The Nature and Creation of Money
“A bank is a place that will lend you money if you can prove that you don’t need it.”
-Bob Hope
Slide 1 of 32
We have an interesting relationship with money!
I am routinely amazed at how willing people are to accept small pieces of paper in exchange for labor or a good or service.
They do not question the paper’s intrinsic value, it’s producer, or its origin.
They simply have faith that the next person will take it….
…because they always have.
Let’s stop to think about it…what is money? What are its functions? And who controls it?
Slide 2 of 32
What are the functions of money?
1-Medium of Exchange
2-Unit of Account
3-Store of Value
It is very convenient to exchange money for goods and services. If it were not available,
you’d have to find someone that had a demand for whatever you were trading. That would
significantly slow down an economy.
With money, we can compare the value of any two goods, even if they are unrelated.
With money, we can work today and enjoy the benefit of that work in the future. Imagine if you
were paid in a perishable good such as milk. You would not be able to keep it for any length of
time.
Keep in mind that money is not a good store of value over long periods. It erodes due to
inflation!
In our reading material, three functions for money
are outlined…
Slide 3 of 32
There are at least two other functions of money not covered in the reading
Money is a Brand Statement– Money is used to demonstrate the culture of a
country.
– On the next slide, we’ll look at the pictures: they include kings, queens, founders, religious buildings, animals and other proud symbols.
Money is a Speculative Instrument– Currency traders buy and sell currency in the
hopes of gaining value over time.
– Foreign Exchange or “Forex” is the largest market in the world with more than $4 trillion traded every day.
– Only 2.5% of forex is in exchange for goods and services. The rest is “bet” in speculative investments.
Slide 4 of 32
A brand statement indeed!
Enjoy this sample of world currencies. I think you will be astonished by the variety, color, and
choice of symbolism.
I think you will agree…
…This rainbow of currency makes our “Greenbacks”
look boring!
Slide 5 of 32
What backs our money? In other words, how do you know it is worth the number that is printed on it?
More specifically, it is backed by the promise of our federal government that
they will keep the value stable.
Nothing!!!
Slide 6 of 32
Where does our money come from…part 1?
Currency and coins are either printed or stamped by the Federal
Government.
Bills are printed by the U.S. Bureau of Engraving in Washington DC.
They offer tours, but not free samples .
Slide 7 of 32
Our currency used to be backed by precious metal
These “Silver certificates” were worth a dollar in
silver. You could go to a Federal bank and obtain a dollar in silver in exchange
for them at any time.
Look at the language…clearly, the government was trying to reassure
people that these notes were valuable.
The U.S. abandoned the use of precious metal in 1973 in what was called
“The Nixon Shock”.
Slide 8 of 32
Where does our money come from…part 2?
Money is also created out of thin air by the U.S. Banking system.
In fact, we depend on banks to perform this important task.
Right about now you must be wondering…”how do banks create
money out of thin air”?!?!Slide 9 of 32
The money creation process is a Key Learning Outcome so lets
see how it unfolds….
So how do banks create money? Let’s take a trip down memory lane
In early history, owning gold was risky. Houses did not have locks and towns did not have lights. Owning and possessing gold was dangerous.
There might have been one person in the village that had a safe place to keep gold. The goldsmith, who made jewelry and other things, had to keep gold in his or her inventory. As such,
they had a secure house and guards.
People realized this and starting asking the goldsmith to keep their gold (and other valuables) in his or her house.
He or she agreed, for a fee.Slide 10 of 32
A “100% reserve system”
To keep track, the goldsmith would issue receipts for the gold he held. Eventually, people started to trade receipts instead of gold.These receipts were like paper money but were fully backed by gold.We all knew the goldsmith so we trusted the system…wouldn’t you?
These tickets are good as gold.
Every time I ask the goldsmith to redeem
the, he seems to have the gold ready.
This is an example of a 100% reserve
system: Currency in circulation is fully backed by gold (or other valuable item)
held in reserves
Slide 11 of 32
I have never seen everyone come and
cash in their receipts at the
same time.
In other words, I have never had all my “reserves” called for at once!
The birth of the “fractional reserve system”
This is an example of a
Fractional reserve system: Currency
in circulation is only partially
backed by gold (or other valuable
item) held in reserves
“I think I’ll print some fake receipts and
spend them or loan them out for profit!”
To see how money can be created, follow this goldsmith's
thoughts.
And this would work fine unless everyone
turned in their receipts at the same
time.
He just created money out of
thin air!
Slide 12 of 32
What if everyone did ask for their gold back at the same time?
• If every customer asked for their deposits back, the goldsmith could not meet demand.
• If you heard that the goldsmith was running low on gold, you’d probably RUN there to get your gold.
• If everyone did that, the goldsmith would be in trouble-there simply isn’t enough gold in the vault to meet demands.
• In modern times, that is called a “bank run” or “bank panic”.
DOWN WITH
THE
GOLDSMITH!GIVE ME MY
GOLD!
Give me my money!
Give me my money!
Give me my money!
NO MORE
TICKETS!
Slide 13 of 32
See this link for some anecdotal interviews of bank runs:
Source: Wessels Living History Farm.
“Bank Runs” or “Bank Panics” were tough on the economy
Bank runs were not pretty.
In many cases, a lot of people lost their life savings.
In some cases, the banker would be killed.
Sometimes banks would be burned to the ground in hopes
of burning the mortgage paperwork inside!
Bank runs were a perpetual event in the 1800s and early
1900s. They were very disruptive.
The picture shows a bank run. Some of those people would get their money back. Many would
not.
http://www.livinghistoryfarm.org/farminginthe30s/money_08.html
Slide 14 of 32
What prevents bank runs now?
Three things help prevent bank runs now:
#1: Deposit InsuranceThe U.S. Federal government insures your
deposits in many banks up to $250,000. If the bank fails, they will pay you.
#2: The Discount WindowThe U.S. Federal Reserve (discussed later)
stands ready to loan money to banks that are “in trouble”. If a bank nears bankruptcy, it can
borrow from the “Fed”
#3: The Required Reserve RatioBanks are forced to hold a portion of your deposits in reserve so that they can meet
demand for withdrawals. Slide 15 of 32
Required Reserve Ratios help prevent bank runs
Today, when you deposit money in a bank, that bank
is required to hold some of it in reserve.
Typically, banks are required to hold 10% of all
deposits.
The required reserve ratio has a big role in “money
creation”.
If you deposit $1000 in a bank today, then a bank will hold $100 and loan out the
remaining $900 (in normal times)
Slide 16 of 32
Examine the table that follows to see how much money is created given a 40% RRR and
a $10 million deposit
That loan of $900 creates money out of thin air. You still have $1000 on deposit, yet
someone else is now carrying around that $900.
But it doesn’t stop there!
Let’s return to the question:How do banks create money?
A new deposit of $10 million is made in a bank called Bank A.
Bank A holds 40% ($4 million) in reserve and loans out the rest. $6
million has been created!
That $6 million would eventually get deposited somewhere else, perhaps
in Bank B.
Bank B holds 40% ($2.4 million) in reserve and loans out the rest. $3.6
million has been created!
That $3.6 million would eventually get deposited somewhere else,
perhaps in Bank C.
Bank C holds 40% ($1.44 million) in reserve and loans out the rest. $2.16
million has been created!
This cycle continues over and over, each time getting smaller until eventually, a total of $25 million in deposits have occurred. The original deposit was $10
million. Banks have created $15 million!
Slide 17 of 32
How does the required reserve ratio affect money creation?
Here is another scenario where the required reserve ratio is 3% instead of 40%.
Notice how a lot more money is created with a lower required reserve ratio. In this case, $10 million in an initial deposit results in $333.3 million of total deposits. $323.3
million has been created!
The real lesson here is this: A lower Required Reserve Ratio causes a lot more money to be created. But it also causes reserves to be low which can threaten the health of the bank. If reserves are low and we all come calling for our deposits…they will not have them! A balance must be found…many developed countries require banks to
hold around 10% of deposits in reserve.Slide 18 of 32
Calculating money creation
There is an easier way to calculate money
creation.
= 1/.03 = 33.3333
= $10 million * (1-.03)= $9.7 million
= $9.7 million * 33.33 = $323.3 million
Step one:
Calculate the money multiplier
Step two:
Calculate the initial excess reserves
Step three:
Multiply the money multiplier by the initial
excess reserves
Understanding how the banking system creates money is a Key Learning
Outcome!
Slide 19 of 32
You try it!Please fill in all blank cells and answer the question below.
In which Scenario is more money created and why? ___________________
Sce
nario
#1:
Req
uire
d
Res
erve
Rat
io is
50%
Sce
nario
#2:
Req
uire
d
Res
erve
Rat
io is
25%
The second because the reserve requirement is lower!
Slide 20 of 32
More practice!
$90 million
Less
Please fill in the blank cells and answer the questions below.
Slide 21 of 32
So how much money is there?
That depends on how you measure it.
If you count currency only, there is about $1.1 trillion in circulation.
But what about all that “created” money?
Slide 22 of 32
Includes M1 and:Savings deposits
Small time deposits(CDs)
Money Markets and Mutual Funds
Money (what we will call the Money Supply) is measured two ways: M1, and M2
IncludesCurrency in circulation
(coins and bills)
and Money in checking accounts
M1
M2
Slide 23 of 32
Definition Type Value, in Billions Percent of TotalCurrency $1,109.6 11.9%Traveler's Checks $3.8 0.0%Demand Deposits $811.7 8.7%Checkable Deposits $443.5 4.7%Savings Deposits $5,729.0 61.4%Small Time Deposits $603.9 6.5%Money Market Funds $635.4 6.8%
M1 + M2 $9,336.9 100.0%
U.S. Money Supply- as of March 2013
M1
M2
M2 = $9.4 trillion
Current Money Supply
M1 = $2.37 trillion
Slide 24 of 32
Money creation…we need it!
Let’s take a quick review
Our government has allowed $1.1 in bills and coins to circulate.
But our banking system has expanded that supply of money to $9.4 trillion
through the money creation process.
All that money floating around facilitates commerce – it lets us trade with each
other and makes our economy go!
Slide 25 of 32
As an economy grows, it requires more currency to facilitate trade.
Over time, the money supply has grown to accommodate a larger economy
So who manages it?
As can be seen here, the U.S. money supply (M2) increased from around $3 trillion in 1990 to $11 trillion in 2013!
Changes in this measure can also be used to offset shocks.
For example, as the 2008 financial crisis occurred, the money supply was increased
to help soften the economic impact.
Slide 26 of 32
The U.S. Federal Reserve “The Fed”
A Review of the U.S. Federal Reserve System
If you have ever been to Washington D.C., You may have seen this building. It is the U.S. Federal Reserve headquarters, located across the
street from the Lincoln Memorial on Constitution Ave. 27
What is the Federal Reserve System?
The Federal Reserve System is the monetary authority in the United States.
That means that they are in charge of determining how big the money supply should be.
“The Fed” was created by Congress in the Federal Reserve Act of 1913 after a banking crisis in 1907.
Slide 28 of 32
How is the Fed Organized?
• Part One: Board of governors• The central governing body• Consists of 7 members-Presidentially appointed Senate
confirmed• Every 2 years a term expires• One member is appointed as chairman for 4 year term,
and can be reappointed• A full term is 14 years and cannot be reappointed• Current Chairman is Ben Bernanke
These long terms are key – they are designed to insulate Fed officials from
political pressure.
Any president would want the money supply expanded as it might “rev up” the
economy.
But doing so could cause a lot of inflation and might not be in the American people’s
interest.
Fed Governors have long terms so that they can resist this pressure. Something
tells me it is still applied though!
Slide 29 of 32
How is the Fed Organized?
• Part Two: Federal Reserve District Banks• U.S. is divided into 12 districts, each has a district bank• Each acts as a central bank for its district
Our Federal Reserve District Bank is in Richmond.
Slide 30 of 32
How is the Fed Organized?
• Part Three: Federal Open Market Committee• Consists of 19 member: 12 with a vote, 7 non voters.
– Voters:» Seven Governors from the B.O.G.» NY District Bank President» Four other members rotate through the remaining eleven
districts
• The FOMC assesses the economy to determine if changes in the money supply are needed.
We will learn in a future module how this works.
For now think of it this way:
If the Fed believes the economy is in recession, it can increase the
money supply, allowing more money to circulate. That will
increase spending!
If the Fed believes inflation is the main worry, it can decrease the
money supply, allowing less money to circulate. That will
reduce price pressures!
Slide 31 of 32
In Summary
Money has many functions including facilitating commerce.
Money has historically been backed by precious metal but in the U.S. and all other developed countries, that is no longer true.
Over time, the money supply can be altered to facilitate more trade and to
manipulate an economy.
It is the job of the U.S. Federal Reserve (The Fed) to manage our
money supply.
Slide 32 of 32