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The process of how banks create money shows how the quantity of money in an economy is closely linked to the quantity of lending or credit in the economy. Indeed, all of the money in the economy, except for the original reserves, is a result of bank loans that are re-deposited and loaned out, again, and again.

Finally, the money multiplier depends on people re-depositing the money that they receive in the banking system. If people instead store their cash in safe-deposit boxes or in shoeboxes hidden in their closets, then banks cannot recirculate the money in the form of loans. Indeed, central banks have an incentive to assure that bank deposits are safe because if people worry that they may lose their bank deposits, they may start holding more money in cash, instead of depositing it in banks, and the quantity of loans in an economy will decline. Low-income countries have what economists sometimes refer to as “mattress savings,” or money that people are hiding in their homes because they do not trust banks. When mattress savings in an economy are substantial, banks cannot lend out those funds and the money multiplier cannot operate as effectively. The overall quantity of money and loans in such an economy will decline.

Watch a video of Jem Bendell discussing “The Money Myth.”

Money and banks—benefits and dangers

Money and banks are marvelous social inventions that help a modern economy to function. Compared with the alternative of barter, money makes market exchanges vastly easier in goods, labor, and financial markets. Banking makes money still more effective in facilitating exchanges in goods and labor markets. Moreover, the process of banks making loans in financial capital markets is intimately tied to the creation of money.

But the extraordinary economic gains that are possible through money and banking also suggest some possible corresponding dangers. If banks are not working well, it sets off a decline in convenience and safety of transactions throughout the economy. If the banks are under financial stress, because of a widespread decline in the value of their assets, loans may become far less available, which can deal a crushing blow to sectors of the economy that depend on borrowed money like business investment, home construction, and car manufacturing. The Great Recession of 2008–2009 illustrated this pattern.

The many disguises of money: from cowries to bit coins

The global economy has come a long way since it started using cowrie shells as currency. We have moved away from commodity and commodity-backed paper money to fiat currency. As technology and global integration increases, the need for paper currency is diminishing, too. Every day, we witness the increased use of debit and credit cards.

The latest creation and perhaps one of the purest forms of fiat money is the Bitcoin. Bitcoins are a digital currency that allows users to buy goods and services online. Products and services such as videos and books may be purchased using Bitcoins. It is not backed by any commodity nor has it been decreed by any government as legal tender, yet it used as a medium of exchange and its value (online at least) can be stored. It is also unregulated by any central bank, but is created online through people solving very complicated mathematics problems and getting paid afterward. Bitcoin.org is an information source if you are curious. Bitcoins are a relatively new type of money. At present, because it is not sanctioned as a legal currency by any country nor regulated by any central bank, it lends itself for use in illegal trading activities as well as legal ones. As technology increases and the need to reduce transactions costs associated with using traditional forms of money increases, Bitcoins or some sort of digital currency may replace our dollar bill, just as the cowrie shell was replaced.

Key concepts and summary

The money multiplier is defined as the quantity of money that the banking system can generate from each $1 of bank reserves. The formula for calculating the multiplier is 1/reserve ratio, where the reserve ratio is the fraction of deposits that the bank wishes to hold as reserves. The quantity of money in an economy and the quantity of credit for loans are inextricably intertwined. Much of the money in an economy is created by the network of banks making loans, people making deposits, and banks making more loans.

Given the macroeconomic dangers of a malfunctioning banking system, Monetary Policy and Bank Regulation will discuss government policies for controlling the money supply and for keeping the banking system safe.

Problems

Humongous Bank is the only bank in the economy. The people in this economy have $20 million in money, and they deposit all their money in Humongous Bank.

  1. Humongous Bank decides on a policy of holding 100% reserves. Draw a T-account for the bank.
  2. Humongous Bank is required to hold 5% of its existing $20 million as reserves, and to loan out the rest. Draw a T-account for the bank after this first round of loans has been made.
  3. Assume that Humongous bank is part of a multibank system. How much will money supply increase with that original loan of $19 million?

Got questions? Get instant answers now!

References

Bitcoin. 2013. www.bitcoin.org.

National Public Radio. Lawmakers and Regulators Take Closer Look at Bitcoin . November 19, 2013. http://thedianerehmshow.org/shows/2013-11-19/lawmakers-and-regulators-take-closer-look-bitcoin.

Questions & Answers

what does it array
Cbdishakur Reply
what are the differences between monopoly and.oligopoly
Onome Reply
what are the difference between monopoly and oligopoly
Cbdishakur
The deference between Monopoly and Oligopoly: Monopoly means:A single-firm-Industry producing and selling a product having no close business and Oligopoly means:A market structure where a few sellers compete with each other and each controls a significant portion of market .
Basanta
so that the price-output policy one affects the other.
Basanta
what are difference between physical policy and monotory policy
hon
what is economic
Emakpor Reply
what is economic
Cbdishakur
the word economic was derived from the Greek word oikos (a house)and mein(to manage) which in effect meant managing a household with the limited funds available 🙂.
Basanta
good excample about scarsity
hon
An Enquiry into the nature and causes of wealth Nations, this book clearly defined what economic is🙂🙂🙏🙏 thank you...
Basanta
good example about scarcity: money,time, energy, human or natural resources. Scarcity of resources implies that there supply is very much limited in relation to demand.
Basanta
equilibrium is a situation in which economic forces such as demand and supply are balanced and in the absence of external influences,the value of economic variables will not change
Onome Reply
hmnn
Emakpor
marginal cost and marginal revenue is equilibrium .
Kho
yessss
Basanta
what is equilibrium
Rodrice Reply
policy prescriptions for unemployment
Jeslyne Reply
Am working on it
Blacks
Study
Janelle
study
simeon
what are the factors effecting demand sedule
Kalimu Reply
we should talk about more important topics, you can search it on Google n u will find your answer we should try to focus on how we can improve our society using economics
shubham
so good night
hon
ways of improving human capital
kelly Reply
what is human capital
kelly
Capital can be defined as man made assets use in production .
Abdulai
What is the differences between central Bank And Commercial Bank ?. 2 for each
Abdulai
Two types of bank clearing house.
Abdulai
what are the most durable assets of a bank
Ngongang
What is Opportunity Cost?
Cephas Reply
may be defined as expression of cost in terms of forgone alternative.
Abdulai
Helloo, im new, can i get to know more?
Saniya Reply
You ask questions on any topics you find difficult.
Favour
What is opportunity cost?
Cephas
is price elasticity of demand the same as elasticity of demand
Favour Reply
not really
Victoria
hi
Gh
hello
Bhartendu
i hope everyone be ok
Gh
No
Hassan
please explain
Favour
No
William
explanations please
cleophas
price elasticity of demand is the reaction of customers /demand to price changes(increase or decrease) elasticity of demand is the reaction of prices brought about by the change in demand
Victoria
thank you
Favour
state the laws of demand and supply
William
dd: when price rises demand decreases whereas when price reduces dd rises ss: when ss rises the price rises and when ss decreases price also reduces. There is a positive relationship
Dhoonah
nice
Victoria
Draw a demand curve graph
William
though price elasticity and elasticity are used interchangeably, the demand can respond to income changes and prices of related goods as well.
Gurpalak
explain the difference between merit goods and public goods and show why it is possible for profit to be made in the supply of one of these types of good but not the other
Kavishek
Public goods are defined as products where, for any given output, consumption by additional consumers does not reduce the quantity consumed by existing consumers. Merit goods are, for example, education and to some extent the health-care. They are provided by state as "good for you".
ahmed
The ladies are doing much better than the men
Blacks
what happens when there is a shift in demand curve?
Favour
What is Specialization ? Explain in detail
Muhammad
any one ?
Muhammad
specialisation is a method of production whereby an entity focuses on the production of a limited scope of goods to gain a greater degree of efficiency.
Favour
It's ok
Muhammad
hello
Onome
yah
Abdulai
No. price elasticity of demand refers to the manna in which price of good demanded fluctuate mean while elasticity of demand explains the way consumer change in their willingness as they plan or purchase a good
Ngongang
diffirence between demand and supply
Bonny
Demand refers to the quantity of a product that purchasers are willing and able to buy at a various prices per period of time, while,Supply refers to the quantities of a product that suppliers are willing and able to sell at various prices per period of time.
Favour
what is economic
Seray Reply
It is a social science which studies human behavior as a relationship between ends and scarce which have alternative uses
Obeng
what is norminal wage
Demba Reply
is the wages measured in money as distinct from actual purchasing power
Favour
what is demand curve
Azeez Reply
this is a curve that slop downward from left to rich
Obeng
yes
Basanta
different between capital and wealth
Samuel Reply
Wealth refers to the amount of asset you have, while, capital is the amount of cash money you have with you now and willing to invest in any business.
Favour

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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