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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 is the best definition of economic?
Humble Reply
what is aggregat demand in open economy
Dagim Reply
Aggregate demand is expressed as the total amount of money exchanged for those goods and services at a specific price level and point in time.
Bayou
What is the full meaning of GDP
Akinbulejo Reply
gross domestic product
Yanish
Gross Domestic Product
bode
Formula for calculating the percentage of change in price, quantity, price elasticity of demand
Augustina Reply
Given that the elasticity of supply for a good is 2 and the percentage change in price is 45%.What is the percentage change in quantity supplied
Mbe Reply
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Augustina
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Adebisi
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Owoeye
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Owoeye
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Egba Reply
the circular flow model of the economy is a simplification showing how the economy works and the relationship between income,production and spending in the economy as a whole
Anna Reply
It is an idea that show us the way the economy works about their income, production, and spending in the economy
Augustina
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Ntokozo Reply
what is economics?
Dorcas Reply
Economics is defined as the science that study human behaviour as a relationship between ends and scarce means which have alternative uses.
Emmanuella
economics is a social science concerned with the production,distribution, and consumption of goods and services
Michael
Economics as a science studies human behaviour as a relationship between ends and scarce means with alternative use.
Augustina
economics can be defined as social science which studies human behavior as a relationship between ends and scare means which have alternative uses.... Lionel C Robins
Owoeye
in 2021 Amazon reduced the annual subscription fee for its prime membership service which provides free two_day shipping on many goods and other benefits, from $119 to $99. Zoppa consulting, an investment firm estimated that before the price reduction, prime had 62million subscribers globally. If so, what is the arc elasticity of demand for a prime membership.
Joan Reply
Differences between microeconomics and macroeconomics
tatiana Reply
Macroeconomics deal with the economy as a whole.that is an economy affect the firm ,government and the households eg.unemployment, whilst Microeconomics deal with the the decision making of households,firm and government separately.
Amah
Microeconomics is the branch of economic which studies the behaviour of individual households, firms and industries whiles macroeconomic studies the economy as a whole. It looks at the economy from a a broader perspective.
Augustina
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Ebem Reply
the branch of knowledge concerned with the production, consumption, and transfer of wealth and has Influence by sociology!!!!
Ajay
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Abdullah
Economics is the study how humans make decisions in the faces of scarcity.
Rose
economic is the study of how human make decision in the fact of scarcity.
Toang
Economics is a social science which study human behavior as a relationship between earn and scarce mean which have alternative uses
Juliet
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Fatima
market structure in economics depicts how firms are differentiated and categorised based on types of goods they sell and how their operations are affected by external factors and elements.
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Madara
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Gooluck Reply
demand is the willingness to purchase something
Mohamed
demand is the potential ability or williness to purchases something at a particular price at a given period of time..
Ahmed
Demand refers to as quantities of a goods and services in which consumers are willing and able to purchase at a given period of time. Demand can also be defined as the desire backed by ability to purchase .
Fadiga
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John Reply
is the production of goods in scarcity
David
thanks
John
Demand refers to as quantities of a goods and services in which consumers are willing and able to purchase at a given period of time.
Fadiga
Demand refers to the quantity of goods and services that a consumer is willing and able to buy at a given price over a period of time
Augustina
Do high interest rate in a country increase investment
Alfred
Government sector is the place they can gain more investment but the economy as a whole investment decrease
Augustina
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music Reply
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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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