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Chapter 25: Problem 7

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

Expert verified
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

01

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.
02

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.
03

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'.

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Most popular questions from this chapter

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