Author; Athar Mudasir
Introduction
The
purpose is to describe the basic process of money creation in a
"fractional reserve" banking system. The approach taken signifies the
changes in bank balance sheets that occur when deposits in banks change as a
result of monetary action by the Federal Reserve System - the central bank of
the United States.
Money is
such a routine part of everyday living that its existence and acceptance
ordinarily are taken for granted. A user may sense that money must come into
being either automatically as a result of economic activity or as an outgrowth
of some government operation. But just how this happens all too often remains a
mystery. The importance of money is very crucial and plays a dynamic role in
our every social, political, economical and technological advancement. Money as
by its nature is power to exchange goods and service by the seller and buyer in
a certain market at a given period and time with general acceptability and negotiable
with the banks. Money simply in modern world is based on confidence of buyer
and seller that the note bearing a government and central promise to accept as
value as determined on note.
What is Money?
If money is viewed simply as a tool used to facilitate
transactions, only those media that are readily accepted in exchange for goods,
services, and other assets need to be considered. Many things - from stones to
baseball cards - have served this monetary function through the ages. Today, in
the United States, money used in transactions is mainly of three kinds -
currency (paper money and coins in the pockets and purses of the public);
demand deposits (non-interest bearing checking accounts in banks); and other
checkable deposits, such as negotiable order of withdrawal (NOW) accounts, at
all depository institutions, including commercial and savings banks, savings
and loan associations, and credit unions. Travelers checks also are included in
the definition of transactions money. Since $1 in currency and $1 in checkable
deposits are freely
convertible into each other and both can be used
directly for expenditures, they are money in equal degree. However, only the
cash and balances held by the nonbank public are counted in the money supply.
Deposits of the U.S. Treasury, depository institutions, foreign banks and
official institutions, as well as vault cash in depository institutions are
excluded.
This transactions concept of money is the one
designated as M1 in the Federal Reserve's money stock statistics. Broader
concepts of money (M2 and M3) include M1 as well as certain other financial
assets (such as savings and time deposits at depository institutions and shares
in money market mutual funds) which are relatively liquid but believed to
represent principally investments to their holders rather than media of
exchange. While funds can be shifted fairly easily between transaction balances
and these other liquid assets, the money-creation process takes place principally
through transaction accounts. In the remainder of this booklet,
"money" means M1.
The distribution between the currency and deposit
components of money depends largely on the preferences of the public. When a
depositor cashes a check or makes a cash withdrawal through an automatic teller
machine, he or she reduces the amount of deposits and increases the amount of
currency held by the public. Conversely, when people have more currency than is
needed, some is returned to banks in exchange for deposits.
While currency is used for a great variety of small
transactions, most of the dollar amount of money payments in our economy are
made by check or by electronic transfer between deposit accounts. Moreover,
currency is a relatively small part of the money stock. About 69 percent, or
$623 billion, of the $898 billion total stock in December 1991, was in the form
of transaction deposits, of which $290 billion were demand and $333 billion
were other checkable deposits.
What Makes Money Valuable?
In the United States neither paper currency nor
deposits have value as commodities. Intrinsically, a dollar bill is just a
piece of paper, deposits merely book entries. Coins do have some intrinsic
value as metal, but generally far less than their face value.
What, then, makes these instruments - checks, paper
money, and coins - acceptable at face value in payment of all debts and for
other monetary uses? Mainly, it is the confidence people have that they will be
able to exchange such money for other financial assets and for real goods and
services whenever they choose to do so.
Money, like anything else, derives its value from its scarcity in relation to its usefulness. Commodities or services are more or less
valuable because there are more or less of them relative to the amounts people
want. Money's usefulness is its unique ability to command other goods and
services and to permit a holder to be constantly ready to do so. How much money
is demanded depends on several factors, such as the total volume of transactions
in the economy at any given time, the payments habits of the society, the
amount of money that individuals and businesses want to keep on hand to take
care of unexpected transactions, and the forgone earnings of holding financial
assets in the form of money rather than some other asset.
Control of the quantity
of money is essential if its value is to
be kept stable. Money's real value can be measured only in terms of what it
will buy. Therefore, its value varies inversely with the general level of prices.
Assuming a constant rate of use, if the volume of money grows more rapidly than
the rate at which the output of real goods and
services increases, prices will rise. This will happen
because there will be more money than there will be goods and services to spend
it on at prevailing prices. But if, on the other hand, growth in the supply of
money does not keep pace with the economy's current production, then prices
will fall, the nations's labor force, factories, and other production
facilities will not be fully employed, or both.
Just how large the stock of money needs to be in order
to handle the transactions of the economy without exerting undue influence on
the price level depends on how intensively money is being used. Every
transaction deposit balance and every dollar bill is part of somebody's
spendable funds at any given time, ready to move to other owners as
transactions take place. Some holders spend money quickly after they get it,
making these funds available for other uses. Others, however, hold money for
longer periods. Obviously, when some money remains idle, a larger total is
needed to accomplish any given volume of transactions.
Who Creates Money?
Changes in the quantity of money may originate with
actions of the Federal Reserve System (the central bank), depository
institutions (principally commercial banks), or the public. The major control,
however, rests with the central bank.
The actual process of money creation takes place
primarily in banks.(1) As noted earlier, checkable liabilities of banks
are money. These liabilities are customers' accounts. They increase when
customers deposit currency and checks and when the proceeds of loans made by
the banks are credited to borrowers' accounts.
In the absence of legal reserve requirements, banks
can build up deposits by increasing loans and investments so long as they keep
enough currency on hand to redeem whatever amounts the holders of deposits want
to convert into currency. This unique attribute of the banking business was
discovered many centuries ago.
It started with goldsmiths. As early bankers, they
initially provided safekeeping services, making a profit from vault storage
fees for gold and coins deposited with them. People would redeem their
"deposit receipts" whenever they needed gold or coins to purchase
something, and physically take the gold or coins to the seller who, in turn,
would deposit them for safekeeping, often with the same banker. Everyone soon
found that it was a lot easier simply to use the deposit receipts directly as a
means of payment. These receipts, which became known as notes, were acceptable
as money since whoever held them could go to the banker and exchange them for
metallic money.
Then, bankers discovered that they could make loans
merely by giving their promises to pay, or bank notes, to borrowers. In this
way, banks began to create money. More notes could be issued than the gold and
coin on hand because only a portion of the notes outstanding would be presented
for payment at any one time. Enough metallic money had to be kept on hand, of
course, to redeem whatever volume of notes was presented for payment.
Transaction deposits are the modern counterpart of
bank notes. It was a small step from printing notes to making book entries
crediting deposits of borrowers, which the borrowers in turn could
"spend" by writing checks, thereby "printing" their own
money.
What Limits the Amount of Money Banks Can
Create?
If deposit money can be created so easily, what is to
prevent banks from making too much - more than sufficient to keep the nation's
productive resources fully employed without price inflation? Like its
predecessor, the modern bank must keep available, to
make payment on demand, a considerable amount of currency
and funds on deposit with the central bank. The bank must be prepared to
convert deposit money into currency for those depositors who request currency.
It must make remittance on checks written by depositors and presented for
payment by other banks (settle adverse clearings). Finally, it must maintain
legally required reserves, in the form of vault cash and/or balances at its
Federal Reserve Bank, equal to a prescribed percentage of its deposits.
The public's demand for currency varies greatly, but
generally follows a seasonal pattern that is quite predictable. The effects on
bank funds of these variations in the amount of currency held by the public
usually are offset by the central bank, which replaces the reserves absorbed by
currency withdrawals from banks. (Just how this is done will be explained
later.) For all banks taken together, there is no net drain of funds through
clearings. A check drawn on one bank normally will be deposited to the credit
of another account, if not in the same bank, then in some other bank.
These operating needs influence the minimum amount of
reserves an individual bank will hold voluntarily. However, as long as this
minimum amount is less than what is legally required, operating needs are of
relatively minor importance as a restraint on aggregate deposit expansion in
the banking system. Such expansion cannot continue beyond the point where the
amount of reserves that all banks have is just sufficient to satisfy legal
requirements under our "fractional reserve" system. For example, if
reserves of 20 percent were required, deposits could expand only until they
were five times as large as reserves. Reserves of $10 million could support
deposits of $50 million. The lower the percentage requirement, the greater the
deposit expansion that can be supported by each additional reserve dollar.
Thus, the legal reserve ratio together with the dollar amount of bank reserves
are the factors that set the upper limit to money creation.
Bank reserves
Currency held in bank vaults may be counted as legal
reserves as well as deposits (reserve balances) at the Federal Reserve Banks.
Both are equally acceptable in satisfaction of reserve requirements. A bank can
always obtain reserve balances by sending currency to its Reserve Bank and can
obtain currency by drawing on its reserve balance. Because either can be used
to support a much larger volume of deposit liabilities of banks, currency in
circulation and reserve balances together are often referred to as
"high-powered money" or the "monetary base." Reserve
balances and vault cash in banks, however, are not counted as part of the money
stock held by the public.
For individual banks, reserve accounts also serve as
working balances.(2) Banks may increase the balances in their reserve
accounts by depositing checks and proceeds from electronic funds transfers as
well as currency. Or they may draw down these balances by writing checks on
them or by authorizing a debit to them in payment for currency, customers'
checks, or other funds transfers.
Although reserve accounts are used as working
balances, each bank must maintain, on the average for the relevant reserve
maintenance period, reserve balances at their Reserve Bank and vault cash which
together are equal to its required reserves, as determined by the amount of its
deposits in the reserve computation period.
