Modern Money Creation Is Not What You Think It Is

Most economists focus on the role of banks in creating money by using a simple model.  Banks create money when they make loans, and the amount of money created is limited by the excess reserves held in their reserve accounts at central banks.  The government plays a role in this process by its control over the reserve ratio.  It also insures bank deposits, acts as lender of last resort to banks, and it can influence the interest rates that banks charge when they make short term loans to other banks.  There is another process of credit creation and money creation that is described in this article.

A hedge fund may use a bond that it holds as collateral for a loan from its bank which acts as its primary broker.  The bank may use the bond that it holds as collateral for a loan that it makes from another bank.  This process of reusing securities as collateral in the banking system is also a factor in credit creation and in determining the money supply.  It is limited by the interest rates (haircuts) that banks charge each other for these short term loans, and it is also limited by the trust that banks have in each other.  This process of credit creation has been affectively limited by higher counterparty risk in the system.  It has affected the interest rates that banks pay for short term loans and it has led to shorter reuse chains for collateral.  The net result is higher interest rates for many businesses.