Money Creation
The "creation" of money sounds like a mysterious and magical thing, and a power than many people would covet. In reality, it is quite simple: people are willing to accept in transactions a document to receive money on a future date, even if that money does not presently exist: they have faith that the bank will collect its debts and have that money to pay out on the date that the document specifies. And it is this willingness and faith that "creates" money by providing people the ability to trade on funds that do not yet exist (but which will in future).
The ability of banks to create unlimited money by issuing loans has caused a calamity in the past. When one bank does this, its notes and bills become suspect and worthless in the market; but when many banks engage in rampant lending and money creation, it can damage the entire market, debasing currency by the creation of a large volume of new money as well as the inevitable collapse of credit when borrowers fail to repay. To remedy this, the central bank sets a reserve rate that limits the amount of loans that banks may extend based on the amount of deposits they have.
This is a part of the function of central banks: to ensure that there is sufficient money in circulation to provide funding for business growth, yet not so much money in circulation that there is rapid and uncontrolled inflation. There is mich debate over what is a healthy rate of inflation, and central banks are constantly adjusting the reserve rates required of their participating banks.
The primary cause of the growth of money is the demand for credit at a given rate of interest. No money is created if no-one wants to borrow money, and what discourages borrowing is interest rate: to take a loan at a given rate of interest, an entrepreneur must make at least the interest rate on his borrowings by means of his productive operations. That is, to break even, an entrepreneur must make a 6% profit on capital he has borrowed at 6% - and more, he most prove his creditworthiness to borrow at that rate. Which is to say that the bank must believe that he can make a return on the capital they lend him.
What is Money?
The author dials it back a bit to consider a very basic question: what is money? In ancient times, money was a desirable commodity (usually precious metals, but in primitive economies it could be tobacco leaves, sacks of grain, salt. Etc.) that would be accepted in trade for any other commodity. As commerce evolved, money became metal and paper tokens that could be redeemed for a desirable commodity or even a physical artifact. In the twentieth century, society dispensed for the need for money to be redeemed and arrived at what is the modern incarnation of money: it is a token of exchange that is accepted as payment for goods and services.
Essentially, money represents a denominated value in which things are priced. The value may be indicated in physical artifacts (notes and coins) or simply in an amount that is indicated in the ledgers of a bank as being on deposit. In the present day, very few exchanges are made in currency - most are in the movement of bank deposits through paper checks and electronic transfers of funds. The medium is inconsequential - the "money" is the value that is represented on a coin, note, check, or transfer authorization. Money has become an intangible concept.
There's a brief mention of the different measurements of money, from M0 (notes and coins) to M4 (notes, coins, money in deposit accounts, and other things that can be converted into liquid capital in short order), which has been detailed better in other sources.
Monetary Banking Institutions
There are various institutions that provide some level of retail banking services (private banks, rural banks, mutual banks, and even the post office and various building societies), the core function of which is to maintain deposit accounts for individuals, companies, and other organizations.
Some (but not all) banking institutions engage in lending to the public and private sector, maintaining the surplus balance of government organizations, extending credit to the government, creating credit money, and issuing notes and coins.
The Function of Credit
There has been much tedious and futile debate over the morality of charging interest on borrowed sums, largely based on doctrines that are generally ignored or circumvented in order to obtain access to money on credit. Arguments of religious belief aside, credit performs a valuable function and economic growth would be near zero without it.
Credit enables production to occur: those who have an entrepreneurial vision are unable to pursue it without financing. Not all entrepreneurs wish to give their financiers a share of ownership (and control) of their operations, and not all who have capital wish to participate or undertake the risk of partnership.
On the other side of the coin, interest represents an expense that is ultimately passed along to the consumer and the (rather flawed) argument that having to pay interest discourages production by increasing the margin that the producer must earn in order to recover his expenses and earn a profit.
It is also suggested that there is a causal relationship between interest and consumer price inflation, as interest both adds to the cost of the good and decreases the supply of money in the hands of consumers (presuming that the investor will use his profit for something other than consumption).
Constraints to Money Creation
The author returns to the notion of money creation as a unique function of banks in their role as credit issuers. When a loan is issued, the contract for repayment is worth more than the borrowed sum because it includes the present value of interest payments. (EN: It's been suggested that banks do not create money but merely bring it forward in time from the future, but I believe that may be splitting hairs.)
He reiterates that it is not really the bank that creates money, but those members of the market who are willing to accept a bill or note of credit as if it were money. If the public lost faith in these instruments, banks would be unable to issue them, hence unable to create money (and would have to hold their loans to maturity).
It's also noted that the banks' power to create money is also dependent on the demand for loans, and in this way borrowers can also curtail the bank's ability to create money by simply not borrowing money or negotiating down the rate.
The final constraint to the banks' ability to create money is the authority of the government and the central bank, which set limits on the amount of deposits that must be held in reserve, which may legally restrict the rate of interest that can be charged, or may put in place a framework that makes it easier or more difficult to issue credit to certain borrowers.
The Cash Reserve Requirement
Because banks are required to return deposits on demand, they cannot loan out all their depositors' money but must maintain some cash in reserve. When banks were independent, the amount to keep in reserve was at the sole discretion of a bank's management. There a are few countries in which bankers are permitted to have complete autonomy - in most economies, a government agency or the central bank requires banks to keep a certain amount of funds on reserve.
Because banks must lend money to earn interest, the cash held in reserve is dead money and makes no profit, hence it reduces the amount of funds the bank can lend. Unless the bank is able to lend the remainder at a higher rate (financing riskier loans), the amount of interest it can pay to depositors is also diminished, making bank accounts less attractive to depositors. In this way, a change in the reserve rate ripples through the economy.
Money creation does not start with a bank receiving a deposit
The author pauses to address a misstatement in "many textbooks on money and banking" that lead their readers to believe that money creation begins with the bank receiving a deposit.
All deposits begin as liabilities for the bank, as the bank is committed to pay a certain rate of interest on deposits regardless of whether the funds are employed productively by the bank.
Banks can also create money by borrowing at a low interest rate and lending those funds at a higher interest rate, which commonly occurs when the central bank wishes to increase the money supply. And again, the borrowed funds are a liability for the bank until they can lend them.
While it is true that money creation depends on having money (deposits) to lend out, it is the act of lending that deposit, not simply depositing the funds, that initiates the money creation process. So ultimately, money creation starts with issuing a loan, not receiving a deposit.
Money creation is not dependent on a cash reserve requirement
The author then goes to some length to address another myth: that a cash reserve requirement is necessary for money to be created. By the logic of the last section, this should be obvious: if money is created by lending it, then a policy requiring the bank to maintain a reserve of cash (rather than lend it) decreases its ability to create money.
By decreasing the reserve requirement, governments and central banks seem to make more capital available to lend and increase the creation of money. However, easing a probation is not the same as facilitating an activity. Also, the reserve requirement is a minimum that banks must meet, and not a maximum: a bank can always choose to keep more money in reserve than the minimum required.
Is "money supply" a misnomer?
There is some nitpicking over terminology and whether "money supply" is quite the right term to be used when referring to the amount of money that exists in an economy.
Technically speaking, the amount of money that exists in an economy is the "money stock," as the "supply" is the amount of money made available for borrowing. People, organizations, and even banks may at time have a preference to hold money and not make it available for others to borrow - in the same way that a manufacturer may stockpile finished goods in his warehouse and not make them available for sale to consumers.
To have a money stock that is not inside the money supply, individuals and organizations would need to horde notes and coins, accepting that interest will erode their purchasing power. Bankers would need to keep cash on their books and refuse to lend it out, again accepting that the interest they pay depositors will remain an expense even if the money is not working.
None of these actions are in the interest of those who have money - but people are completely capable of acting in an irrational manner, and some definitely do. However, it is not known to be a common practice, so the difference between the money stock and the money supply is largely a punctilious argument.
The Role of the Central Bank in Money Creation
The role of a central bank is to maintain the stability of a currency by balancing the money supply against the demand for credit. Essentially, the central bank attempts to ensure that there is enough money available to borrowers (so that the interest rate is not "bid up" and the price of goods is not inflated by borrowers' having high interest expense) but not so much money that credit becomes cheap and money becomes debased (so that the interest rate, hence inflation, is kept at a moderate level). To do so, the central bank supplies more or less money to the market.
It should be clear that the central bank is not proactive, but is reacting to the level of demand for money. If the central bank is too aggressive in creating new money, the value of money will diminish; and if it is too conservative, the value of money will increase - but this is merely in failing to act (or acting in a poorly considered degree) in response to the demand for money.
The author then details some of the actions of the central bank can take to manage the money supply, which is a tedious enumeration and is better described in other sources.