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Money Created from Nothing

How banks make money from nothing

Money is a fascinating subject.  Since the dawn of man, people have used money in one form or another, often using a barter system as a means of trade.  Seashells, beads, livestock, and produce have all been used as money at one time or another.  Money has been called the root of all evil, and it is said to make the world-go-round. So, what is money, what does it do, and where does it come from?  Who controls the money supply, and how do they do it?  Read on for the answers to these pressing questions and be prepared to learn more about money than you ever thought you wanted to know.

These days, money consists of only a few items.  Coins and paper money; also called currency, demand deposits; also known as checking accounts, and other checkable deposits such as NOW (negotiable orders of withdrawal) accounts, create what is known as the M1 money supply.  Recently, traveler’s checks have been included in calculating the money supply. As we can see from the M1 chart, currency makes up over half of our money supply, while travelers check only account for 1% of the total M1 money supply.

Many people feel that the M2 money supply is a more accurate depiction of the real money supply in the United States. To find M2, we add savings deposits, individual money market funds, and small denomination time deposits to M1. Small denomination deposits are deposits of less than $100,000. The M2 chart to the left shows us that M1 is only 21% of the real money supply, while savings deposits, individual market funds, and small denomination deposits make up 79% of our money supply.  You can see why it is important that we consider these easily converted M2 factors when calculating the money supply, and how it can present a more realistic picture, but M1 is still considered by traditional economists as the money supply.

An even broader measure of our money supply is found in the M3 supply.  M3 is found when we add large denomination time deposits, money market funds held by financial institutions, and other less liquid assets to the M2 supply. Large denomination time deposits are deposits of more than $100,000.  Because most of these assets cannot easily be liquidated into cash, they are not as closely watched as the other money supply factors. Our M3 chart shows us that M2 counts for 68% of the M3 money supply, while the less liquid assets account for only 32%.

Now that we know how the money supply is calculated, let’s look at what money does.  Money basically has four jobs.  It is a medium of exchange, a standard of value, a store of value, and a standard of deferred payment.  Without money, we would be forced to exist in a barter system. For a barter system to work, I would need to have something that you want, and you would need to have something that I want.  This exchange of goods does not always work in the real world where there is a great diversity in products, and the ability to produce them.  Thus, money was developed to simplify the exchange of goods.

So, where does money come from? You might be surprised to learn that the creation of money has nothing to do with minting coins or printing currency, but that is the truth of the matter. To put it simply, banks create money. I know you are thinking that this cannot possibly be true, but it is.  Allow me to explain with this example; when you go to the bank, and you are qualified for a $15,000 loan, the bank simply makes a computer-activated deposit into your account. Although you sign a form promising to pay this money back, no money changes hands because this money is simply inventory to the bank.  In a sense, you are lending the money to yourself because the money will not actually exist until you pay it back. However, $15,000 has been added to the demand deposit portion of the money supply, and money has been created. Incidentally, when you pay back the loan, you are destroying money.  Paying the loan back to the bank would take that money out of demand deposits and put it back into the banks inventory.  Once that money is back in the inventory, it is no longer a part of the money supply.  Before you go into a panic over all this money created for nothing more than a promise, take a deep breath, and remind yourself that there are limits to how much money banks are allowed to create.

Founded in 1913 and comprised of 12 district banks and numerous member banks, the Federal Reserve, or the FED as it is affectionately referred to, oversees controlling the money supply. The Board of Governors of the Reserve, headed by Alan Greenspan, is the leader of the FED. The Board of Governors of the Reserve is made up of seven members.  Each member is appointed by the President and confirmed by the senate for a fourteen-year term.  These terms run sequentially, with one position becoming vacant every two years.  The FED has five basic responsibilities.  First, they oversee the monetary policy.  Monetary policy involves controlling the rate of growth of the money supply to create a relatively full employment rate, price stability, and a satisfactory rate of economic growth .  The second job the FED has is to act as the last-resort lender for financial institutions who find themselves caught short.  Third, the FED issues currency. The fourth job of the Federal Reserve is to act as the banker for the government, and the fifth job for the FED is to monitor the operations of the financial institutions. The Board of Governors of the Reserve also serve as members of the FOMC, otherwise known as the Federal Open Market Committee. The FOMC has twelve members; eight permanent members which include the Board of Governors, and the president of the New York Federal Reserve Bank, and four presidents from other reserve banks who serve rotating one-year terms.  Although presidents from all the reserve banks participate in monetary policy meetings, only the twelve members of the FOMC have voting power. Now that we know who controls the money supply, we will look at how they do it.

The FED has several tools available to attain the goals of monetary policy.  In case you forgot, monetary policy is used to control the growth rate of the money supply so we can enjoy full employment, a satisfactory rate of economic growth, and price stability. The first tool the FED uses to achieve these goals is the open-market operation. When the FED feels that the money supply is too low, and we may be headed for a recession, they go to the open market, and buy securities. If the FED buys enough securities, it can drive up the value of the securities, and in turn, decrease the interest rates.  By the same token, if the money supply is growing too quickly, perhaps pushing us into inflation, the FED will sell securities in order to drive down the price and increase the interest rates.  As we know from our studies of supply and demand, when interest rates are high, consumers are less likely to borrow, and when consumers begin holding on to their personal money supply, the growth rate of the economy begins to slow down.

Another tool the FED has at its disposal to control the money supply to stave off inflation, or to fight a recession, is the discount and federal funds rate. The discount rate is the rate of interest banks pay to the FED if they need to borrow money to covers their reserve requirements, while the federal funds rate is the interest rates banks pay each other if they need to borrow to cover reserve requirements.  We will get to reserve requirements in a minute, but for now, let’s consider the recent actions of the FED and the Federal Funds rate. On June 30th, 2004, Alan Greenspan, and the Federal Reserve, raised the federal funds rate for the first time in four years to control inflation.  On August 10th, 2004, the federal funds rate was raised another quarter of a percentage point, bringing the federal funds rate to 1.5%. The FED plans a measured increase in the federal funds rate, and we could see another increase as early as September. These measures are meant to slow inflation without adversely affecting the growth of the economy.

The final tool the FED uses to curb inflation or fight a recession is to change the reserve rate. The reserve rate is the amount of money that a financial institution must keep at the Federal Reserve to meet the reserve requirements.  For example, if a bank has financial deposits of $100,000, with a reserve requirement rate of 20%, they will need to hold $20,000 in reserves.  If the FED raises the reserve rates, and banks are required to hold more of their inventory in reserves, the money supply will decrease, and prices will be forced to stabilization. Rest assured, the FED only uses this tool as a last resort, and only after all other methods have failed to stem inflation.  This tool is also used as a last resort to stimulate the economy in the event of a recession.

With all these tools at their disposal, the FED is generally successful in fighting inflation. While only time will tell what results the current actions of the FED will produce, most economist have a bright outlook for the future. This concludes our session on the money supply. Now that you know more than you ever thought you wanted to know about money, be sure to spread the news!



Slavin, Stephen L. Economics 7th Edition Pub. McGraw-Hill/Irwin 2005 Chapters 13 & 14