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Understanding Money

How Most Money is Created

Most money does not exist in tangible form. In fact, less than 10 percent of U.S. money is in the form of bills or coins. Over 90 percent exists only as electronic data stored in a computer. Think about your own money, for example. Although you probably have some cash, most of your money exists in bank accounts or brokerage accounts, and your wealth is actually stored as data in various computer systems.

There are two ways in which new money can be created. First, it can be physically fabricated: that is, printed as bills or manufactured as coins. More frequently, however, money is created just by changing the data stored in a computer. For instance, if your bank were to credit your checking account with, say, a million dollars, all that would happen is that they would make a new entry in their computer. As soon as they made this entry, you would have a million dollars to your name. No new bills or coins would need to be created.

Although it is unlikely that your bank is going to credit your account with a million dollars out of the goodness of their heart, the scenario I have described is similar to the way in which most of the money in the economy is actually created.

When you put money in the bank, the bank does not keep all of your money in a vault (or even in a computer). They loan most of it out to other people. That is how banks make a profit: they accept a deposit from one person, and then loan the money to another person. The profit comes from loaning the money out at a higher rate of interest than what they pay for it. For example, a bank might pay you 2% interest on your savings account, but loan the same money out to another customer at 8% interest.

The Federal Reserve, which regulates banking, does not let banks loan out all of their deposits. By law, banks must retain a certain amount of money on reserve, called the RESERVE REQUIREMENT or RESERVE RATIO. In most cases, the reserve requirement is 10%. In other words, banks are allowed to loan out 90% of the money that they accept for deposit. Here is an example to show how it works.

Let's say you deposit $10,000 into your bank account. The bank keeps $1,000 (10%) on reserve, and loans $9,000 (90%), to someone else. That person then uses the $9,000 to buy something, and the money ends up being deposited in another bank.

Once the $9,000 is deposited, the second bank keeps $900 (10%) on reserve and loans $8,100 (90%) to another person. At this point, there is $19,000 loaned and $1,900 held on reserve, so the total money free to circulate in the economy has jumped from the original $10,000 to $17,100 ($19,000 - $1,900).

Of course, we don't have to stop there. The $8,100 that was loaned out by the second bank will find its way to a third bank, whereupon 90% of the $8,100 will be loaned to someone else. This same process will be repeated, again and again, generating more money each time. If you know how to do the math, you will see that, in theory, a deposit of $10,000 can turn into $90,000 (a total of $100,000 in loans and $10,000 held back on reserve).

This is the way in which most of the money in our economy is created. It comes into being because the banks loan out most of the money they take in, and most of that money is loaned out again and again.

The reason the system works is that people have enough faith in the banks to leave their money on deposit. If a large number of people lost faith in the banks, they might demand that the banks return all the money they have deposited. This is called a RUN on the banks. If this were to happen, it would force the banks to try to recall as many of their loans as they could. In such a situation, two things would happen.

First, every time a loan was recalled successfully, the system would work in reverse and the amount of money in circulation would shrink. If this were to happen on a large scale, the decrease in the money supply would slow down the economy and create a serious recession.

Second, many banks would not be able to recall all their loans fast enough. After all, most loans have repayment schedules that cannot be speeded up. If a bank ran out of money, it would have to close and, once one bank closes, it scares people who have money in other banks.

If a run on the banks got out of hand, it could close down many of the banks and paralyze the economy. This is exactly what happened during the Great Depression. As I discussed earlier, in 1929, there were 24,633 banks in the U.S. By 1933, only 15,015 were still in business (a decrease of 31 percent).

The reason this does not happen is that the Federal Reserve never lets things get out of hand. For example, if a bank is ever faced with extraordinary withdrawals, it could always borrow money to meet its obligations. If, for some reason, a bank were not able to borrow enough money, the Fed would step in and loan the bank whatever is necessary to satisfy the depositors. In this way, the Fed acts as the lender of last resort.

Even more important, the Fed is charged with the job of regulating U.S. banks. By making sure that the banks are run correctly, the Fed inspires continuing faith in the system.

During the 1929-1933 recession, the Fed was much younger and was not nearly as effective as it is now. In retrospect, economists now believe that if the Fed had done a better job maintaining an adequate money supply during the first crucial years, the Depression would have been significantly shorter and a lot milder.

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