While most of us use New Zealand dollars every day to buy goods and services, few probably stop to think about where that money actually comes from in the first place. Let’s take a deep dive into the mechanics of how money enters circulation in the New Zealand economy.
The creation of money in New Zealand is a fascinating process that involves the Reserve Bank of New Zealand (RBNZ), the government, and the commercial banking sector.
Bonds and the RBNZ’s role
One key way that new money is created is through the issuance of government bonds by the Reserve Bank of New Zealand. Bonds are debt securities that the government sells to investors, essentially issuing an IOU in exchange for cash up front.
When an investor purchases a government bond from the RBNZ, they are handing over their existing cash deposits. The RBNZ then credits those cash amounts into the government’s accounts, simultaneously recording the bond as a liability on the government’s books.
This bond issuance process has the effect of swapping one type of money (cash deposits) for another (bond securities). While the total amount of money hasn’;t changed, it has been transformed from depositors’ accounts into the government’;s accounts at the RBNZ.
Crown Accounts and Government Spending
The New Zealand government keeps a set of accounts at the RBNZ called the Crown accounts. These function essentially as the government’s bank accounts, allowing it to receive funds like tax payments and make outgoing payments like public servant salaries or welfare benefits.
When the government spends money from these Crown accounts, it is effectively creating new money by crediting private bank accounts with funds. For example, if it pays a teacher’s salary, those funds enter circulation and the teacher can then spend that money in the economy.
Conversely, when people and businesses pay taxes to the government, this has the opposite effect of removing money from circulation as those tax payments flow out of private bank accounts and into the Crown’s RBNZ accounts.
While the RBNZ’s activities like issuing bonds increase the overall money base, the government’s own spending and taxing activities also expand or contract that money supply over time.
The Settlement Account System
At the heart of the money creation process is the RBNZ’s settlement account system that facilitates transactions between banks and the central bank itself. Each registered bank in New Zealand maintains settlement accounts at the RBNZ to settle interbank obligations and clear payments.
Here’s a simplified example of how it works:
1. Customer A writes a $500 Cheque to Customer B who banks at a different institution.
2. B’s bank sends that Cheque through the clearance system to A’s bank.
3. A’s bank debits A’s account by $500 and transfers that amount to its settlement account at the RBNZ.
4. The RBNZ then transfers that $500 from A’s bank’s settlement account to B’s bank’s settlement account.
5. Finally, B’s bank credits B’s personal account by $500.
This interbank settlement system run by the RBNZ allows money to be shifted between institutions while keeping the overall level of money supply unchanged. It’s essentially just a shuffling of existing money from one bank’s books to another’s.
However, the really fascinating part is what happens when banks make new loans to customers. This
is where brand new money is created out of thin air.
The Money Multiplier Effect
When a bank loans money to a customer, it doesn’t actually transfer funds from an existing deposit. Instead, it simply credits the borrower’s account with new money, backed by the fractional reserve lending model.
In New Zealand, banks are only required by regulation to hold a fraction of their deposits in cash reserves at the RBNZ, usually around 10%. So if a bank receives a new $10,000 deposit, it might only need to keep $1,000 as reserves, allowing it to lend out the other $9,000 as new money.
When that borrower spends the loaned $9,000, it will eventually end up being deposited into other banks. Those other banks can then lend out a portion of that deposit (keeping a fraction in reserve), creating even more new money.
This cycle continues indefinitely with loan money perpetually being “multiplied” through the banking system. So while an initial $10,000 deposit created $9,000 in new loanable funds, that $9,000 can then lead to $8,100 in new money, which becomes $7,290, and so on.
Economists call this the “money multiplier” effect. The size of this multiplier depends on the reserve ratio set by regulators - the lower the required reserve ratio, the higher the multiplier effect from a given cash injection into the banking system.
The key point is that while the RBNZ’s activities like setting interest rates influence the conditions for money creation, it is actually the commercial banks who create the vast majority of new money through their lending activities.
Bringing it all together
The creation of money in the New Zealand economy is a fascinating, interdependent process involving multiple players and mechanisms:
The RBNZ issues bonds to investors, swapping cash deposits for bond securities held on its balance sheet. It also implements monetary policy and oversees the overall banking system.
The government’s spending from its Crown accounts at the RBNZ injects new money, while tax payments remove existing money.
The interbank settlement system allows money to be shifted between institutions while maintaining total levels.
But most importantly, it is the commercial banks, through their lending activities, that create new money in an almost unlimited fashion by leveraging fractional reserve requirements into the money multiplier effect.
Of course, in the real world money creation is balanced by money destruction - such as when loan principals are repaid or government bonds mature. But the core mechanics highlight that money itself is essentially just an IOU and an accounting entry facilitated by trust and confidence in the banking system.
As long as banks remain willing to lend, businesses and consumers remain willing to borrow, and people retain faith that money will continue being accepted, the perpetual cycle of money creation continues to drive economic activity. It’s a complex yet elegant system built on collective belief.
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