Currency Creation Procedure

The creation of new money in a modern economy is a complex, interconnected process that involves both central banks and commercial banks. 

  1. Central Bank Monetary Policy: This is the starting point for money creation. By setting the policy interest rate, the central bank influences the cost of borrowing in the economy. A lower rate encourages more borrowing and thus more money creation, while a higher rate discourages it.
  2. Bank Lending: When a bank approves a loan, it creates a deposit in the borrower's account. This deposit is new money that didn't exist before. The act of lending is therefore the primary way that commercial banks create new money.
  3. Reserve Requirements and Capital Requirements: Banks are required to hold a certain amount of reserves and capital. These requirements act as constraints on how much money banks can create. If a bank doesn't have enough reserves or capital, it can't make new loans and thus can't create new money.
  4. Central Bank as Lender of Last Resort: If a bank is short of reserves, it can borrow from the central bank. This allows the bank to meet its obligations and continue making loans, supporting the creation of new money.
  5. Open Market Operations: When the central bank buys securities from banks, it pays by creating new reserves. This increases the amount of reserves in the banking system, allowing banks to make more loans and create more money.
  6. Quantitative Easing: This is another way the central bank can inject money into the economy. By buying large amounts of securities, the central bank increases the amount of reserves in the banking system, enabling more money creation.
  7. Repurchase Agreements: Repurchase agreements, or repos, are another tool the central bank uses to manage the amount of money in the economy. When the central bank buys securities through a repo, it creates money. When the repo is reversed and the securities are sold back to the banks, the money is destroyed.

In all these ways, the central bank and commercial banks interact to create new money. The central bank sets the conditions for money creation through its monetary policy and provides the necessary reserves through its lending and open market operations. The commercial banks create new money through their lending activities, within the constraints set by the central bank's reserve and capital requirements. This interconnected process ensures that the amount of money in the economy is responsive to the demand for loans and is consistent with the central bank's objectives for inflation and financial stability.

Sovereign Financing through Currency Creation

Currency creation occurs when a central bank, such as the Federal Reserve in the United States or the European Central Bank (ECB), creates new money and adds it to the economy. This process is also known as monetary expansion. There are a few different ways in which money can be created, but one standard method is through off-balance sheet to on-balance sheet conversion.

Off-balance sheet refers to assets or liabilities that are not included on a balance sheet. These assets and liabilities may still impact the financial position, but they are not included in the traditional balance sheet presentation. On the other hand, on-balance sheet items are included in the balance sheet and represent the financial position.

In the context of currency creation, off-balance sheet to on-balance sheet conversion refers to converting an off-balance sheet asset or liability into an on-balance sheet asset or liability. This can occur when a central bank purchases an asset, such as a government bond, from a bank and adds it to its balance sheet. By doing so, the central bank is effectively creating new money and adding it to the economy.

There are a few different ways in which a central bank can conduct off-balance sheet to on-balance sheet conversion. One common method is through open market operations, in which the central bank buys or sells securities in the open market in order to affect the supply of money in the economy. Another method is through the use of lending facilities, in which the central bank provides loans to banks to increase the supply of money.

Central banks in countries outside of the United States, such as the European Central Bank (ECB) and the Bank of Japan, also use off-ledger to on-ledger conversion as a tool for monetary policy. Like the Federal Reserve in the United States, these central banks can create new money and add it to the economy by purchasing assets, such as government bonds. By conducting off-ledger to on-ledger conversion, these central banks can move the assets onto their balance sheets and effectively create new money.

Overall, off-balance sheet to on-balance sheet conversion is an integral part of the currency creation process. By converting off-balance sheet assets and liabilities into on-balance sheet assets and liabilities, central banks are able to create new money and add it to the economy. This process helps to regulate the supply of money and maintain a stable financial system. To understand as well the role of Shadow Money, please click here.

Converting Off- to On-Balance Funds

Already existing off-balance Funds

Off-balance funds from the Central Bank refer to funds that are not included on a bank's balance sheet. These funds may be held in accounts outside of the bank's normal operating accounts, such as in a special purpose vehicle (SPV), or may be invested in certain financial instruments that do not qualify as on-balance sheet assets.

Converting off-balance funds from the CB into on-balance funds can be done in several ways, depending on the specific circumstances of the funds and the bank involved. Here are some possible approaches:

  • Securitization: If the off-balance funds consist of loans or other assets that can be securitized, the bank can create a securitization vehicle to issue bonds or other securities backed by those assets. These securities can then be sold to investors, bringing the off-balance funds onto the bank's balance sheet as on-balance assets.
  • Repurchase agreements: The bank can enter into repurchase agreements, or repos, with other financial institutions or investors. In a repo, the bank sells the off-balance funds to the counterparty with an agreement to buy them back at a later date. The funds are treated as collateral for the repo transaction and are therefore included on the bank's balance sheet.
  • Structured notes: The bank can issue structured notes that are linked to the performance of the off-balance funds. These notes are similar to bonds, but their value depends on the underlying assets rather than a fixed interest rate. The notes can be sold to investors, and the bank can use the proceeds to bring the off-balance funds onto its balance sheet.


Newly issued off-balance Funds

If the Central Bank creates new off-balance funds with the intention of eventually converting them into on-balance funds, the process for doing so would likely involve a combination of regulatory and accounting measures.

If the funds have been newly created by the central bank as off-balance funds, it may not be possible to convert them into on-balance funds in the same way as existing off-balance funds. This is because the newly created funds may not yet have any underlying assets that can be securitised, used as collateral in a repo, or linked to structured notes.

In this case, the bank may need to wait until the newly created funds have been invested in qualifying assets before they can be brought onto the bank's balance sheet. Alternatively, the bank may need to find a solution that allows the funds to be treated as on-balance-sheet assets

  • One possibility is that the CB could issue new bonds or other debt securities, which would be classified as off-balance funds. The CB could then use the proceeds from these securities to purchase eligible assets, such as government bonds or other securities that qualify as on-balance sheet assets. Once these assets have been acquired, the CB could then transfer them onto its balance sheet, effectively converting the off-balance funds into on-balance funds.
  • Another option is that the CB could use its off-balance funds to create special purpose vehicles (SPVs) or other similar entities, which could be used to hold eligible assets. 




It's important to note that converting off-balance funds into on-balance funds can have implications for a bank's capital and liquidity requirements, as well as its overall risk profile. Therefore, banks should carefully consider the potential benefits and risks of each approach before deciding which one to use. Additionally, banks should ensure that they comply with regulatory requirements for on-balance sheet assets.

Converting Off-Balance to On-Balance Sheet Funds within Central Banks

Off-Balance Sheet Funds

Off-balance sheet funds in the context of central banks typically refer to transactions and commitments that do not immediately impact the central bank's balance sheet. These may include:

  1. Repurchase Agreements (Repos): Central banks engage in repo transactions to provide temporary liquidity. These are usually short-term and are off-balance because they are contractual agreements to buy back the securities.
  2. Currency Swaps: These involve exchanging currencies with other central banks but often do not appear directly on the balance sheet.
  3. Derivative Contracts: Includes forward contracts, options, and swaps that have not yet been settled.
  4. On-Balance Sheet Funds: On-balance sheet funds are straightforward accounting entries that reflect assets and liabilities. For central banks, these include:
  • Foreign Reserves: Currency and gold reserves.
  • Securities Holdings: Government and corporate bonds.
  • Loans to Commercial Banks: Represented as assets on the balance sheet.

Methods of Conversion

  1. Direct Accounting Entry: The central bank may simply pass a journal entry to move an item from off-balance to on-balance. For example, when a repurchase agreement matures, the security is returned to the central bank and cash to the other party, resulting in an accounting change.
  2. Collateral Substitution: In the case of repos, the central bank may substitute the original collateral with another on-balance sheet asset, thus effectively converting the off-balance repo agreement to an on-balance sheet item.
  3. Swap Expiry: A currency swap agreement between central banks could expire, causing the originally swapped currency to return, transforming the off-balance sheet item into an on-balance sheet item.
  4. Derivative Exercise: If a central bank exercises a derivative option it holds, the resulting financial transaction will become an on-balance sheet item.
  5. Securitization and Sale: Off-balance sheet items can be bundled and sold as financial instruments, like Mortgage-Backed Securities (MBS). The proceeds become cash, an on-balance sheet item.

Probabilities for Conversion Method

  1. Direct Accounting Entry: Very High (~95%) because this is an internal decision.
  2. Collateral Substitution: Moderate (~50%) as it depends on the terms of the repo agreement.
  3. Swap Expiry: High (~80%) since this is dictated by the swap contract terms.
  4. Derivative Exercise: Low to Moderate (~20-40%) depending on market conditions and contract terms.
  5. Securitization and Sale: Low (~15%) given the complexities and market conditions.

By converting off-balance sheet items to on-balance sheet, central banks make these items part of their official accounting, thereby affecting key monetary variables like the money supply and reserve ratios. However, such conversions may also expose the central bank to additional risks or requirements such as capital adequacy ratios.

The selection of a method for conversion depends on strategic objectives, market conditions, and regulatory landscape. Each method comes with its pros and cons that the central bank must carefully evaluate.

Reverse Repo as critical part of the financial System

The reverse repo market is a crucial component of the financial system, playing a significant role in money market operations and liquidity management. To understand the reverse repo market, it's essential to first grasp the concepts of repurchase agreements (repos) and reverse repurchase agreements (reverse repos).

Repos and Reverse Repos:

  • A repurchase agreement, or repo, is a short-term financial transaction in which one party (the seller) agrees to sell a security (typically government bonds, corporate bonds, or other marketable securities) to another party (the buyer) with a commitment to repurchase the security at a predetermined date and price. Essentially, it's a collateralized loan where the security serves as collateral
  • A reverse repurchase agreement, or reverse repo, is the opposite side of this transaction. In this case, the buyer agrees to purchase a security from the seller and to sell it back at a later date for a higher price. In other words, the buyer is effectively lending money to the seller, and the security serves as collateral for the loan.

The Reverse Repo Market:
The reverse repo market is an essential component of the money market, where participants (such as banks, financial institutions, and central banks) engage in reverse repo transactions for various purposes. These purposes include:

  • Managing liquidity: Financial institutions use reverse repos to invest their excess cash temporarily. Reverse repos provide a secure, short-term investment vehicle with a known return, allowing them to earn a return on their idle cash while maintaining liquidity.
  • Central bank operations: Central banks, such as the Federal Reserve in the United States, use reverse repo operations as a monetary policy tool to control short-term interest rates and manage the money supply. By engaging in reverse repo transactions, central banks can absorb excess liquidity from the financial system, which helps maintain the target interest rate.
  • Collateral transformation: Reverse repos can also be used by financial institutions to obtain high-quality collateral, which they can use to meet regulatory requirements or for other purposes, such as securing other loans or entering into derivatives transactions.

Mechanics of the Reverse Repo Market:

In a reverse repo transaction, the buyer (lender) and the seller (borrower) agree on the terms, such as the amount, interest rate (also called the repo rate), and maturity date. The buyer provides cash to the seller in exchange for the security, which serves as collateral. The agreement states that the seller will repurchase the security at a specified future date and a predetermined higher price, which includes the principal amount plus interest. When the transaction matures, the seller repurchases the security and returns the cash plus interest to the buyer.

Risks and Benefits:

The reverse repo market offers benefits such as providing a secure, short-term investment option for cash-rich institutions, enabling central banks to manage liquidity and implement monetary policy, and facilitating collateral transformation for financial institutions.

However, there are risks associated with the reverse repo market, including counterparty risk (the risk that the other party will not fulfill its obligations), collateral risk (the risk that the value of the collateral declines), and operational risk (the risk of errors or failures in the transaction process).

Overall, the reverse repo market plays a vital role in the financial system, helping institutions manage liquidity and supporting the implementation of monetary policy by central banks.


Currency, as a medium of exchange, serves as a vital instrument for facilitating the transaction of goods and services within an economy. Essentially, it represents money in the form of physical notes or coins, which are typically issued and regulated by a sovereign government, and are widely accepted at their face value for making payments.

To maintain a stable and less volatile currency relative to other global currencies, central banks and monetary authorities may employ a strategy known as pegging. Pegging involves linking the value of a local currency to another, more stable asset, such as another currency, a basket of currencies, or even a commodity like gold. This connection ensures that the value of the local currency remains relatively constant, thereby reducing fluctuations and providing increased stability to the economy.

The practice of pegging a currency to an external asset has various benefits, including the promotion of confidence in the local economy, attracting foreign investments, and facilitating international trade by reducing exchange rate risks. Moreover, it can help mitigate the impact of external economic shocks and provide a buffer against inflationary pressures.

However, it is essential for central banks and monetary authorities to manage and monitor the pegging process vigilantly, as it may require intervention in the form of adjusting interest rates or conducting foreign exchange operations to maintain the desired exchange rate. Failure to effectively manage the peg can result in significant economic consequences, such as depletion of foreign exchange reserves, loss of monetary policy autonomy, and potential financial crises.

In conclusion, when executed effectively, pegging a currency to other assets can play a pivotal role in stabilizing the local currency, thus making it less volatile in comparison to other currencies. This, in turn, can contribute to fostering economic growth and stability in the long term.

The terms M0, MB, M1, M2, and M3 refer to different measures of the currency supply in an economy. These measures provide a way to quantify the amount of currency available in an economy at a given point in time and are typically used by economists and policymakers to understand economic conditions and guide monetary policy.

Here's a brief explanation of what each of these measures includes:

  1. M0: Also known as the monetary base or narrow currency, M0 includes liquid currency in circulation. It includes coins, paper money, and other forms of currency that are in circulation but not held by the government or financial institutions. M0 also includes central bank reserves, which are the deposits that commercial banks hold with the central bank.
  2. MB (Monetary Base): The Monetary Base, includes currency in circulation (coins and banknotes) and reserves held by commercial banks at the central bank. In some definitions, it might also include vault cash — money kept in the vault of commercial banks.
  3. M1: M1 includes all of M0, plus other assets that are nearly as liquid as cash. Specifically, M1 includes checking accounts (funds in current accounts that can be withdrawn at any time without any notice) and other demand deposits. In essence, it includes all funds that are readily accessible for spending.
  4. M2: M2 includes everything in M1, plus other types of deposits that are less immediately accessible. Specifically, M2 includes savings accounts, money market accounts, and small-denomination time deposits (certificates of deposit that are below a certain size, often $100,000). These are forms of money that can be converted into cash relatively easily, but not as quickly or conveniently as the components of M1.
  5. M3: M3 includes everything in M2, plus large time deposits, institutional money market funds, short-term repurchase agreements, along with other larger liquid assets. These are types of money that are less liquid than those included in M2, but still contribute to the total amount of money available in the economy.

Each of these measures provides a different perspective on the money supply, and each can be useful for understanding different aspects of the economy. M0 and M1, for example, are often used to analyze the most immediate forms of liquidity in the economy, while M2 and M3 are used to understand broader trends in the money supply.
It's important to note that the exact definitions of these measures can vary between different countries. 

Approximate figures for major economies as of February 2023 for M0, M1, M2, and M3 for some major economies (in Billions of US Dollars)

Please note that the figures are approximate and should be used for illustrative purposes only. For the most accurate and up-to-date information, refer to the official sources, such as the respective central banks or statistical agencies.

National Currencies: An Overview

As stated by, there are presently 180 national currencies recognized by the United Nations in circulation worldwide. Additionally, 66 countries either utilize the U.S. dollar or peg their currencies directly to the dollar, showcasing the influence of the U.S. dollar on the global economy.

The majority of countries issue their distinct currencies, such as the Swiss franc in Switzerland or the yen in Japan. However, the euro serves as a notable exception, having been adopted by a significant portion of European Union member states as their official currency.

Certain countries accept the U.S. dollar as legal tender alongside their domestic currencies. For instance, Costa Rica, El Salvador, and Ecuador all recognize U.S. dollars for transactions. Interestingly, Americans continued to use Spanish coins for some time after the establishment of the U.S. Mint in 1792, primarily because these coins were heavier and perceived as more valuable.

Moreover, there are branded currencies, such as airline miles, credit card points, and Disney Dollars. These currencies are issued by corporations and can only be used to purchase the specific products and services associated with the issuing entity.

Currency Trading and Exchange Rates

The exchange rate signifies the current value of a given currency when converted into another currency. This rate is subject to constant fluctuations due to various economic and political factors.

These fluctuations give rise to the currency trading market. The foreign exchange market, where such transactions take place, ranks among the largest global markets in terms of trading volume. Trades typically occur in substantial quantities, with a standard minimum lot size of $100,000. The majority of currency traders are professionals investing on their own behalf or for institutional clients, such as banks and large corporations. The enormous scale and complexity of the currency trading market render it a critical component of the global financial system.

Currency in some form has been in use for at least 3,000 years. 

In the picture you see Shells that had been utilised as currency. Cowrie shells started being used as early as 1200 B.C. in China and were the most widely and longest used currency in history.

The Lydian Stater was the official (gold) coin of the Lydian Empire, introduced before the kingdom fell to the Persian Empire. The earliest staters are believed to date to around the second half of the 7th century BCE, during the reign of King Alyattes (r. 619-560 BCE). According to a consensus of numismatic historians, the Lydian stater was the first coin officially issued by a government in world history and was the model for virtually all subsequent coinage.

Paper currency first developed in Tang Dynasty China during the 7th century, although true paper money did not appear until the 11th century, during the Song Dynasty. The usage of paper currency later spread throughout the Mongol Empire or Yuan Dynasty China to Europe.

European explorers like Marco Polo introduced the concept in Europe during the 13th century.

King Henry VIII, King of England, in 1100 A.D. produced sticks of polished wood, with notches cut along one edge to signify the denominations. The stick was then split full length so each piece still had a record of the notches.The King kept one half for proof against counterfeiting, and then spent the other half into the market place where it would continue to circulate as money.

Because only Tally Sticks were
accepted by Henry for payment of taxes, there was a built in demand for them, which gave people confidence to accept these as money. So good was the system he created, it lasted until 1854! 


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