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Monetary Policy and Money Creation in the United States

What are the uses of money? How do banks create money? Is monetary policy conducted independently in the United States and is the intended effect always achieved? Why or why not?

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Monetary Policy:

What are the uses of money?

Money (in terms of an economist): assets that can be used in making payments (I.e., cash, checking accounts)

Money (in terms of everyday talk): income or wealth

Functions of Money (defined by Abel and Bernake's book "Macroeconomics"):
(1) medium of exchange function, which contributes to a better-functioning economy
by allowing people to make trades at a lower cost in time and effort than in a barter economy
(2) the unit of account function which provides a single uniform measure of value
(3) the store of value function by which money is a way of holding wealth that has
high liquidity and little risk

How do banks create money?
(source: Linda Beale from the University of Nebraska, Omaha; "How Banks Create Money")

Banks increase the supply of money through their lending activities which create money in the form of new checking deposits. This process is called multiple deposit creation. Commercial banks play a crucial role in the expansion and contraction of the supply of money and credit in our economy. Through their lending activities, banks increase or decrease the checking deposit component of the money supply. Checking deposits make up the largest portion of our money supply.

Economists have defined numerous measures of the money supply to pinpoint the impact of money supply changes on our economy's health. M1 is the basic measure of our money supply. M1 includes coins and currency in people's hands plus the funds available in checking accounts. M1 functions as the primary medium of exchange in our economy. M2 is a broader definition of the money supply and includes M1 plus savings accounts, certificates of deposit, and money market funds.

Banks operate under a fractional reserve system which means they are required by law to set aside a fraction of their customers' deposits as required reserves. Banks may lend an amount equal to their remaining reserves which are called excess reserves. Banks earn revenue and profits through lending and charging interest on loans. They also increase or decrease the checking deposit component of the money supply through lending.

The process whereby banks make loans equal to the amount of their excess reserves and create new checkbook money is known as multiple deposit creation. Each time a bank receives a deposit, it sets aside some of it to meet reserve requirements and may lend an amount equal to the remaining excess reserves. These loans take the form of new checking accounts for the borrower which increases the checkbook portion of the money supply. When the borrower spends the loan, he or she writes a check on the new checking account. The recipient of the check, in turn, deposits his or her funds into another bank. After this second bank sets aside its required reserves against the new deposit, it may lend an amount equal to its remaining excess reserves. These loans also take the form of new checking accounts for the borrowers, and each
Successive cycle of lending generates an increase in the money supply in the form of these new checkbook dollars. Additionally, ...

Solution Summary

Money serves many purposes and how banks increase the supply of money in the United States is a rather complex process that includes lending activities through the issuance of bank deposits. These lending practices can directly affect the money supply. The Federal Reserve (FED) sets monetary policy and establishes the reserve rates banks must hold. There are several methods for which the FED does this.