Speech
Money - Born of Credit?
[*]
Christopher Kent Assistant Governor (Financial Markets)
Remarks at the Reserve Bank's Topical Talks Event for Educators
Sydney - 19 September 2018
Most of us would put cold hard cash at the top of our list when we think of money. Others would
include funds they have on deposit at a bank. Some might contemplate broader measures of their
wealth. Historians would be tempted to tell us about the role of precious metals, coins, salt, shells
and even rum when the topic of money is raised. When thinking about the role that money plays in
an economy, economics teachers and academics might educate us about money multipliers, the
velocity of money and money demand and supply functions. Keen students of episodes of high
inflation would discuss Milton Friedman and the notion that inflation is 'always and everywhere' a
monetary phenomenon. Given this, concerned citizens might be worried about what they see as the
ability of private banks to create money via the extension of credit, seemingly at will.
While there are many interesting aspects of money, today I want to focus on the questions of how
money is created and how money relates to lending or credit. Along the way, I'll also review what's
been happening to both money and credit in Australia over recent decades. The process of money
creation is often subject to a degree of confusion, in part because the explanation draws upon a
combination of disciplines - accounting, banking and economics.
What Is Money?
It is relatively standard practice to define money according to its ability to do each of the following
three things:
money can be used for transactions - it facilitates the exchange of goods, services or assets
thereby avoiding the substantial costs associated with barter
money is a store of value - it's worth does not fluctuate wildly, nor does it degrade rapidly over
time, and
money acts as a commonly accepted unit of account - it provides a convenient means of
comparing the value of a range of different goods, services or assets.
Banknotes and coins - otherwise known as currency - satisfy each of these functions. Currency long
ago pushed aside other physical forms of money.
Currently, there is around $75 billion of currency in circulation in Australia (outside of the banking
system). However, despite its usefulness, currency represents only a small share of money in
modern economies.
Most money consists of deposits in banks, building societies and credit unions (simply referred to
here as banks). Just as I can pay for my morning coffee using currency, I can also transfer funds in
my bank deposit to the café's account. In either case, the café owner receives a liquid store of value
which they are confident will be accepted by others.
Not all bank deposits are equally liquid - for instance, it can take some time to gain access to funds
in a term deposit. For this reason, it is common to construct a range of different 'monetary
aggregates', from the more liquid narrower forms of money - such as M1, which includes currency
and current deposits at banks - to 'broad money', which also captures less liquid deposits and other
financial products that share the characteristics of money discussed earlier (Table 1; Graph 1); for
example, broad money includes certificates of deposit or short-term debt securities. For convenience,
in what follows I'm going to focus on broad money.
Table 1: Monetary Aggregates
(a)
Measure Description
Currency Notes and coins held by the private non-bank sector
Money base Currency + banks' holdings of notes and coins + deposits of banks with the Reserve Bank +
other Reserve Bank liabilities to the private non-bank sector
M1 Currency + current (cheque) deposits of the private non-bank sector at banks
M3 M1 + all other deposits of the private sector at banks (including certificates of deposit) except
deposits of authorised deposit-taking institutions (ADIs) + all deposits of the private non-ADI
sector at credit unions and building societies (CUBS)
Broad money M3 + other deposit-like borrowings of all financial intermediaries (AFIs) from the non-AFI private
sector (such as short-term debt securities)
(a) These descriptions abstract from some detail. See the Financial Aggregates release for more information.
Graph 1
Broad money represents a relatively liquid form of wealth held by Australian households and
[1]
businesses. It includes currency, deposits and deposit-like products. Unlike ancient forms of
physical money - think shells or gold found in the natural environment - these are liabilities issued
[2]
by authorised deposit-taking institutions (ADIs) and other financial intermediaries. Broad money
in Australia is currently around $2 trillion or 115 per cent of the value of annual economic output as
measured by nominal GDP; most of that is in the form of banking deposits. Over the past decade,
the share of broad money represented by term and other bank deposits has increased in importance
at the expense of holdings of current deposits and other borrowings from the private sector.
How Is Money 'Created'?
Australia's banknotes are produced by the Reserve Bank of Australia and account for most (about
95 per cent) of the value of Australian currency. The rest is accounted for by coins produced by the
Royal Australian Mint.
Banks purchase banknotes from the Reserve Bank as required to meet demand from their customers
and, in turn, the Reserve Bank ensures that it has sufficient banknotes on hand to meet that
demand. Previous research by the Reserve Bank points to a number of drivers of demand for
[3]
banknotes. The most important is the size of the economy. This is consistent with people holding
some fraction of their income in this most liquid form of money in order to undertake
[4]
transactions. Some share of demand is also accounted for by the desire for a liquid store of
wealth. The value of banknotes in circulation as a share of nominal GDP has actually increased over
recent years (to around 4 per cent), which suggests that this source of demand has grown strongly.
This increase has been observed in a range of countries and is consistent with the low level of
interest rates, which has reduced the opportunity cost of holding money (compared with holding
interest-bearing deposits).
When customers withdraw currency from an ATM or a bank branch, the value of their deposit
holdings declines and the value of their currency holdings increases. The stock of broad money,
however, is unchanged.
As I mentioned earlier, the vast bulk of broad money consists of bank deposits. These banking
liabilities are created when an Australian household or business has funds credited to their deposit
account at an Australian bank. One way this can occur, for example, is when a business deposits
currency it has earned with its bank. Again, such transactions add to deposits but do not create
money because the bank customer is simply exchanging one type of money (currency) for another (a
deposit).
Money can be created, however, when financial intermediaries make loans. Accordingly, the concepts
of money and credit are closely linked in a modern economy, albeit not one for one. When a bank
extends a loan, it makes money available to the borrower, for example, to buy a car, a house or
equipment for a business. The bank may credit the deposit account of the borrower, who withdraws
the funds to make their purchase. Alternatively, the bank may directly credit the deposit account of
the seller on behalf of the borrower. In either case, the loaned funds will tend to find their way into a
deposit somewhere in the banking system. This process adds to the supply of money.
If I stopped here, you might be left with the impression that the process of lending allows the
banking system to create endless quantities of money at no cost. However, the process of money
creation is constrained in numerous ways and depends on the behaviour of borrowers, banks and
regulators, as well as the stance of monetary policy.
In the first instance, the process of money creation requires a willing borrower. That demand will
depend, among other things, on prevailing interest rates as well as broader economic conditions.
Other things equal, lower interest rates or stronger overall economic conditions will tend to support
the demand for credit, and
vice versa.
The bank then has to be willing and able to issue the loan:
It has to satisfy itself that the borrower can service the loan.
The bank must maintain a sufficient share of its assets in liquid form to meet any drawdowns
[5]
relating to the new loan, as well as meeting any withdrawals from existing depositors.
Otherwise, the bank runs the risk of failing to meet its obligations when they fall due.
The bank's loans and other assets need to be backed by adequate capital. Capital is needed to
absorb unexpected losses arising from defaults or other sources of variation in the value of assets.
The interest rates charged on loans must cover expected losses on the loan portfolio, as well as
the costs of deposits and other sources of funding. Revenues from loans and other assets will also
have to cover the operating costs of the bank, while allowing it to earn a profit so that
shareholders can earn a reasonable return on the bank's capital.
All of these considerations imply that money creation occurs at some cost, which serves to constrain
the extent of lending. These constraints are reinforced by regulatory requirements for liquidity,
capital adequacy and lending standards set by the Australian Prudential Regulation Authority. Other
things equal, anything that reduces the willingness or ability of banks to make loans can be expected
to result in lower growth of (system-wide) money.
It's also worth emphasising that the process of money creation is not the result of the actions of any
single bank - rather, the banking system as a whole acts to create money. A single bank may make
loans by drawing on its liquid assets, yet not receive the corresponding deposits created in return.
Before extending further loans, that bank would need to raise funds in other ways - for example, by
issuing debt or equity securities or by waiting for its deposits and liquid assets to rise via other
[6]
means.
Graph 2 illustrates how the process of money creation can work. It shows an example of an increase
in loans of $100 billion. However, the increase in loans in this case leads to an increase in deposits of
$60 billion; in other words, the changes are not one for one. This is because there are other sources
of funding besides deposits - and indeed, loans are not the only assets held by banks. In the
example shown, other funding comes from issuance of debt and equity. The shares from different
sources are in line with the actual funding behaviour of the banking system over recent years
(Graph 3).

In summary, changes in the stock of broad money are the result of a myriad of decisions, including
those of banks, their borrowers, creditors and shareholders. And these decisions take place within
the framework of a range of regulatory and institutional arrangements. It is worth noting that the
Reserve Bank does not target a particular level or growth rate of money (although it has done so
[7]
under a previous monetary policy regime). Instead, the Reserve Bank has some influence on the
money stock via the effect of its interest rate target for the overnight cash rate on other interest
rates in the economy. These in turn affect the cost of borrowing and economic conditions more
generally. Ultimately, borrowing and lending decisions - and thus the creation of money - are
constrained by the need for prudent banking behaviour, the budget constraints of borrowers and the
profitability of lenders.
One final word on the creation of money is that as fun as it is to teach students about traditional
money multipliers, I don't find them to be a very helpful way of thinking about the process. In
Australia, simple regulatory regimes - which had earlier required banks to hold a minimum share of
their deposits as reserves with the Reserve Bank - have been replaced with modern prudential
regulation and market discipline. Again, the demand for and supply of credit is the real driver of
money. That point can be reinforced by examining the behaviour of credit and money over time.
What Has Money Been Doing and Why?
Given that money is used for transactional purposes and as a store of value, it makes sense that
most of the time it would at least keep pace with growth in the value of nominal spending. Indeed,
in Australia it has grown faster than that over the past 40 years, roughly doubling as a share of
nominal GDP (Graph 4).
Growth of credit has been stronger still, roughly tripling as a share of nominal GDP, from under
50 per cent in the early 1980s to over 150 per cent currently. A closer look at the banks' balance
sheets shows how these changes have occurred.
Graph 4
In 1980, Australian banks held more than 80 per cent of their liabilities as deposits (worth around
$47 billion at the time) (Graph 5). This deposit base was more than sufficient to fund loans of about
60 per cent of assets (worth $34 billion). The majority of the remaining assets were held in the form
[8]
of securities (mostly government bonds).
Graph 5
As banks grew through the next four decades or so, there was a marked change in the composition
of their balance sheets. These changes reflected choices by both banks and the private sector and
were strongly influenced by the deregulation of the financial system. In particular, constraints on
banks' business activities were progressively removed in the 1970s and early 1980s (for example, the
interest rates they could charge and pay, their product offerings, lending volumes and their asset
holdings). This was associated with significant changes in banks' abilities to attract and use different
[9]
funding sources to support balance sheet growth. By the early 1990s, Australians' demand for
credit from banks became larger than the sum of all of their deposits.
Following a period of slower growth around the early 1990s recession, credit growth picked up again
and continued to grow much more quickly than money. To enable this, a greater proportion of bank
funding during this period was drawn from sources other than deposits. Much of it owed to an
increase in the issuance of debt securities, which was supported, in part, by a strong appetite from
non-residents for Australian bank debt.
These trends continued until the global financial crisis. Following the crisis, credit growth fell for a
while (reflecting a decline in both the supply of and demand for credit). At the same time, the stock
of (broad) money increased noticeably, rising by around $1.1 trillion dollars, from around 80 per cent
of GDP in 2007 to around 115 per cent in 2018. This strong growth reflected a sharp increase in the
share of funding sourced from deposits at the expense of short-term debt securities, consistent with
banks seeking more stable funding. Meanwhile, households and businesses increased the share of
their assets held in the form of deposits.
While loans have grown dramatically in nominal terms, to around $2.6 trillion today, the share of
[10]
loans on banks' balance sheets is the same as it was in 1980 (Graph 6). In contrast, and
notwithstanding the increase in deposits since the global financial crisis, the share of deposits has
declined over the past 40 years from above 80 per cent to around 50 per cent of banks' balance
[11]
sheets. Currently, a sizeable share of banks' liabilities is in the form of bonds on issue - a source
[12]
of funding that was less important in 1980. Banks also have a much larger share of 'other
liabilities' (such as those to non-residents and related parties, which are not included in domestic
monetary aggregates).
Graph 6
Looking back, it is clear that there have been many instances of sustained gaps between the growth
of deposits - and broad money more generally - and the growth of credit (Graph 7). While broad
money growth outpaced credit growth for most of the period since the financial crisis, this was not
the experience of the two decades or more prior to the crisis, when credit typically outpaced broad
money.
This long history suggests that we should not be concerned about a so called deposit 'funding gap'.
Some commentators have suggested that the recent decline in the growth rate of money has left
banks with insufficient deposit funding to support credit growth. According to this hypothesis, banks
have been forced to seek other forms of funding, including from short-term money markets, which,
so the argument goes, can help to explain the notable rise in rates in those markets in recent
[13]
months.
What are we to make of this hypothesis? First, such a gap between the growth of deposits and credit
has been commonplace over recent decades - and conditions in short-term money markets were
benign through much of those earlier episodes. Second, loans are not the only assets on banks'
balance sheets; indeed, in recent quarters, growth in these other assets has been particularly slow -
slower than both credit and deposits (Graph 8). So deposit growth has more than matched the
growth in total assets.
Third, if some banks really did have insufficient deposit funding, we would expect to see them
competing more vigorously for deposits by raising interest rates on those products. But retail deposit
rates have been flat to down over the past year (Graph 9).
In short, there is little evidence that there is any relationship between the slowing of deposit growth
and recent funding pressures in short-term money markets. More generally, given my earlier
discussion about the extension of credit leading to the creation of banking system deposits, worrying
about slower deposit growth impinging on the banking system's ability to generate credit is putting
the cart before the horse.
What Can Money or Credit Tell Us about Broader Economic
Developments?
Given this discussion, it is worth asking whether the behaviour of money can tell us anything useful
about broader economic developments and, if so, is it more or less useful than the behaviour of
credit?
I'm going to address these questions in a very narrow way by examining whether the growth of
broad money or credit provides any useful statistical information about the growth of nominal GDP.
Because data for money and credit are available about five weeks ahead of the quarterly GDP
release, we can examine whether growth in the current quarter of these series provides any
additional information about the likely outcome for nominal GDP this quarter. This exercise is
intended to merely determine whether money or credit are useful indicators of GDP. It is not
intended to demonstrate whether a causal link exists between money or credit and GDP. (Indeed it is
possible that the direction of causation runs in either or both, directions.)
I start with a simple model of quarterly nominal GDP growth as a function of recent lags of nominal
GDP growth (Model 1 in Table 2). The model is estimated over the inflation-targeting period. This
simple model is not particularly useful; lags of nominal GDP growth explain only about 8 per cent of
the variation in the current growth of nominal GDP. But it gives us a useful baseline for comparison.
(a)
Table 2: Simple Models of Nominal GDP Growth
March quarter 1993 - June quarter 2018
Model 1 Model 2 Model 3 Model 4
Constant 1.14** 0.85** 0.88** 0.70**
(b)
GDP growth 0.21 0.04 -0.06 -0.08
(c)
Broad money growth 0.26* 0.16
(c)
Credit growth 0.31** 0.25**
R-squared 0.08 0.15 0.17 0.22
Adjusted R-squared 0.04 0.07 0.09 0.10
(a) Quarterly data; ** indicates statistical significance at the 5 per cent level; * indicates statistical significance at the 10 per cent
level (b) Coefficient presented is the sum of the coefficients on the past four lags of quarterly nominal GDP growth; statistical
significance is based on a joint significance test for these coefficients (c) Coefficients presented are the sum of the coefficients on
the current and past four lags of quarterly broad money or credit growth; statistical significance is based on joint significance tests
for these coefficients Sources: ABS, RBA
Adding current and past lags of money growth to the baseline model doesn't improve its
performance much; the sum of the coefficients on the money terms are statistically significant, but
only at a 10 per cent level (Model 2). Similarly, adding current and past lags of credit growth
improves the model's explanatory power only slightly; however, the sum of coefficients on the credit
terms are statistically significant at the 5 per cent level (Model 3). Interestingly, if both money and
credit terms are included at the same time, only credit growth is statistically significant (Model 4).
This suggests that credit growth is a marginally more useful statistical indicator of the growth of
economic activity than money growth; again, I should stress that the contribution of the credit
[14]
variable to the model in terms of its additional explanatory power is very modest.
Conclusion
Currency in circulation has increased as a share of nominal GDP - indeed it's as high as it's been in
many decades. But the increase in money, which includes bank deposits, has been even greater over
the same period. That increase has been driven by the extension of credit, which depends on the
decisions of borrowers and lenders. Banks have been able to fund that additional credit via growth in
other sources of funding, including debt securities and equity. The recognition that deposits are
created by the banking system via the extension of credit suggests that we should not be concerned
about the banking system facing a deposit funding gap. Moreover, it is consistent with simple
empirical analysis that suggests that credit is a marginally more useful indicator of the near-term
growth in the value of economic activity than money.
References
Battellino R (2007), 'Australia's Experience with Financial Deregulation', Address to China Australia
Governance Program, Melbourne, 16 July.
Battellino R and N McMillan (1989), 'Changes in the Behaviour of Banks and Their Implications
for Financial Aggregates', RBA Research Discussion Paper No 8904.
Black S, J Kirkwood, A Rai and T Williams (2012), 'A History of Australian Corporate Bonds',
RBA Research Discussion Paper No 2012-09.
Bullock M (2018), 'The Evolution of Household Sector Risks', Remarks to Ai Group, Albury, 10
September.
Doherty E, B Jackman and E Perry (forthcoming), 'Money in the Australian Economy', RBA
Bulletin, September.
Flannigan G and A Staib (2017), 'The Growing Demand for Cash', RBA Bulletin, September, pp
63-74.
Flannigan G and S Parsons (2018), 'High-denomination Banknotes in Circulation: A Cross-
country Analysis', RBA Bulletin, March.
Grenville S (1991), 'The Evolution of Financial Deregulation', in I Macfarlane (ed), The
Deregulation of Financial Intermediaries, Proceedings of a Conference, Reserve Bank of Australia,
Sydney, pp 3-35.
Macfarlane I (1998), 'Australian Monetary Policy in the Last Quarter of the Twentieth Century',
Shann Memorial Lecture, University of Western Australia, Perth, 15 September.
Endnotes
[*] I would like to thank Emma Doherty, Ben Jackman and Emily Perry for their excellent assistance in helping to
prepare these remarks. Indeed, I draw heavily on their work: Doherty, Jackman & Perry (forthcoming).
[1]
Holdings of these forms of money by the government, residents of other countries and financial intermediaries that
issue deposits or similar products are generally excluded from broad money. Considerations such as data availability
mean that there are some exceptions to this general rule.
[2] 'Other financial intermediaries' includes registered financial corporations (RFCs) and cash management trusts.
[3] Growth in nominal GDP will reflect growth in real per capita income, population growth and inflation. Other
determinants include interest rates and access to the payment system. See Flannigan and Staib (2017) for more
details.
[4] Survey data indicate that the share of payments made with cash continues to fall. See Flannigan and Staib (2017)
for a discussion of the different types of demand for currency. Also, Flannigan and Parsons (2018) provide a
crosscountry perspective on the increase in the number of high-denomination banknotes in circulation.
[5]
Doherty et al (forthcoming) contains a highly stylised example that demonstrates how liquidity and capital
considerations can affect the decision to extend a loan.
[6] In the same way that extending loans can create deposits, repayment of loans can extinguish deposits. For
example, if the funds credited to the seller's bank account above are used to repay an existing loan, the
(systemwide) deposit base will remain as it was prior to this series of transactions. Other transactions of financial
intermediaries can also create or extinguish deposits and therefore money. For example, when a bank issues a bond
or equity, it receives payment, which is typically from the buyer's deposit account, thereby decreasing the stock of
money. The reverse occurs when the principal of the bond is repaid, or in the case of the bank buying back its
equity.
[7] Macfarlane (1998) provides a summary of the evolution of the RBA's approach to monetary policy in the last quarter
of the twentieth century.
[8]
Banking regulation from this period required banks to maintain sizeable holdings of certain types of assets. For more
information see Battellino and McMillan (1989).
[9] See Grenville (1991), Battellino & McMillan (1989) and Battellino (2007) for further details.
[10] Note that 'loans' on bank balance sheets here is distinct from 'credit' in the financial aggregates, which is a slightly
broader measure.
[11] Graph 3 shows that banks' deposits are around 60 per cent of funding liabilities, which are a subset of total liabilities
on banks' balance sheets - excluding those not used for funding. There are also some conceptual differences in the
definition of deposits used.
[12]
See Black, Kirkwood, Rai and Williams (2012).
[13]
See RBA (2018), 'Domestic Financial Conditions', Statement on Monetary Policy, August, pp 39-50 for a summary of
recent conditions in short-term money markets and a discussion of factors contributing to elevated short-term
money market rates.
[14] Two caveats regarding the interpretation of these simple modelling results are in order. First, it is possible that the
statistical relationship between credit and GDP growth reflects the effect of some omitted factor - perhaps an
indicator of overall financial conditions, such as interest rates for example. Second, this exercise is not intended to
capture a potential role for credit in determining the longer-term economic outlook. For instance, the Council of
Financial Regulators has identified growing economic risks relating to the high level of indebtedness among
Australian households. For a recent discussion of these risks, see Bullock (2018). Taking account of such
relationships is beyond the scope of my simple exercise.