There are two interesting things that we will learn in this chapter. FIRST, banks create money when doing their normal business of accepting deposits and making loans. When banks make loans they create money. When I got a loan for my boat the bank called me up and said that they deposited the loan in my checking account.
They created money. The Federal Reserve has tool that it can use to control how much money banks create. To understand the money creation process we first need to learn about the balance sheet of a bank. They are also called "owner's equity". It's what the owners of the bank have in the bank, i. Nonmember banks keep deposits at a member bank. These deposits are used by the Fed to help banks "clear" checks.
The Fed's Reserve Requirements for Banks:. Banks create money during their normal operations of accepting deposits and making loans. In this example we'll use M1 as our definition of money. When a bank makes a loan it creates money. For example when I got a loan to buy my boat, my credit union called an told me that the loan was approved and that I should come in and get the check. I told them to just deposit it in my checking account.
So they did. They turned on their computers, typed in my account number, and added the loan to my checking account balance. I now had more money M1. The bank created this money when they gave me the loan. We then multiply the money multiplier by the change in excess reserves to determine the total amount of M1 money supply created in the banking system. See the Work it Out feature to walk through the multiplier calculation. Step 1. Step 2. We have identified that the excess reserves are?
Step 3. Thus, we can say that, in this example, the total quantity of money generated in this economy after all rounds of lending are completed will be? The money multiplier will depend on the proportion of reserves that the Federal Reserve Band requires banks to hold. Additionally, a bank can also choose to hold extra reserves. Banks may decide to vary how much they hold in reserves for two reasons: macroeconomic conditions and government rules.
When an economy is in recession, banks are likely to hold a higher proportion of reserves because they fear that customers are less likely to repay loans when the economy is slow. The Federal Reserve may also raise or lower the required reserves held by banks as a policy move to affect the quantity of money in an economy, as Monetary Policy and Bank Regulation will discuss. The process of how banks create money shows how the quantity of money in an economy is closely linked to the quantity of lending or credit in the economy.
All the money in the economy, except for the original reserves, is a result of bank loans that institutions repeatedly re-deposit and loan. Finally, the money multiplier depends on people re-depositing the money that they receive in the banking system. If people instead store their cash in safe-deposit boxes or in shoeboxes hidden in their closets, then banks cannot recirculate the money in the form of loans.
Central banks have an incentive to assure that bank deposits are safe because if people worry that they may lose their bank deposits, they may start holding more money in cash, instead of depositing it in banks, and the quantity of loans in an economy will decline. When mattress savings in an economy are substantial, banks cannot lend out those funds and the money multiplier cannot operate as effectively. The overall quantity of money and loans in such an economy will decline.
Money and banks are marvelous social inventions that help a modern economy to function. Compared with the alternative of barter, money makes market exchanges vastly easier in goods, labor, and financial markets. Banking makes money still more effective in facilitating exchanges in goods and labor markets. Moreover, the process of banks making loans in financial capital markets is intimately tied to the creation of money.
However, the extraordinary economic gains that are possible through money and banking also suggest some possible corresponding dangers. If banks are not working well, it sets off a decline in convenience and safety of transactions throughout the economy.
If the banks are under financial stress, because of a widespread decline in the value of their assets, loans may become far less available, which can deal a crushing blow to sectors of the economy that depend on borrowed money like business investment, home construction, and car manufacturing.
The — Great Recession illustrated this pattern. The global economy has come a long way since it started using cowrie shells as currency. We have moved away from commodity and commodity-backed paper money to fiat currency. As technology and global integration increases, the need for paper currency is diminishing, too. Every day, we witness the increased use of debit and credit cards.
The latest creation and perhaps one of the purest forms of fiat money is the Bitcoin. Bitcoins are a digital currency that allows users to buy goods and services online. Products and services such as videos and books may be purchased using Bitcoins. It is not backed by any commodity nor has it been decreed by any government as legal tender, yet it used as a medium of exchange and its value online at least can be stored. It is also unregulated by any central bank, but is created online through people solving very complicated mathematics problems and getting paid afterward.
Bitcoins are a relatively new type of money. At present, because it is not sanctioned as a legal currency by any country nor regulated by any central bank, it lends itself for use in illegal trading activities as well as legal ones. As technology increases and the need to reduce transactions costs associated with using traditional forms of money increases, Bitcoins or some sort of digital currency may replace our dollar bill, just as the cowrie shell was replaced. The quantity of money in an economy and the quantity of credit for loans are inextricably intertwined.
Much of the money in an economy is created by the network of banks making loans, people making deposits, and banks making more loans. Given the macroeconomic dangers of a malfunctioning banking system, Monetary Policy and Bank Regulation will discuss government policies for controlling the money supply and for keeping the banking system safe. Imagine that you are in the position of buying loans in the secondary market that is, buying the right to collect the payments on loans made by banks for a bank or other financial services company.
Explain why you would be willing to pay more or less for a given loan if:. Humongous Bank is the only bank in the economy. National Public Radio. November 19, Skip to content Chapter This video explains how money is created and reviews the concepts you just learned about the money multiplier.
This does not happen in practice, and the multiplier remains closer to 3. Practice until you feel comfortable doing the questions. Improve this page Learn More. Skip to main content. Module Money and Banking. Search for:. How Banks Create Money Learning Objectives Explain and show how banks create money Use the money multiplier formula to calculate how banks create money.
Figure 4. First National Balance Sheet. Figure 5. Try It. Watch It This video explains how banks use deposits and loans to create money. Watch it This video explains how money is created and reviews the concepts you just learned about the money multiplier. Did you have an idea for improving this content?
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