How does a central bank create money

Money creation by the ECB - how money comes into circulation

Money creation out of nothing? Is that possible? Many laypeople as well as economists ask themselves when reviewing the last few years of the financial and debt crisis.

The reason: Money creation by the European Central Bank (ECB) is one of the central building blocks of our monetary system.

If the central banks lose control of the creation of money, this can lead to excessive exaggerations in the financial markets - and this also affects all investors.

How does money creation by the ECB work?

But first it has to be clarified how the money creation of the European Central Bank (ECB) actually works. In particular, the central question that arises is how central bank money actually becomes book money or deposit money (paper money, coins).

Only central banks (ECB in the EU, FED in the USA) are allowed to create and print cash. The central banks give credit to commercial banks such as Deutsche Bank or Commerzbank.

The commercial bank must deposit collateral or securities for this loan. In addition, the ECB obliges commercial banks to hold a so-called minimum reserve for customer deposits.

Since 2012, this minimum reserve has been relatively small at 1%. This means: If a commercial bank receives deposits and wants to grant a loan of € 10,000 to the customer, it must in theory deposit a minimum reserve of € 100 with the central bank.

In practice, the equity ratio of at least 8% that banks have to meet has to be taken into account.

Money creation by the ECB - a practical example

A customer (A) of a bank receives a loan of € 10,000 from his bank. For this sum, the customer (A) purchases a small solar system from the supplier (B). The supplier (B) pays the sum of € 10,000 into his commercial bank.

For the sake of simplicity, a minimum reserve of 10% is assumed in this example.

The commercial bank must therefore deposit € 1,000 with the ECB as security for this € 10,000 deposit. This means that the commercial bank can issue a further loan of € 9,000 to the customer (C). Customer (C) pays an invoice with the supplier (D) with the 9,000 €.

The supplier (D) puts the money (€ 9,000) back into his commercial bank, which again issues a loan (€ 8,100) minus the minimum reserve (€ 900).

This means that € 1,900 has already been deposited with the ECB and the next time the loan is granted, the game starts all over again until the minimum reserve finally limits the granting of loans.

Overall, this multiplier effect results in a tremendous amount of money being created by the ECB through lending, which in this example ultimately results in a money creation of € 100,000 from a simple loan of € 10,000.

Money creation through commercial banks

Today, money is also created by commercial banks through a so-called balance sheet extension when lending. This is done through a simple booking record, which makes the loan amount appear on both the assets and liabilities side of the bank.

No bank reserves or savings from other customers are used for this type of loan. Rather, through this process, both the liability (liability side) and the claim (asset side) are placed on the same person: the borrower.

Conclusion: Money is always created through lending

Overall, it can be said that money is always created through lending, both at the ECB and at commercial banks.

In this way, many financial experts are already talking about a debt-money system, which inevitably increases the debt mountains of private households, but also of states.

The ECB can control the money creation process to a certain extent via the minimum reserve ratio and the key interest rate, but the instruments of the central banks are ultimately limited. A significant rate hike seems unlikely due to the high level of debt.

For investors, this means that interest rates are likely to remain low for the foreseeable future. This means: cheap loans, but also mini interest for deposits (overnight money, fixed-term deposits).

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