How money creation is done in the economy? (PART-2- Open Market Operation)

  

     Money creation is a method followed by banks, to introduce some money into the economy. This happens when there is a shortage of money or when the economy is slowing down. Money can be introduced into the economy either by printing it (by purchasing bonds) or by giving loans, out of the deposit, or thin air. On the before topic, we had discussed money creation through loans, issued by commercial banks to individuals, which you can access from the below article.

https://sciencetopic03.blogspot.com/2021/11/how-money-creation-is-done-in-economy.html

In this topic, we shall discuss the money creation process, which is done by purchasing bonds. The process of money creation through loans, which we learned on before topic is fine, till there is no huge demand for money. If there is any such situation as huge demand or very shortage of money, then the central bank steps into action, to print more money. Every country has one central bank in them and only they have the authorization to print money. Even the central bank can’t use this printing method to be done in an unusual manner to make everyone rich, as it could create a big problem, in the end, making the country’s economy go even worse. So it must be done in a timely and accurate manner.

The central bank introduces new money in the economy through the process of Open Market Operations. It is the type of operation in which the central bank buys or sells bonds (government securities) to and from the government via other financial institutions (mostly commercial banks) to increase the money supply in the economy. These bonds were initially issued by the government to commercial banks for a sum of amount, to furnish the activities like building schools, laying roads, improving defenses, etc,. So it acts as a debt to the government. This debt is classified as National Debt. Also, these bonds are interest-bearing and need to be paid by the issuer. Thus the bond acts as the written proof of the debt, which needs to be paid by the government with interest, for the money they got. It is similar to the loan we get but on a larger scale.

Treasury Auction and Open Market Operation

The bonds are useful in two different ways. At first, if the government requires money to furnish its activities, it may issue bonds to commercial banks to get money from them as loans. But if the economy needs money, the central bank again buys bonds from those commercial banks and issues them to the economy by printing them as new money. So by placing this bond, the government or the central bank gets or produces money.  The bond is very important during the transaction. If there is no bond, and the central bank prints money according to its wish, then there will be a severe problem in the economy. So the central bank and the government must be cautious in printing the money, and the debt increase. Now let’s see how the government and the central bank play a pivotal role, in injecting the currency at the right time into the economy and maintaining it in a steady balance.

As we have seen at the starting, the central bank is responsible for printing currency in the country. By printing currency, the central bank also controls the interest rates in the country.  So at first, the treasury bonds are created by the treasury department of the government with a face value on them. The face value is the amount needed by the government to furnish its activities. These bonds are sold to financial institutions (mostly commercial banks) through the process of auction. This auction is held for the minimum interest rates. The commercial banks who bid on the lower interest rates will win the auction. As the government is going to pay the interest for the bond, the government will always ask for the minimum interest rates. Also, commercial banks make investments in the belief of making higher returns (higher interest). When both the government and the bank settle at one coupon (interest rate), the government sells bonds to that bank. As these bonds hold an interest value over it, after the maturity value of the bond, the loan is repaid back by the government with an interest over it. So, financial institutions bid on the bond to get it.

Treasury Auction

Financial institutions buy a huge amount of these government securities and distribute some of them to their clients in the secondary market for higher profits. This will be in the form of ETF, Mutual funds, Insurance policies, etc. Also, when the central bank needs to increase the money supply in the economy, it too buys bonds from those institutions. But if the central bank wants to decrease the money supply it sells the bonds to those institutions. This process of buying and selling securities by the central bank with the primary dealers (financial institutions) is called Open market operations. The primary dealers also act as market makers, who increases the reserve requirement and make the transactions easier. They also maintain the liquidity of the securities purchased. The Primary dealers are also responsible for facilitating the trade of the government auction. Now let’s see in-depth when the central bank inserts money into the economy.

Open Market Operation

Let’s consider an example, where there are two banks present, namely Bank A and Bank B. Let’s consider that Bank B has given out a huge amount of loans and was running low on reserve. A reserve should be kept by a bank from the people’s deposit, to urgently meet the needy requirements of people, if they withdraw their money in an emergency. Thus, in this case, Bank B has got low on reserve and cannot meet people’s requirements. So Bank B asks for money from another bank called Bank A. Bank A lends out money to Bank B at an interest rate. This process of lending between banks is called interbank lending. So both the bank alternate sources, to satisfy people’s needs. But as the day goes, both the banks cannot issue loans as before. So the interest rates to the people also become high. Therefore loan decreases, borrowing decreases, spending decreases, productivity decreases, and there will be no income to the government. Thus economy suffers.

So, at this time, the central bank steps into action and buys treasury bonds from the banks that won at the auction. The central bank gets the bond and gives the face amount over the bond as a check. The important point to be noted here is that the central bank has no reserve of money in buying these bonds. If someone stated that the central bank buys bonds, it means it is creating money just by printing it. This check is called the new money (currency). In this digital world, it is simply added as several numbers on the computer. So therefore currency is created and injected into the economy. What a simplest and ingenious mechanism! So in the banking system, the money circulates and satisfies the needs of the people. This method of injecting cash into the system is called Expansionary monetary policy. The opposite of Expansionary monetary policy is Contractionary monetary policy, which tends to take out the cash from the economy if there is over money circulation. When the contractionary monetary policy occurs, the central bank destroys the newly created money, by selling those bonds it got at starting. So the central bank creates money if it buys bonds, and destroys money if it sells bonds. The Monetary Policy is always handled by the Central Bank, which monitors the cash flow and the interest rates over the banks. The opposite of Monetary Policy is Fiscal Policy which is handled by the central government that controls the economy by altering taxes and consumer spending.

Open Market Operation

    Now the currency is got by the bank, and given as a loan in the market. This money keeps on circulating over the economy until the debt for the bond is paid off. If it is not paid, it creates a greater national debt and will cause a serious burden on the country. This debt is majorly cleared by the government through taxation. If there is so much of national debt (Treasury bonds), then the government has to increase the cost of every goods and services used by the consumers by means of tax, which will also create a burden on the people in the country. Thus in the case of over debt, not only is the government responsible for paying the national debt but also the people in turn. If we cheat the government by not paying the taxes, it is considered as Black Money which could create a huge national debt that will shake the country. So let’s move our country from huge debt by paying proper taxes.

Note: The word “money” represented in the passage is actually “currency”. For your understanding, it has been written as money. It is because; the word “money” should be used only if the exchange medium has a stored value in it (e.g., Gold, silver). But as paper currency has no stored value in it, and changes its value over time, it is termed as currency.