pcecon.com Class Notes
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Where Our Money Comes From:
The True Story

The process of money creation in modern societies is carried out by banks.
Each bank creates some new money by creating new loans, and creating new bank deposits (which are a form of money). The basis for all these loans is that the banks start with some excess reserves (more than needed to back up the bank account deposits).

The process of money creation by banks is called "bank expansion" (or sometimes, "deposit expansion").

How much, altogether will all of the banks (the "banking system") be able to make (maximum) if they start with $1,000,000 worth of new money ($900,000 excess reserves) and if the required reserve ratio is 10%?

Banks can create an amount of money that is many times as large as the amount of new money they start with. This multiple, called the "multiplier" is determined by the required reserve ratio, here called "r."

The maximum value of the multiplier, called the "potential multiplier" is ¹/_r

If we want to figure out how much money the banks create from the time the first loan is made until the banks run out of excess reserves, we get what we can call the "bank expansion multiplier." Since the bank expansion is produced because of excess reserves and creating new loans, the total amount of new loans and deposits produced by banks is

^{initial ER}/_r
In this example, since the first bank had $900,000 in excess reserves to loan that amount would be (potentially)

^$900,000/_.1 =$9,000,000 created by banks
If we want to discover how much total money is created by the whole process (including the part originally created by the genie), we can apply the multiplier to the amount of new money originally created (by the genie in our story). If we do this, we can call the result the "money multiplier," which would be

^{new money}/_r
In this example, the genie created $1,000,000 in new money, so the maximum total amount of money created by the genie and the banks (altogether) is

^$1,000,000/_.1 =$10,000,000
Again, the genie made $1,000,000 of this, and the banks did the rest.

About the Genie Story
This is no fairy tale...
The Fed is the genie and this is a true story. To add some more reality, we can remember the following.

There are two factors that may reduce the bank expansion:

• Normally, people keep some of their money in the form of cash, perhaps to use for everyday purchases or to keep for emergencies. The proportion of money that people want to hold as cash rather than bank deposits is called the "desired currency ratio." This will be a factor reducing the actual multiplier. As people pull cash out of the banks, the "cash drain" or "cash leakage," will reduce the amount of reserves banks retain as the process goes on. If the desired currency ratio goes up, the multiplier will get smaller.
• Often, banks hold on to excess reserves without making loans on them (if they are afraid that depositors will be likely to come after their deposits, for example). Banks may make fewer or smaller loans because of this. When this is so, the multiplier will be smaller than its potential maximum.

Tools of the Fed

In what ways does the Fed control the whole bank expansion process?

• First, the Fed sets the required reserve ratio (so the Fed controls the multiplier)
• Second, the Fed lends reserves to banks, so it can somewhat control the reserves banks have to make loans on. The Fed charges banks a special interest rate called "the discount rate" on borrowed reserves. The discount rate is the only interest rate directly set by the Fed, and only banks can get it. By lowering the discount rate, the amount of reserves (and excess reserves) of banks can be increased, assuming banks want to borrow reserves.
• Third, and most important, the Fed acts like the genie in our story by doing Open Market Operations. This is the name for the Fed buying (or selling) bonds from the public. When the Fed buys a bond, it creates new money out of thin air with which to do it. The Fed doesn't create cash (as in our genie story), but instead it writes a check. When the check is deposited by the bond seller, the money supply immediately rises, since the bank account of the bond seller is money. Then, when the check clears, the Fed gives the bond seller's bank new reserves in the amount of the check. Neither the money in the bond seller's account nor the bank reserves existed before the purchase. The Fed just creates them.

These three ways the Fed can control the amount of money (the "money supply") in the country are called the "tools of the Fed."

To increase the money supply (or the growth rate of the money supply), the Fed can

• 1. reduce the required reserve ratio. Generally, the Fed doesn't like to do this, since it affects the multiplier and thus is a very powerful tool. However, the Fed might use this tool to offset increases in the desired currency ratio or increases in the excess reserves held by banks.
• 2. reduce the discount rate. This will increase bank reserves only if banks are willing to borrow reserves, perhaps because they have lots of potential borrowers they are unable to grant loans to. However, since this tool depends on the banks, it is sometimes not very effective (it is like a dog's leash; letting it out will let the dog go where it wants to, but pushing on it can't make the dog go in a particular direction that it doesn't want to go).
• 3. buy bonds on the open market. Buying bonds will directly increase the amount of money in existence, and will also increase bank reserves by the same amount as the bond purchase.

To decrease the money supply (or the growth rate of the money supply), the Fed can

• 1. increase the required reserve ratio. Generally, the Fed doesn't like to do this, since it affects the multiplier and thus is a very powerful tool. However, the Fed might use this tool to offset decreases in the desired currency ratio or decreases in the excess reserves held by banks.
• 2. increase the discount rate. This will reduce the ability or willingness of banks to borrow reserves. It will only have an effect if banks were contemplating making more loans than they have the reserves to make.
• 3. sell bonds on the open market. Selling bonds will directly decrease the amount of money in existence, and will also decrease bank reserves by the same amount as the bond sale.