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

Bank Finance and a Fractional Reserve System

Bank finance lies at the heart of the process through which money is created. To understand money creation, we need to understand some of the basics of bank finance.

Banks accept deposits and issue checks to the owners of those deposits. Banks use the money collected from depositors to make loans. The bank's financial picture at a given time can be depicted using a simplified balance sheet, which is a financial statement showing assets, liabilities, and net worth. Assets are anything of value. Liabilities are obligations to other parties. Net worth equals assets less liabilities. All these are given dollar values in a firm's balance sheet. The sum of liabilities plus net worth therefore must equal the sum of all assets. On a balance sheet, assets are listed on the left, liabilities and net worth on the right.

The main way that banks earn profits is through issuing loans. Because their depositors do not typically all ask for the entire amount of their deposits back at the same time, banks lend out most of the deposits they have collected - to companies seeking to expand their operations, to people buying cars or homes, and so on. Banks keep only a fraction of their deposits as cash in their vaults and in deposits with the Fed. These assets are called reserves. Banks lend out the rest of their deposits. A system in which banks hold reserves whose value is less than the sum of claims outstanding on those reserves is called a fractional reserve banking system.

Table 9.1 "The Consolidated Balance Sheet for U.S. Commercial Banks, January 2012" shows a consolidated balance sheet for commercial banks in the United States for January 2012. Banks hold reserves against the liabilities represented by their checkable deposits. Notice that these reserves were a small fraction of total deposit liabilities of that month. Most bank assets are in the form of loans.

Table 9.1 The Consolidated Balance Sheet for U.S. Commercial Banks, January 2012

Assets Liabilities and Net Worth
Reserves $1,592.9 Checkable deposits $8,517.9
Other assets $1,316.2 Borrowings 1,588.1
Loans $7,042.0 Other liabilities 1,049.4
Securities $2,546.1

Total assets $12,497.2 Total liabilities $11,155.4

Net worth $1,341.8

This balance sheet for all commercial banks in the United States shows their financial situation in billions of dollars, seasonally adjusted, in January 2012.

In the next section, we will learn that money is created when banks issue loans.