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How Money is Created

Describe fully how money is created through the actions of the federal reserve and presence of a fractional reserve banking system.

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The Federal Reserve controls the three tools of monetary policy--open market operations, the discount rate, and reserve requirements. The term "monetary policy" refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals.

Using the three tools, the Federal Reserve influences the demand for, and supply of, balances that depository institutions hold at Federal Reserve Banks and in this way alters the federal funds rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.

Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can only directly set the Federal Funds Rate. This rate has some effect on other market interest rates, but there is no direct, definite relationship. In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By altering the interest rate(s) under its control, a monetary authority can affect the money supply.
Changes in the federal funds rate trigger a chain of events that affect employment, other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of ...

Solution Summary

This solution provides a description of how money is created.