What money does
Money is anything widely accepted in exchange. It serves three roles: a medium of exchange (avoiding the double coincidence of wants in barter), a unit of account (prices are quoted in it) and a store of value. Narrow measures such as M1 include cash and checkable deposits; broader ones such as M2 add savings accounts and similar assets.
How banks create money
Banks take deposits and lend most of them out, keeping a fraction as reserves. In a fractional-reserve system, the required reserve ratio sets the minimum fraction.
If the ratio is 10%, then the simple money multiplier = 1 ÷ 0.10 = 10.
Worked example
Ava deposits 1,000 dollars. The reserve requirement is 10%, and borrowers redeposit every loan in the banking system.
- Bank A keeps 100 and lends 900.
- The 900 is deposited at Bank B, which keeps 90 and lends 810.
- The 810 is deposited at Bank C, and so on.
- Total deposits created = 1,000 ÷ 0.10 = 10,000, so 9,000 of new deposits beyond the original 1,000.
In reality, banks hold extra reserves and some people hold cash, so the multiplier is smaller.
A bank with 5,000 in deposits, a 20% requirement and 1,300 in reserves must hold 1,000, so it has 300 in excess reserves that it can lend.
The central bank
A central bank (in the US, the Federal Reserve) conducts monetary policy. Its main tools:
- Open market operations: buying government bonds adds reserves, lowers short-term interest rates and expands the money supply; selling bonds does the reverse.
- Policy interest rate (in the US, the federal funds rate target, together with the rate paid on reserves): changing it moves borrowing costs across the economy.
- Reserve requirements and the discount rate (rarely used for steering).
How policy works
Expansionary policy: lower interest rates make borrowing cheaper, so investment and durable-goods purchases rise, AD shifts right, and output and prices rise. Contractionary policy does the reverse. The central bank often targets low and stable inflation (many aim for about 2%) and some also have a mandate for maximum employment.
Policy works with lags and cannot push interest rates much below zero, which limits it in deep recessions. Central banks have then used tools such as large-scale asset purchases. There is debate about their side effects and about the relative role of fiscal and monetary policy.