Money: Where Does it Come From?

Each country has its own currency. Thus the U.S. uses the dollar ($); 19 continental countries use the euro (€); the U.K. – the pound (£); Japan uses the yen; China – the Yuan; Russia – the ruble; Mexico – the peso; Canada – the Canadian dollar and so on. The value of one currency in terms of another is called an exchange rate, and every exchange rate has an inverse; if £1=$2 than $1=£1/2. If the £ rises in value (appreciates) to, say, $3, then the dollar declines in value (depreciates) in £1/3. Such is the bilateral exchange rate behavior. The exchange rate is one of the most important devices in the economy.

Historically, money took on a variety of forms. But today money supply in the U.S. consists of paper notes (about a quarter of the total) and checking accounts otherwise known as demand deposits (about ¾). The reason demand deposits can serve the function of money is the existence of a check clearing system operated by the central banks, which is the Federal Reserve (also known as the Fed.) in the U.S., people, corporations and other economic entities keep checking accounts in banks, and draw on them to make payments or settle debts. Hence such demand deposits are money. In turn, banks maintain reserves against these deposits in the form of cash but mainly in the form of deposits at the central bank (for simplicity, the following discussion ignores the cash component). In fact, the central bank dictates the fraction of people’s deposits that banks are obligated to maintain as reserves. This is known as a mandatory reserve requirement. For example, if deposits in a bank add up to $1,000, and reserve requirements are 10 percent, then that bank must keep $100 on deposit with its central bank. Any such deposit in excess of the required 10 percent is known as excess reserves. Only commercial banks and the Federal government have access to the Federal Reserve.

What enables demand deposits to serve the function of money is the check clearing system operated by the central bank. Suppose Jack send Jill a $100 check drawn on his bank (Bank A) and Jill deposits it in her bank (Bank B). Bank B would send it to the Fed. for clearing and the Fed. would credit Bank B by $100 and debit bank A by $100; transaction complete.

Such a clearing system exists in every country, operated by its central bank.

The single bank can loan out a maximum of the amount of its excess reserve. To show this, suppose the mandatory reserve requirement was 10 percent of demand deposit. Consider the position of Bank B in Scheme A (check clearing). After receiving Jill’s deposit of $100 and depositing it at the Federal Reserve, the bank has $100 in deposits of the public (Jill), and $100 in reserves, of which $10 is required reserves (10 percent of $100) and $90 is excess reserves. 

Banks are eager to lend money because that’s how they make a profit (on the interest they charge). Suppose the bank loaned out $95 to various customers. These borrowers write checks totaling that amount to a variety of other people who in turn deposit them in their banks. With thousands of commercial banks existing in the United States, none of this money (or a very small part of it) is likely to return to Bank B. So Bank B is now short of required reserves: It needs $10 to cover Jill’s deposit of $100 and is left with only $5 ($100-$95). Thus the single bank can only loan out the amount of its excess reserve.

But what is true of the single bank is not true of the entire system of thousands of commercial banks, because the $95 that Bank B loaned out are redeposited somewhere in the system. That is why the banking system as a whole is the major source of our money supply. Indeed, any time a bank makes a loan it is made in the form of a demand deposit against which the loan owner can write checks. So when banks make loans they create money. And because the banking industry is the source of most of our money supply, it is subject to tighter regulations (by the Fed.) than any other industry. In general, the central bank is responsible for the quality of money in circulation and for the rate(s) of interest prevailing in the economy. Much of the conduct of monetary policy is done by the Fed.’s control over the banking system.  

Such a clearing system exists in every country, operated by its central bank.

The single bank can loan out a maximum of the amount of its excess reserve. To show this, suppose the mandatory reserve requirement was 10 percent of demand deposit. Consider the position of Bank B in Scheme A (check clearing). After receiving Jill’s deposit of $100 and depositing it at the Federal Reserve, the bank has $100 in deposits of the public (Jill), and $100 in reserves, of which $10 is required reserves (10 percent of $100) and $90 is excess reserves.

Banks are eager to lend money because that’s how they make a profit (on the interest they charge). Suppose the bank loaned out $95 to various customers. These borrowers write checks totaling that amount to a variety of other people who in turn deposit them in their banks. With thousands of commercial banks existing in the United States, none of this money (or a very small part of it) is likely to return to Bank B. So Bank B is now short of required reserves: It needs $10 to cover Jill’s deposit of $100 and is left with only $5 ($100-$95). Thus the single bank can only loan out the amount of its excess reserve.

But what is true of the single bank is not true of the entire system of thousands of commercial banks, because the $95 that Bank B loaned out are redeposited somewhere in the system. That is why the banking system as a whole is the major source of our money supply. Indeed, any time a bank makes a loan it is made in the form of a demand deposit against which the loan owner can write checks. So when banks make loans they create money. And because the banking industry is the source of most of our money supply, it is subject to tighter regulations (by the Fed.) than any other industry. In general, the central bank is responsible for the quality of money in circulation and for the rate(s) of interest prevailing in the economy. Much of the conduct of monetary policy is done by the Fed.’s control over the banking system. 

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