Creation of Money and Monetary Policy

Creation of Money and Monetary Policy

In society, there are many interesting topics of discussion amongst individuals and groups, either in the private or public sector. However, there is one inescapable subject we all fall prey to, which is money. We have a love, hate relationship with money that dictates almost everything we do, or at least, strive to do. Money, a powerful force to reckon with, establishes our buying power, or lack there of, to the point where lifestyle choices might be endless or limited -creating a swinging door that can either be opened or closed for opportunities in all facets of life. But, do we ever come to a halt and ponder how money is created? More than likely the answer is no. Nonetheless, the time is now.

The way society interacts with money now is much different from the original transactions of the early pioneers. Let's step back into the past to understand how money was created, and then leap to the present to explore current money generating methods. Purchases were settled with gold for traders in earlier times. The practicality of transporting gold became a huge burden and made the traders venerable to crime (i.e. attacks and robberies). Typically, the metal would have to be measure each time a transaction occurred for negotiation purposes. It became much easier for traders to "deposit their gold with goldsmiths, who would store it in vaults for a fee. On receiving a gold deposit, the goldsmith would issue a receipt to the depositor. Soon people were paying for goods with goldsmiths' receipts, which would serve as the first kind of paper money" (Brue and McConnell, 2004, p.253). This system reflects the infant stages of banking.

The vaults housing the gold grew substantially with the general public's acceptance of the gold-receipt exchange process. The goldsmith's ensured a "100 percent reserve system" allowing full access to gold on demand based on receipt amount (Brue and McConnell, 2004, p.253). However, excess gold developed as a result of forgotten or unclaimed gold from owners, remaining in the vaults creating a new opportunity to expand services to the community. The gold surplus, in the form of paper receipts, would be used as "interest-earning loans to merchants, producers, and consumers" which was an acceptable medium of exchange (Brue and McConnell, 2004, p.253). This practice birthed the fractional reserve system where bank vaults housed only a "fraction of the total money supply" (Brue and McConnell, 2004, p.253). Now, spring forward to present day practices of how money is created.

Travel in time to the 21st century, or current times, where financial institutions, or specifically commercial banks, have the ability to create money with checkable deposits through the loan process. Much like the goldsmiths, bankers generate money on loans based on how much money is in their excess reserves, much like traders in the 16th century. Our system is a bit more sophisticated driven by required percentages that must be accounted for on each deposit. The more reserves you have, the more a bank can lend, but there is more to it than that. As referenced in the reading, "money creation is thus limited because, in all likelihood, checks drawn by borrowers will be deposited in other banks, causing a loss of reserves and deposits to the lending bank equal to the amount of money that it has lent" (Brue and McConnell, 2004, p.265). Deposits and reserves go hand-in-hand because both are needed in the creation of loans which also draw interest rates which are profit generators for banks as well; therefore, consumers agree to pay an agreed dollar amount for borrowing money while the loan is outstanding.

Banks are not limited to loans as a means to creating money. They can also opt to purchase bonds with the excess reserves. As noted, "bond purchases from the public by commercial banks increase the supply of money in the same way as lending to the public does," and bonds generate money through interest rates much like loans (Brue and McConnell, 2004, p.265). Another source for money creation for banks is Federal funds rates which is an interest rate on excess reserves that are for "overnight loans" to banks that are "temporarily short of required reserves" (Brue and McConnell, 2004, p.260). In all, there are numerous ways for banks to create money. Banks impact the economy through the creation of money which is overseen by monetary policies that are outlined by the government.

For reference, monetary policy is defined as "the process by which the government, central bank, or monetary authority manages the money supply to achieve specific goals--such as constraining inflation or deflation, maintaining