05Economics2ndEdition

8/7/2019 05Economics2ndEdition

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Chapter 7 The Meaning and Creation of Money 187

as people felt secure in using notes astem worked. But problems eventually emerged.1834 to 1860. over sixteen hundred state-

Because of these difficulties, governments began

paper currency issued toance the Civil War. The general acceptance ofse monies was encouraged by the treasury'sof taxesby the requirement that creditors accept them

, debtors were legally absolved of theirWhen the Federal Reserve System was estab-1913, private bank notes became illegal

and were replaced by Federal Reserve Notes, thepaper money we use today. At first Fed noteswere backed by a government pledge to redeemthe notes in gold and silver. The number of notesin circulation was determined partly by theamount of gold held by the government. Thesenotes were considered so sound by foreigners thatthey tended to be in short supply in the UnitedStates. To increase the money stock and raiseprices, President Franklin Roosevelt took theUnited States off the gold standard in 1933.Roosevelt declared that dollars would no longer beredeemed in gold at the Treasury or the FederalReserve. Indeed, he outlawed private hoarding ofgold and required people who held it to sell it tothe government for $22.50 an ounce. (Later theprice of gold was set officially at $35 an ounce.) In1968 Congress revoked the Fed's obligation toredeem silver certificates in silver.The U.S. monetary system is now based entirelyon inconvertible paper currency, or fiat money.Fiatmoney is a medium of exchange or store ofvalue that cannot be redeemed for anything otherthan a replica of itself. A fiat dollar can be ex-changed only for another dollar. The generalacceptability of fiat money does not depend oneither its intrinsic market value (as was the casewith corn), or its redemption value (as was thecase with silver certificates). It depends entirely onpeople's confidence in its continued usefulness intrade.

(V): the rate of Since 1987, the Fed n o longer targets or specifies an nu al growth ratesin Ml (currency in circulation, checkable deposits, and traveler's checks).oney stock (At) Ml was changed fro m a "targeted" to a "monitored" variable. Although th eGNP; thus, Fed still considers Ml to be a predictor of future changes in national in-e m . come, it now targets only M2 and M3. T h e problem with M 1 was that it hadlost its reliability because of unstable velocity. Velocity (V) is the rate of


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Part I11 Money and Monetary Policy

Several points should be made about these transactions.1. The check causes your bank balance to fall and the bookstore's ban

balance to rise (entries e and a).2. The check causes an adjustment in the Fed's reserve deposits. Youbank's reserve deposit goes down; the other bank's reserve deposit

goes up (entries c and b ) .3. The Fed's reserve deposits are not the same as the deposits you anyour bookstore maintain at your local banks. They are bookkeepinentries based on the demand deposits of member banks. Thus re-serve deposits are not money. They are not used directly in trade, demand deposits are.4. Reserve deposits are assets to the member banks that maintain them(that point will become clearer in the next section). Thus any check

you write causes your bank's assets at the Fed to fall, and the assetsof another bank to rise (entries f and 4. (This statement assumesthat the person who writes the check and the person who receivesit maintain accounts in different banks. If the two parties haveaccounts with the same bank, one person's deposit will go upand the other's down, but the bank's assets at the Fed will remainthe same.)

5. Most important, when anyone writes a check, the nation's moneystock does not change. Money is simply moved from one account tanother.

The Creation of MoneyA 7. How do banks When gold was used as a medium of exchange, the creation of money wcreate money? much like the production of jewelry. Gold ore was mined from the grounand smelted, and the pure metal was molded into coins. How much monewas created depended primarily on the amount of gold in the ground anthe cost of getting it out. Today, in industrial nations like the United Statmoney is created principally through the commercial banking systemBanks create money; they create it every time they make a loan.How is it done? Simply lending out someone else's money wouamount to transferring money already in existence from one person

another. When banks create money it is by writing checks to, or increasithe deposits of, borrowers. Suppose you have negotiated a $5,000 car lowith Northwestern National Bank. You sign the necessary papers and thbank gives you a check to deliver to the car dealer. When the dealer deposthe check, money is created.It is money's general acceptability in trade that enables your bankcreate money out of thin air, as it were. As long as the car dealer is willingaccept the bank's check, and other people are willing to accept the checthe dealer writes, something has been created that has general acceptabity: money.


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Chapter 7 The Meaning and Creation of Money 193

the portion of ach as a bank's) reservesy law cannot beto create money.

theof a depository(such as a

The Reserve RequirementBanks are not allowed to create unlimited amounts of money. Legally, theamount of money a bank can create depends on the level of its customerdeposits. Th e more customer deposits it has, th e more money it can lendand the more money it can create. Even if there were no legal restrictions, abank would need to maintain sufficient liquidity to satisfy its customers'needs. If the bank's customers were uncertain about its solvency, therecould be a run on the bank, whereby a significant percentage of its cus-tomers withdraw their deposits over a short period of time.

T he money-creating capability of banks is fur ther restricted by theFederal Reserve, which imposes reserve requirements, branch limitations,restraints on interstate banking, and the like. The most impor tan t of theseis reserve requirements. When a bank receives a customer's deposit, itsreserve deposit with the Federal Reserve bank increases. When you ask fora loan, your bank writes its check against this reserve account, and itsreserve deposit decreases. Th e bank cannot write checks indefinitely againstits reserve deposit, however. It must maintain a minimum deposit, calledthe reserve requirement, at the Federal Reserve Bank in its district, as vaultcash (or in the case of nonmember banks, balances with a Federal ReserveBank indirectly on a pass-through basis with certain approved institutions).In any event, the funds are idle in the sense that they cannot be put intointerest-earning loans or investments. The reserve requirement ratio isthat portion of a depository institution's (such as a bank's) reserves that bylaw cannot be used to create money. A bank's total legal reserves are allassets held by the bank that the law permits to be used in meeting reserverequirements.

The reserve requirement ratio is expressed as a percentage of thedepository institution's (such as the bank's) total demand deposits. For ex-ample, if the reserve requirement is 15 percent, the bank must maintain areserve deposit equal to at least 15 percent of its demand deposits. That is,through loans the bank can create money equal to 85 percent of its demanddeposits. Thus the amount of money a bank can create depends on itsexcess reserves. Excess reserves equal the amount of a depository institu-tion's (such as a bank's) total reserves minus the required reserves:

Excess reserves = total legal reserves - required reservesExcess reserves are any reserves above and beyond the minimum requiredby law.

A bank can lend out safely the amount of its excess reserves even if the'homing power" on new loans is zero and all the money goes to differentbanks. If, however, it retained part of its newly created deposits, the bankcould lend out a bit more than that amount. A banking system that operateswith banks acting independently can end up lending many times theamount of excess reserves, even if each bank in the system lends only theamount of its excess reserves. A bank's excess reserves depend on the re-serve requirement (as shown in the table on page 194)and on its total legalreserves, or funds that according to law may be counted as part of the


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Part 111 Money and Monetary Policy

reserves that the bank must keep against its deposits. A decline in thereserve requirement increases a bank's excess reserves and its money-creating capability. When the reserve requirement goes up, excess reserveand money-creating capabilities go down.ReserveRequirement Loans Can Be Equal to:(percentage) (percentage of demand deposits)

A bank with a total demand deposit of $10 million and a reserve requirement of 10 percent can make loans of up to $9 million (90 percent of $10million). If the reserve requirement is 17 percent, the bank can make loan8.3 million (83 percent of $10 million). The purpose of reservrequirements is to restrain credit expansion.Many people have the impression that the reserve requirement is ameans of ensuring that banks have some money on hand to meet thepublic's withdrawals. In fact, it is illegal to use reserves to meet unanticipated cash withdrawals. Even if the reserves were available, they would beinsufficient under fractional reserves if there were a serious bank runThus, the reserve requirement is not intended to serve that purpose o r tmaintain the financial soundness of the banking system. The purpose othe reserve requirement is simply to restrict the amount of money thabanks can create. If banks want security against customer withdrawals, themust maintain reserves above and beyond their required reserves, whichare bookkeeping entries only. Banks do not really lend out other people'money when they make loans. Although reserve deposits are calculated onthe basis of a bank's demand deposits, they are not the same thing. If thewere, banks would not be able to create money. Loans would merely transfer money from depositor to borrower. Banks create money by lendingtheir excess reserves.

The Multiple Effects of LoansSo far we have considered only the immediate effects of creating money byloan. The process extends beyond the addition of a specific amount omoney to the economy in the form of a loan check, however.Assume Bank A has total customer deposits of $10 million and a reserve deposit of an equal amount. Its accounts and those of the FederaReserve are shown in Step 1of Figure 7.4 (pp. 196-197). Assume also thathe reserve requirement is 20 percent. Bank A can therefore lend agains80 percent of its 10million in reserves, or as much as $8 million. Bank Adecides to lend all $8 million to a local firm that needs new equipment. Th

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