The Nature and Creation of Money
Read these sections, "What is Money?" and "The Banking System and Money Creation", to examine money and its impact on real GDP and the price level. Specifically, learn about what money is and its three functions. Distinguish between the M1 and M2 definitions of money. Also, learn about the money creation process and role of banks in it in a fractional reserve banking system. You will revisit certain sections of the chapter later in this unit.
The Banking System and Money Creation
Learning Objectives
- Explain what banks are, what their balance sheets look like, and what is meant by a fractional reserve banking system.
- Describe the process of money creation (destruction), using the concept of the deposit multiplier.
- Describe how and why banks are regulated and insured.
Where does money come from? How is its quantity increased or decreased? The answer to these questions suggests that money has an almost magical quality: money is created by banks when they issue loans. In effect, money is created by the stroke of a pen or the click of a computer key.
We will begin by examining the operation of banks and the banking system. We will find that, like money itself, the nature of banking is experiencing rapid change.