Chapter 7 The Meaning and Creation of Money 187

for more than the value of the gold in their vaults.
People would continue to circulate the notes in
trade, confident they could be redeemed when
desired.
So long as people felt secure in using notes as
money, the representative commodity monetary
system worked. But problems eventually emerged.
From 1834 to 1860. over sixteen hundred state-
chartered banks, most of them largely unregu-
lated, issued notes. Many banks issued so many
notes that they could not always redeem them at
full face value. Runs on banks, in which panicked
noteholders attempted to cash in their notes for
gold, became common. Some banks collapsed
when they could not redeem all the notes pre-
sented to them. Counterfeiting sometimes pro-
voked a run on a bank. Because each of the
sixteen hundred banks issued notes of its own
design, the average trader could not always tell a
counterfeit or worthless note from a genuine one.
Counterfeit bills increased the information cost of
using notes and reduced their general acceptance.
Because of these difficulties, governments began
to issue paper money. In the United States, the
federal treasury issued gold and silver certificates
that could be redeemed for metal coin, and
'greenbacks"-unbacked paper currency issued to
finance the Civil War. The general acceptance of
these monies was encouraged by the treasury's
willingness to accept them in payment of taxes
and by the requirement that creditors accept them
in payment of debt. (If creditors refused to accept
greenbacks and gold and silver certificates as pay-
ment, debtors were legally absolved of their
obligations.)
When the Federal Reserve System was estab-
lished in 1913, private bank notes became illegal
and were replaced by Federal Reserve Notes, the
paper money we use today. At first Fed notes
were backed by a government pledge to redeem
the notes in gold and silver. The number of notes
in circulation was determined partly by the
amount of gold held by the government. These
notes were considered so sound by foreigners that
they tended to be in short supply in the United
States. T o increase the money stock and raise
prices, President Franklin Roosevelt took the
United States off the gold standard in 1933.
Roosevelt declared that dollars would no longer be
redeemed in gold at the Treasury or the Federal
Reserve. Indeed, he outlawed private hoarding of
gold and required people who held it to sell it to
the government for $22.50 an ounce. (Later the
price of gold was set officially at $35 an ounce.) In
1968 Congress revoked the Fed's obligation to
redeem silver certificates in silver.
The U.S. monetary system is now based entirely
on inconvertible paper currency, or fiat money.
Fiat money is a medium of exchange or store of
value that cannot be redeemed for anything other
than a replica of itself. A fiat dollar can be ex-
changed only for another dollar. The general
acceptability of fiat money does not depend on
either its intrinsic market value (as was the case
with corn), or its redemption value (as was the
case with silver certificates). It depends entirely on
people's confidence in its continued usefulness in
trade.

Velocity (V): the rate of Since 1987, the Fed n o longer targets or specifies annual growth rates
turnover or circulation of inMl (currency in circulation, checkable deposits, and traveler's checks).
the money stock (At) Ml was changed from a "targeted" to a "monitored" variable. Although the
relative to GNP; thus, Fed still considers Ml to be a predictor of future changes in national in-
V=e m . come, it now targets only M2 and M3. T h e problem with M 1 was that it had
lost its reliability because of unstable velocity. Velocity (V) is the rate of
 Part I11 Money and Monetary Policy

Several points should be made about these transactions.

1. The check causes your bank balance to fall and the bookstore's bank
balance to rise (entries e and a).
2. The check causes an adjustment in the Fed's reserve deposits. Your
bank's reserve deposit goes down; the other bank's reserve deposit
goes up (entries c and b).
3. The Fed's reserve deposits are not the same as the deposits you and
your bookstore maintain at your local banks. They are bookkeeping
entries based on the demand deposits of member banks. Thus re-
serve deposits are not money. They are not used directly in trade, as
demand deposits are.
4. Reserve deposits are assets to the member banks that maintain them
(that point will become clearer in the next section). Thus any check
you write causes your bank's assets at the Fed to fall, and the assets
of another bank to rise (entries f and 4. (This statement assumes
that the person who writes the check and the person who receives
it maintain accounts in different banks. If the two parties have
accounts with the same bank, one person's deposit will go up
and the other's down, but the bank's assets at the Fed will remain
the same.)
5. Most important, when anyone writes a check, the nation's money
stock does not change. Money is simply moved from one account to
another.

The Creation of Money

A 7. How do banks When gold was used as a medium of exchange, the creation of money was
create money? much like the production of jewelry. Gold ore was mined from the ground
and smelted, and the pure metal was molded into coins. How much money
was created depended primarily on the amount of gold in the ground and
the cost of getting it out. Today, in industrial nations like the United States,
money is created principally through the commercial banking system.
Banks create money; they create it every time they make a loan.
How is it done? Simply lending out someone else's money would
amount to transferring money already in existence from one person to
another. When banks create money it is by writing checks to, or increasing
the deposits of, borrowers. Suppose you have negotiated a $5,000 car loan
with Northwestern National Bank. You sign the necessary papers and the
bank gives you a check to deliver to the car dealer. When the dealer deposits
the check, money is created.
It is money's general acceptability in trade that enables your bank to
create money out of thin air, as it were. As long as the car dealer is willing to '
accept the bank's check, and other people are willing to accept the checks
the dealer writes, something has been created that has general acceptabil-
ity: money.

Reserve requirement
ratio: the portion of a
depository institution's
(such as a bank's) reserves
that by law cannot be
used to create money.
Excess reserves: the
amount of a depository
institution's (such as a
bank's) total reserves
minus the required re-
serves.
Chapter 7 The Meaning and Creation of Money 193
The Reserve Requirement
Banks are not allowed to create unlimited amounts of money. Legally, the
amount of money a bank can create depends on the level of its customer
deposits. T h e more customer deposits it has, the more money it can lend
and the more money it can create. Even if there were no legal restrictions, a
bank would need to maintain sufficient liquidity to satisfy its customers'
needs. If the bank's customers were uncertain about its solvency, there
could be a run on the bank, whereby a significant percentage of its cus-
tomers withdraw their deposits over a short period of time.
T h e money-creating capability of banks is further restricted by the
Federal Reserve, which imposes reserve requirements, branch limitations,
restraints on interstate banking, and the like. T h e most important of these
is reserve requirements. When a bank receives a customer's deposit, its
reserve deposit with the Federal Reserve bank increases. When you ask for
a loan, your bank writes its check against this reserve account, and its
reserve deposit decreases. The bank cannot write checks indefinitely against
its reserve deposit, however. It must maintain a minimum deposit, called
the reserve requirement, at the Federal Reserve Bank in its district, as vault
cash (or in the case of nonmember banks, balances with a Federal Reserve
Bank indirectly on a pass-through basis with certain approved institutions).
In any event, the funds are idle in the sense that they cannot be put into
interest-earning loans or investments. T h e reserve requirement ratio is
that portion of a depository institution's (such as a bank's) reserves that by
law cannot be used to create money. A bank's total legal reserves are all
assets held by the bank that the law permits to be used in meeting reserve
requirements.
T h e reserve requirement ratio is expressed as a percentage of the
depository institution's (such as the bank's) total demand deposits. For ex-
ample, if the reserve requirement is 15 percent, the bank must maintain a
reserve deposit equal to at least 15 percent of its demand deposits. That is,
through loans the bank can create money equal to 85 percent of its demand
deposits. Thus the amount of money a bank can create depends on its
excess reserves. Excess reserves equal the amount of a depository institu-
tion's (such as a bank's) total reserves minus the required reserves:
Excess reserves = total legal reserves - required reserves
Excess reserves are any reserves above and beyond the minimum required
by law.
A bank can lend out safely the amount of its excess reserves even if the
'homing power" on new loans is zero and all the money goes to different
banks. If, however, it retained part of its newly created deposits, the bank
could lend out a bit more than that amount. A banking system that operates
with banks acting independently can end u p lending many times the
amount of excess reserves, even if each bank in the system lends only the
amount of its excess reserves. A bank's excess reserves depend o n the re-
serve requirement (as shown in the table on page 194) and on its total legal
reserves, or funds that according to law may be counted as part of the
Part 111 Money and Monetary Policy

reserves that the bank must keep against its deposits. A decline in the
reserve requirement increases a bank's excess reserves and its money-
creating capability. When the reserve requirement goes up, excess reserves
and money-creating capabilities go down.

Reserve
Requirement Loans Can Be Equal to:
(percentage) (percentage of demand deposits)

A bank with a total demand deposit of $10 million and a reserve require-
ment of 10 percent can make loans of up to $9 million (90 percent of $10
million). If the reserve requirement is 17 percent, the bank can make loans
8.3 million (83 percent of $10 million). T h e purpose of reserve
requirements is to restrain credit expansion.
Many people have the impression that the reserve requirement is a
means of ensuring that banks have some money o n hand to meet the
public's withdrawals. I n fact, it is illegal to use reserves to meet unantici-
pated cash withdrawals. Even if the reserves were available, they would be
insufficient under fractional reserves if there were a serious bank run.
Thus, the reserve requirement is not intended to serve that purpose or to
maintain the financial soundness of the banking system. T h e purpose of
the reserve requirement is simply to restrict the amount of money that
banks can create. If banks want security against customer withdrawals, they
must maintain reserves above and beyond their required reserves, which
are bookkeeping entries only. Banks do not really lend out other people's
money when they make loans. Although reserve deposits are calculated on
the basis of a bank's demand deposits, they are not the same thing. If they
were, banks would not be able to create money. Loans would merely trans-
fer money from depositor to borrower. Banks create money by lending
their excess reserves.

The Multiple Effects of Loans

So far we have considered only the immediate effects of creating money by
loan. The process extends beyond the addition of a specific amount of
money to the economy in the form of a loan check, however.
Assume Bank A has total customer deposits of $10 million and a re-
serve deposit of an equal amount. Its accounts and those of the Federal
Reserve are shown in Step 1of Figure 7.4 (pp. 196-197). Assume also that
the reserve requirement is 20 percent. Bank A can therefore lend against
80 percent of its 10 million in reserves, or as much as $8 million. Bank A
decides to lend all $8 million to a local firm that needs new equipment. The