Money printing: Good or bad?
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If you deposit Rs.5,000 in your bank account, for example, the bank must lend it to somebody else to earn an interest income. However, before doing that it has to comply with one of the Central Bank regulations that require the banks to separate ‘reserves’ from the deposit as per the cash reserve ratio.
If the cash reserve ratio is 5 per cent, the banks must deduct that amount from every deposit and credit to their own accounts at the Central Bank. As per the reserve requirement of 5 per cent, your Rs.5,000-deposit will generate Rs.250 as cash reserves, which will be a liability of the Central Bank.
This is the minimum reserve requirement, while banks can choose to go beyond that, maintaining excess reserves too. After separating the minimum cash reserve requirement, the balance of the deposit, which is Rs.4,750 will be available for some others to get as bank loans.
If somebody walks to the bank and borrows it, what would he possibly choose to do with it? Whatever the purpose of the loan, the borrower will use it to make payments to another who would supply goods or services to him. This supplier will again deposit it in his own bank account so that the bank deposits will rise by Rs.4,750.
Deposit multiplication
Because it is a new deposit to a bank, it is also subject to the cash reserve requirement, which is 5 per cent in our example. As such, this bank will credit Rs.237.50 to its reserve account at the Central Bank and issue another loan up to Rs.4,512.50 to a different bank customer.
Given the same deposit multiplication process, this loan will create another payment and, thereby another bank deposit of Rs.4,512.50. As such, new cash reserves will also be credited to the reserve account at the Central Bank, and a new loan will be issued to some other borrowers.
Technically, the process continues “infinite times” creating more deposits, more reserves and more loans until it reaches zero deposit. What we understand from this process is that the whole multiplication was just from your initial Rs.5,000 deposit.
At the end of the process, the total amount of deposits in the banks will have increased by Rs.100,000, and the total reserves by Rs.5,000. Banks will have also issued total loans up to Rs.95,000.
Stock of money
Even without the involvement of physical cash (other than the initial Rs.5,000 deposit), there have been transactions taking place in the economy. Accordingly, all the transactions in an economy are based primarily on both physical cash and bank deposits.
A country needs a “stock of money” which is known as money supply. It consists of these two components of money – cash and bank deposits. As we just now elaborated, banks’ deposits get multiplied. Although there are various types of bank and non-bank deposits in the financial sector of a country, at this moment let’s not make our analysis complicated.
As we saw, banks’ reserves maintained at the Central Bank and physical cash issued by the Central Bank are the two main components of the stock of reserve money – a liability of the Central Bank. This is also called “base money” because it is the base of money supply in the economy.
In its conduct of the monetary policy, the Central Bank can change reserve money stock to create an impact on money supply – cash and bank reserves. As per the Annual Review 2023 of the Central Bank of Sri Lanka, an increase in Rs. 1 to reserve money stock, will add Rs.9.93 to the country’s money supply (defined as M2b monetary aggregate).
Is money printing bad?
Money printing is, technically the increase in reserve money stock which will eventually multiply the country’s money supply. The Central Bank’s money printing has been a hot topic in Sri Lanka during the past few weeks. Before we try to comprehend this issue, there are a few questions that we need to answer.
Is money printing bad? In principle, it is not. Money printing is the legitimate responsibility of the Central Bank to make sure that money is adequately available to the public. If the economy is growing, transactions get expanded, and money supply must be sufficient to finance growing aggregate demand. Money printing is bad, only when it is printed excessively – above and beyond the requirement of the economy.
Secondly, time duration is important too. Central banks have the legitimate powers to inject money to the economy as well as to absorb money back as and when needed. There are millions and billions of decisions made by people, firms, and organisations that affect the cash flows in the financial sector every day. It is quite natural that they would result in liquidity surpluses or shortages each and every day. And it is the Central Bank’s mandate to manage short-term liquidity, which will alter money supply.
Finally, the Central Bank must strive to achieve the central banking objective of price stability. In its attempt to manage the price level avoiding inflation, such attempts will also carry alterations to money supply.
Tools of money printing
As far as the tools of the monetary policy are concerned, let’s begin with what is being abandoned now by the new Central Bank Act No. 16 of 2023 – the Central Bank’s direct lending to the government by purchasing government securities at their primary auctions. This action would result in Central Bank holding of government securities which has declined during the past 10 months of the year.
The Central Bank continues to engage in “open market operations” on a daily-basis and term-basis in buying government securities from the banks or selling them back to the banks. Since this is a routine work of the Central Bank, you can say that there has been an injection of money by referring to a particular time period; by changing the reference period, you can also say that money has been absorbed by the Central Bank. The point is that the conclusion depends on the ‘length’ of the reference period.
Under the open market operations, the Central Bank attempts to manage liquidity in the banking system. If there is a liquidity shortage, banks should be facilitated getting access to short-term borrowing either from the Central Bank or through inter-bank transactions.
The Central Bank has to operate in the foreign exchange market too. The Central Bank of Sri Lanka has been building the stock of its foreign exchange reserves which is now at about US$6.5 billion. When the Central Bank purchases foreign exchange in the market to build its foreign reserves, there will be an outflow of rupees to the banking system. Accordingly, as the stock of foreign reserves rise, money supply should rise too.
Change in reserve money
It is the increase in the reserve money stock that is counted as money printing. During the first nine months of the year from January-September 2024, reserve money stock has increased by Rs.195 billion. It would have been added after a time lag about 10 times more money to the existing money supply of the economy. If you choose a different period of time, your answer is different too.
If the Central Bank does not finance shortages of the government’s cash flow as it used to do earlier, how does the Treasury meet its expenditure requirements now? Every month, the Treasury must pay loan interests, public sector salaries, pensions and subsidies without any delays. The Sri Lankan government is not yet being able to increase its tax revenue to meet all these expenditure obligations so that the Treasury must continue to borrow.
The primary issuance of the government securities supplements the shortages of the Treasury’s cash flow. Technically, this will absorb liquidity from the economy at least temporarily reducing money supply until it is counterbalanced with injected liquidity.
(The writer is Emeritus Professor of Economics at the University of Colombo and can be reached at sirimal@econ.cmb.ac.lk and follow on Twitter @SirimalAshoka).
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