<< Chapter < Page Chapter >> Page >

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

how are commodities important to the country
Oriho Reply
what is the difference between real cost and opportunity cost in economy
Oriho
real costs are total money expenditure for the production of goods and services and opportunity costs is the money which is not included for production, like work of entrepreneurs in their own company
Maheswar
hi everyone how are you?
Prathana Reply
fine wbu
Abinash
fine
ALIM
What is foreign reserve? Why countries reserved? And have any limitations of this reserve?
Adil Reply
what is the difference between gdp and cpi?
Luyando Reply
endogenous and exogenous
Afzaal Reply
what is the difference between gdp and cpi?
Luyando
CPI is calculates the price change in goods and services purchased by the households whereas, GDP calculates the price change in goods and services purchased by all the consumers, government, businesses and foreigners.
Alice
yes
rusibana
What is the role of price system in The market economy
Cyrielle Reply
(1).Income is the main determined of macro economics. (a). true (b). false
Manisha Reply
yes
Anjali
tell me correct ans with examples!!
Manisha
yes
The
what yes yes?
Manisha
mam actually I want to say that income is not the main determinant of macro economics.
The
based on your knowledge about the production possibility frontier,demonstrate an assumption of supposed schedule of ppe for the production of rice and face masks by Bangladesh.use graphical representation as well
Ashraf Reply
hay
Ashraf
hlo
Karan
can you answer this
Ashraf
whats tradeoff
JUSTIN Reply
tradeoff is a balance achieved between two desirable but conflicting things
Faith
can I read in Hindi?
Rashmi Reply
don't know..
Azka
why not
Omid
Omid Amini....how?
Rashmi
sure thing
Faith
mention two necessities of estimation of national income in india ?
Krishna Reply
what means the supply
Abdourahamane Reply
hello
mosisa
hii
SHWETA
hi
Aleem
its means amount of product available right now.
Aleem
is everything important here🙂
Alizy
I mean anything*
Alizy
u can read it
Aleem
it's mean something needed or wanted
Alizy
where are from shweta
Aleem
where are you from shweta
Aleem
Hello
Anas
it may mean the stock available
DR
to make something needed or wanted available to someone
Faith
is someone who manufactures something
Faith
What is the cost-benefit analysis?
Hannah Reply
A cost benefit analysis is a process by which organizations can analyze decisions, systems or projects, or determine a value for intangibles. The model is built by identifying the benefits of an action as well as the associated costs and subtracting the costs from benefits.
sanga
thanks!
Hannah
Cost benefit analysis is a process used primarily by businesses that weighs the sum of the benefits, such as financial gain, of an action against the negatives, or costs, of that action.
ALIM
process of cost benefit analysis and decision making crieteria
Santosh
hello everyone
BtsARMY
hello every one,
Dereje
hello everyone
waqar
what is the opportunity cost?
SHWETA
The next best option forgone is call the Opportunity cost of selection one.
Oshadi
which commodity is the best to be consumed by human being
Oriho
who is producer?
rishabh Reply
karan johar
Mohd
shut up mr.mohd
rishabh
it's serious question..
rishabh
shut up mr.mohd
rishabh
simple who produce good
Alizy
who is aconsumer?
Ritik Reply
who uses the commodity
Kanza
a consumer is one that buys good for consumption .
rishabh
Kanza consumers uses the commodity..
rishabh

Get the best Macroeconomics course in your pocket!





Source:  OpenStax, Macroeconomics. OpenStax CNX. Jun 16, 2014 Download for free at http://legacy.cnx.org/content/col11626/1.10
Google Play and the Google Play logo are trademarks of Google Inc.

Notification Switch

Would you like to follow the 'Macroeconomics' conversation and receive update notifications?

Ask