Overview: Banks Create Money

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These readings introduce you to one of the mysteries of macroeconomics, that banks create the money of modern economic systems. The idea of banks creating money sounds strange to someone who thinks of money as gold or silver. However, for several centuries now most money has been in the form of bank debt. A checking account is nothing more than funds that the bank owes you, and paper money represents something that the Federal Reserve System owes you. (Try to collect this debt from the Federal Reserve, though, and see what you get.) When one sees the creation and destruction of money as the creation and destruction of bank debt, the process is less mysterious.

These readings explain how bank-debt money evolved from commodity money and how transactions in the banking system can be analyzed using balance sheets. They explain how checks clear through the system, and how in the process of trying to maximize the return on their assets, banks create money. Thus, money creation is a side-effect of banking. Finally, we look at how central banks control the system of money creation in modern economies focusing on the financial institutions of the United States.

After you complete this unit, you should be able to:

  • List the main assets and liabilities of a commercial bank.
  • Show, using balance sheets, how a check clears; the effects of a bank making a loan; the effects of a bank selling a bond to the public or to another bank.
  • Define legal reserves.
  • Distinguish between state and national banks.
  • Outline the structure and powers of the Federal Reserve System.
  • Given data on two of deposits, required reserve ratio, and required reserves, compute the missing one.
  • Given data on required reserves and legal reserves, compute excess reserves.
  • Using balance sheets, show how the three policy tools of the Federal Reserve can influence the amount of money banks create.
Copyright Robert Schenk