
• The increased reserves in banks enable them to offer more loans, sparking new economic activities as individuals and businesses gain access to more funds.

The indirect effect of these actions is to influence market interest rates. Buying bonds tends to lower short-term interest rates, making borrowing cheaper.
Bond purchases are a powerful tool because they don't just stimulate lending but can also alter expectations around future economic conditions. As such, they are often used in periods of economic downturn or when traditional monetary policies have been exhausted, helping to boost spending and investment.