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By delegating the creation of money to private commercial banks, the Central Bank of Iceland, and thereby the state, foregoes considerable income that it would otherwise earn from creating new money to accommodate economic growth.
Commercial banks in Iceland reap a benefit from the ability to create money in the form of demand deposits. Banks can pay lower interest on demand deposits than they would by borrowing in the market.
Owners of demand deposits are content with low interest rates because the deposits are a convenient form of money and for banks that are ‘too big to fail’, there is an inevitable state guarantee on deposits.
Unless banks are engaged in ‘perfect competition’ (a situation that almost never arises outside of economic textbooks), much of this cost-advantage ends up as extra profit for the banks. It can be estimated that by delegating the bulk of money creation in the economy to private banks, the Central Bank of Iceland foregoes estimated annual revenue of close to ISK 20 bn.
Although demand deposits are a convenient form of money from the perspective of businesses and members of the public, fundamentally they are simply a liability (or IOU) of the issuing bank.
A demand deposit represents a bank’s commitment to pay the deposit amount in cash, or to electronically transfer it to another beneficiary, when the owner so demands.
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