Annex 2C


Annex 2c: The Process of Money Creation and Credit Expansion

1. Introduction

There exist close linkages between monetary and fiscal policy. Budget deficits are financed
by credits, either by credits from abroad or from internal sources, such as individuals,
companies, commercial banks, or the central bank. The latter source of financing budget
deficits has been widely used by many governments. In this case, the money spent by the
government is not withdrawn from other uses (via taxes or credits from private sources) but
leads to an overall expansion of money supply. In essence, this means nothing else than
priningof money and bringing it into circulation. The money supply is further increased by
credit expansion within the banking system. Government borrowings from the domestic
banking sector (central bank and commercial banks) increase the assets of the banks (e.g. in
the form of treasury bonds) and provide the basis to expand their lending to others,
contributing to an increase of overall money supply. If the increase of money supply exceeds
real GNP growth, i.e. the growth in production of goods and services, this leads to what has
been called "excess demand" or "excess absorption" which, in turn, is a major cause of
inflation.

2. The Quantity Theory of Money

A simple formula known as "quantity equation" shows the relation between money supply
and prices:
 MxV=PxQ
where
M = stock of money (currency outside banks plus demand deposits),
V = velocity of money circulation (number of times per period that an average unit of
 money changes hands/accounts),
P = the general price level or a price index,
Q = the number of transactions made in an economy during a year, or the real GNP.

If (as the economists who formulated the quantity theory of money originally assumed) the
velocity of circulation and the real GNP are given and constant, then prices are a direct
function of the volume of money supply. The above formula can be re-arranged as follows:

 P=kM
or, to express the impact of increased money supply on inflation:
 dP dM
 P M
where k is a constant defined by V/Q, i the rate of inflation, dP the changes in prices and dM
the change in money supply.

In reality, various factors disturb the direct mechanistic link between money supply and
prices as assumed in the original quantity theory of money (the theory has been


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