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Money Creation

How Banks, not The Federal Reserve, Create Money

You cannot fully understand the topic of Money and Banking without understanding how money gets created.

Summary of Money Creation

Meaning of Money

The concept of money arose from trade that occurred before the use of anything known as money. When people began to trade (or exchange) goods, they did so directly. The person who had an excess of a good, and wanted to exchange it for something he lacked, would have to seek out people who not only had what he wanted but also wanted what he had. This pattern of direct exchange made trade complicated and inefficient.

Some traders found that they could improve this process by using indirect exchange — a pattern in which a trader exchanged his good for another that he wanted solely because he could then exchange it for the good he really desired. Indirect exchange made trading only slightly less complicated and inefficient, but it lead to the discovery of another trading pattern.

Of the goods exchanged — both directly and indirectly — one good became recognized as the most marketable; nearly everyone would accept it in exchange for almost any other good. It began to serve as a general medium of indirect exchange. This good, and its successors, became what we now call money.

Definition of Money

From this brief history we can formulate a definition of money:

Money consists of any economic good, or any claim on such a good, that serves as a general medium of indirect exchange and that acts as a final means of payment.

The word serves plays an important part in this definition. No good has an inherent money characteristic. A good becomes money only through use. Thus, we can accurately refer to the same good at one time as “money” and at another time as “not money.” Gold, for example, has frequently played the role of money, but nothing in the nature of gold makes it money. In the United States today we do not use gold as money.

The importance of use becomes apparent in understanding why bank reserves do not serve the role of money while currency in circulation and bank deposit liabilities do serve as money.

Money Substitutes

Money substitutes, meaning any claim on a good that serves as a general medium of indirect exchange (e.g. bills, checks), replace that good as money for as long as the substitute remains in existence. The good and the substitute cannot both act as money simultaneously. Thus, when a bank holds a good that the market normally uses as money to “back” the claim of a money substitute that good becomes a “reserve” asset—we can no longer consider it money.

In an economy in which the market uses gold as money, when a person takes gold coins to the bank and exchanges them for the bank’s deposit liability, the claim on that gold, represented by the demand deposit account, becomes money. The gold, held as reserve against that claim, is no longer money. Later, when the payee of a check drawn on that account claims the gold, the bank extinguishes the deposit liability and turns the gold over to the payee. The gold again serves as money.#

Fractional Reserves

Banks should hold the reserve good (not money) in sufficient quantity to honor all outstanding claims (money) simultaneously. At some time, however, banks discovered they could get away with issuing claims (money) in a greater quantity than they held of reserves (not money). They did this in order to acquire earning assets—e.g. bonds or notes. Thus, in simple terms, began the practice of fractional reserve banking.

The passage of the Federal Reserve Act institutionalized the already existing practice of fractional reserve banking. Setting reserve requirements allegedly added stability to the banking system by giving the board of governors the ability to limit the money creating capability of member banks.

Fed Assumed Reserves

The Fed assumed control of the reserve good (i.e. gold) (not money). In return The Fed issued to the banks a claim on that gold, and the banks held that claim as their reserve. The reserve accounts of banks at The Fed could not act as money for two reasons: 1) as a reserve for the banks’ own deposit liabilities (money) they could not also serve the role of money, and 2) banks could not transfer the claims on The Fed to any entity other than another bank (i.e. those claims could not serve as a general medium of indirect exchange.)

Fractional Reserve Substitute

In the fractional reserve banking system set up by the federal reserve act we might refer to the reserve accounts at The Fed as a fractional reserve substitute. The Fed, at a different level, employed the same practice used by banks. The Fed could expand and contract bank reserves (not money) by simply increasing and decreasing its liability to banks regardless of the quantity of reserve good (i.e. gold) (not money) it held.

By having the capability of increasing and decreasing bank reserves, The Fed had the capability of changing the limits of banks’ capability to created money (i.e. increase deposit liabilities). The Fed did not, however, have the capability to directly either increase or decrease the quantity of money.

Asset Purchases

I have demonstrated how both banks and The Fed issue claims (money in the case of banks; not money in the case of The Fed) in excess of the assets that they maintain in “reserve.” Both banks and The Fed issue those excess claims for the purpose of acquiring earning assets, but they do so for different purposes.

Banks wish to acquire earning assets because it fits the nature of their business. They issue excess claims (create deposit liabilities), used as money, in order to acquire those assets.

The reason that The Fed acquires assets with its excess claim remains somewhat hidden from the public. Although it seems rational based on the basic banking model that The Fed acquire earning assets, it could create reserves simply by adding them to the accounts of various banks. But, then the books would not balance. Whether on purpose or by happenstance, the acquisition of earning assets acts as a rationing mechanism for deposit liabilities in the banking system. Reserves will flow only to banks that either have securities to sell or have customers with securities to sell. Thus, banks with higher ratio of risk assets will have less capability to acquire reserves, which will increase their deposit liability creating ability.

In either case, additional reserves added to the banking system do not add money to the economy. Only the banks (with excess reserves) can add money to the economy.

Summary

In the modern era, money consists almost entirely of claims issued by banks that the market uses as a general medium of indirect exchange. The reserve accounts held by banks at The Federal Reserve, however, do not serve as money. Although a medium of indirect exchange, reserves do not qualify as money because of both their role as “reserves” and the restriction on their use—only between Federal Reserve member banks.

The practice of fractional reserve banking, used by both banks and The Fed, allows banks to issue claims for amounts greater than their reserve accounts, thereby creating new money. The same practice by The Fed simply creates more reserves (not money), which expands the banks’ capability to create money.

Comprehending what entity actually creates new money, and how, becomes important in understanding the true effects of the actions of The Federal Reserve and how to devise a lasting solution to the problem of monetary expansion. First, “quantitative easing” by The Fed creates mostly bank reserves (not money). It only causes the creation of money in amounts equal to the asset purchases from non-bank entities. Second, “ending The Fed” will not stop monetary expansion. Banks practiced fractional reserve banking before The Fed; they will likely continue the practice after The Fed—particularly with the implicit government guarantee of bank deposit liabilities.

I have developed fairly extensive presentation that demonstrates in words and graphics how banks—not the Federal Reserve System—create new money. That presentation follow this summary.


# Cash (bills and coins) now play a role similar to that formerly played by gold. When banks hold cash in their vault it counts as reserves (not money); when banks put cash into circulation people can then use it as money.

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Note: This page summarizes extensive information provided in the presentation on Money Creation but does not replace the detail. I encourage you to spend the time—now or in the future—to study the full presentation.

Continue Presentation,
which shows how banks create money.

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