Why does the central bank have to keep printing money? It is not a simple choice, but rather a result of the inevitable structure and role of the economic system. In this article, we will explain in simple and clear terms why the central bank cannot stop printing money and the economic background behind it.
The Role of the Central Bank
The lower the reserve requirement ratio, the less money banks have to keep on hand. This means that the lower the reserve requirement ratio, the more money banks can create. In South Korea, the central bank, the Bank of Korea, sets the reserve requirement ratio, which currently averages around 3.5%.
Let’s assume the reserve requirement ratio is 3.5% and imagine how much money can be created. Suppose the Bank of Korea lends $500 million to Apple Bank. Apple Bank lends this $500 million to Man 1, the CEO of a large corporation. Man 1 gives that money to A to pay for materials. Let’s assume that A decides to keep about 5% of it—$25 million—in the company’s safe as cash, and deposits the remaining $475 million into Orange Bank. Orange Bank sets aside 3.5% of the money deposited into A’s account—$16,625,000—as reserve requirements, and lends the remaining $458,375,000 to Man 2. Man 2 also pays B, and B keeps about 5%—$22.92 million—in his safe and deposits the remaining $435.455 million into Banana Bank. If we continue lending in this manner until no further loans are possible, the $500 million will grow to $6.006 billion.
When commercial banks make loans like this to increase the money supply, the principal comes from the central bank. But the central bank also increases the money supply. Why is that? Let’s hear from Professor Richard Shiller of the Department of Financial History at New York University.
“The central bank is a financial institution designed to stabilize the economy financially and mitigate recessions. In modern economies, the central bank manages the money supply. If the economy needs more money, the central bank can supply it. If it wants to reduce the money supply due to inflation, the central bank withdraws money. This is how it stabilizes the economy. The way it works is very simple.”
In short, the role of the central bank is to regulate the money supply in the market—that is, the amount of money. If money becomes excessively scarce or too abundant, it intervenes to correct the situation. In this process, the central bank can utilize two important tools. The first is controlling interest rates (the benchmark rate).
The Bank of Korea, our country’s central bank, has been regulating the amount of money in circulation since 1999 by raising or lowering interest rates. Lowering interest rates increases the money supply, while raising them decreases it.
Reasons for Increasing the Money Supply
However, in addition to this indirect method, the central bank has another way to regulate the money supply. That is simply printing new money directly. Since the U.S. financial crisis, the term we’ve heard most frequently in the news is likely “quantitative easing.” News headlines such as “U.S. Federal Reserve Implements Quantitative Easing” and “Quantitative Easing to Be Scaled Back in the Second Half of This Year” come to mind. When the Fed implements quantitative easing, it means that, in a severe crisis, the U.S. central bank has printed more dollars to increase the money supply. When the method of stimulating the economy by lowering interest rates—as mentioned earlier—reaches its limits, the central bank increases the money supply by directly printing money to purchase government bonds.
Why does this situation occur? Let me give an example to make it easier to understand.
A mother gives her child $30 in allowance each month. This means the child has $1 to spend per day. However, the child sometimes spent $1.20 one day and $1.50 on another. If this continued, the $30 monthly allowance would run out in no time. So the mother told her child: “From now on, you must spend exactly $1 a day. You can’t spend any more than that.” In essence, the mother—acting as the “central bank”—imposed a “$1 per day” interest rate limit to curb the money supply.
However, the child either didn’t listen to her or found themselves in a situation where they couldn’t follow her instructions due to unavoidable circumstances, and ended up buying items on credit at the neighborhood supermarket. When the costs were tallied, the total spent in a month came to $35. Ultimately, the mother had no choice but to take an additional $5 from her own wallet to give to the child. Thus, after failing to control the money supply through the “$1 per day” interest rate, the mother—acting as the central bank—was forced to resort to a “quantitative easing” policy, bringing in an extra $5 on top of the original $30.
Although we’ve described the central bank as printing money to control the money supply, there is actually a separate reason why the central bank has no choice but to keep printing money. That reason is “interest.”
Interest does not exist in the banking system
This issue is explained simply in Roger Langrick’s paper titled “A Monetary System for the New Millennium.”
Let’s imagine an island with a single currency system that has no communication with the outside world. Suppose Central Bank A issues exactly $10, and Citizen B borrows that money and must repay $10.50—including interest—one year later. Let’s also suppose that Citizen B buys a boat from another citizen, Citizen C, and earns money by fishing hard with that boat. In that case, can Citizen B really repay $10.50 to the central bank one year later? The answer is “absolutely not.” This is because there is only $10 on the island, and the $0.50 in interest simply does not exist anywhere. This means that interest does not exist in the financial system of a capitalist economy to begin with. So, what should be done? There is only one way to pay the interest: the central bank must print another $0.50 and lend that money to Citizen D.
This brings the total money on the island to $10.50. Only then, if Citizen B works very hard and earns all the money on the island, will he be able to repay the $10.50 to the central bank. But the problem doesn’t end there. Citizen D must once again pay interest on that $0.50 to the central bank. But, as before, there is no more than $10.50 on the island. Again, there is only one solution: the central bank must print more money, and someone must borrow it. In conclusion, since the banking system does not inherently include “interest,” the central bank has no choice but to continuously print money to generate this interest.
Ellen Brown, director of the U.S. Public Banking Institute, summarizes it this way.
“The only way to pay interest and repay past loans is to issue more loans. This expands the money supply and devalues the currency.”
Ultimately, while the central bank is tasked with “regulating the money supply,” the reality is that—despite the capitalist system—it has no choice but to keep printing money and increasing the money supply, even if it can only slow down the rate at which it grows. In this way, both commercial banks and the central bank are continuously increasing the money supply within the capitalist system, thereby contributing to inflation.
