The Nature and Creation of Money

1. The Nature and Creation of Money
“A bank is a place that will lend you money if you can
prove that you don’t need it.”
-Bob Hope
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2. We have an interesting
relationship with money!
I am routinely amazed at how willing people are to accept small pieces
of paper in exchange for labor or a good or service.
They do not question the paper’s intrinsic value, it’s
producer, or its origin.
They simply have faith that the next person will take it….
…because they always have.
Let’s stop to think about it…what is money? What are its
functions? And who controls it?
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3. What are the
functions of money?
1-Medium of Exchange
2-Unit of Account
3-Store of Value
It is very convenient to exchange money for
goods and services. If it were not available, you’d
have to find someone that had a demand for
whatever you were trading. That would
significantly slow down an economy.
With money, we can compare the value of any
two goods, even if they are unrelated.
With money, we can work today and enjoy the
benefit of that work in the future. Imagine if you
were paid in a perishable good such as milk. You
would not be able to keep it for any length of time.
Keep in mind that money is not a good store of
value over long periods. It erodes due to inflation!
In our reading material,
three functions for money
are outlined…
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4. There are at least two other functions
of money not covered in the reading
Money is a Brand Statement
– Money is used to demonstrate the culture of a
country.
– On the next slide, we’ll look at the pictures: they
include kings, queens, founders, religious
buildings, animals and other proud symbols.
Money is a Speculative
Instrument
– Currency traders buy and sell currency in the
hopes of gaining value over time.
– Foreign Exchange or “Forex” is the largest
market in the world with more than $4 trillion
traded every day.
– Only 2.5% of forex is in exchange for goods and
services. The rest is “bet” in speculative
investments. Slide 4 of 32

5. A brand statement indeed!
Enjoy this sample of world currencies. I think you
will be astonished by the variety, color, and choice
of symbolism.
I think you will agree…
…This rainbow of currency
makes our “Greenbacks”
look boring!
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6. What backs our money? In other words, how do you
know it is worth the number that is printed on it?
More specifically, it is backed by the
promise of our federal government that
they will keep the value stable.
Nothing!!!
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7. Where does our money come
from…part 1?
Currency and coins are either
printed or stamped by the Federal
Government.
Bills are printed by the U.S. Bureau
of Engraving in Washington DC.
They offer tours, but not free
samples .
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8. Our currency used to be backed by
precious metal
These “Silver certificates”
were worth a dollar in
silver. You could go to a
Federal bank and obtain a
dollar in silver in exchange
for them at any time.
Look at the
language…clearly, the
government was trying to
reassure people that these
notes were valuable.
The U.S. abandoned the
use of precious metal in
1973 in what was called
“The Nixon Shock”.
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9. Where does our money come
from…part 2?
Money is also created out of thin
air by the U.S. Banking system.
In fact, we depend on banks to
perform this important task.
Right about now you must be
wondering…”how do banks create
money out of thin air”?!?!
Slide 9 of 32
The money creation process is
a Key Learning Outcome so
lets see how it unfolds….

10. So how do banks create money?
Let’s take a trip down memory lane
In early history, owning gold was risky. Houses did not have locks and towns did not have
lights. Owning and possessing gold was dangerous.
There might have been one person in the village that had a
safe place to keep gold. The goldsmith, who made jewelry and
other things, had to keep gold in his or her inventory. As such,
they had a secure house and guards.
People realized this and starting asking the goldsmith to keep
their gold (and other valuables) in his or her house.
He or she agreed, for a fee.
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11. A “100% reserve system”
To keep track, the goldsmith would issue receipts for the gold he held.Eventually, people started to trade receipts instead of gold.These receipts were like paper money but were fully backed by gold.We all knew the goldsmith so we trusted the system…wouldn’t you?
These tickets are
good as gold.
Every time I ask the
goldsmith to redeem
the, he seems to have
the gold ready.
This is an
example of a
100% reserve
system: Currency
in circulation is
fully backed by
gold (or other
valuable item)
held in reserves
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12. I have never seen
everyone come and
cash in their
receipts at the
same time.
In other words, I
have never had
all my “reserves”
called for at once!
The birth of the “fractional reserve system”
This is an
example of a
Fractional reserve
system: Currency
in circulation is
only partially
backed by gold
(or other valuable
item) held in
reserves
“I think I’ll print some
fake receipts and
spend them or loan
them out for profit!”
To see how
money can be
created, follow
this goldsmith's
thoughts.
And this would work
fine unless everyone
turned in their
receipts at the same
time.
He just created
money out of
thin air!
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13. What if everyone did ask for their
gold back at the same time?
• If every customer asked for their
deposits back, the goldsmith could
not meet demand.
• If you heard that the goldsmith was
running low on gold, you’d probably
RUN there to get your gold.
• If everyone did that, the goldsmith
would be in trouble-there simply isn’t
enough gold in the vault to meet
demands.
• In modern times, that is called a
“bank run” or “bank panic”.
Give me my
money!
Give me my
money!
Give me my
money!
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14. See this link for some anecdotal interviews of bank runs:
Source: Wessels Living History Farm.
“Bank Runs” or “Bank Panics” were
tough on the economy
Bank runs were not pretty.
In many cases, a lot of people
lost their life savings.
In some cases, the banker
would be killed.
Sometimes banks would be
burned to the ground in hopes of
burning the mortgage paperwork
inside!
Bank runs were a perpetual
event in the 1800s and early
1900s. They were very
disruptive.
The picture shows a bank run.
Some of those people would get
their money back. Many would
not.
http://www.livinghistoryfarm.org/farminginthe30s/money_08.html
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15. What prevents bank runs now?
Three things help prevent bank runs now:
#1: Deposit Insurance
The U.S. Federal government insures your
deposits in many banks up to $250,000. If the
bank fails, they will pay you.
#2: The Discount Window
The U.S. Federal Reserve (discussed later)
stands ready to loan money to banks that are “in
trouble”. If a bank nears bankruptcy, it can
borrow from the “Fed”
#3: The Required Reserve Ratio
Banks are forced to hold a portion of your
deposits in reserve so that they can meet
demand for withdrawals.
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16. Required Reserve Ratios help
prevent bank runs
Today, when you deposit
money in a bank, that bank
is required to hold some of it
in reserve.
Typically, banks are
required to hold 10% of all
deposits.
The required reserve ratio
has a big role in “money
creation”.
If you deposit $1000 in a bank today, then
a bank will hold $100 and loan out the
remaining $900 (in normal times)
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17. Examine the table that follows to see how
much money is created given a 40% RRR
and a $10 million deposit
That loan of $900 creates money out of thin
air. You still have $1000 on deposit, yet
someone else is now carrying around that
$900.
But it doesn’t stop there!
Let’s return to the question:
How do banks create money?
A new deposit of $10 million is made
in a bank called Bank A.
Bank A holds 40% ($4 million) in
reserve and loans out the rest. $6
million has been created!
That $6 million would eventually get
deposited somewhere else, perhaps
in Bank B.
Bank B holds 40% ($2.4 million) in
reserve and loans out the rest. $3.6
million has been created!
That $3.6 million would eventually get
deposited somewhere else, perhaps
in Bank C.
Bank C holds 40% ($1.44 million) in
reserve and loans out the rest. $2.16
million has been created!
This cycle continues over and over, each time getting smaller until eventually,
a total of $25 million in deposits have occurred. The original deposit was $10
million. Banks have created $15 million!
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18. How does the required reserve ratio
affect money creation?
Here is another scenario where the required reserve ratio is 3% instead of 40%.
Notice how a lot more money is created with a lower required reserve ratio. In this
case, $10 million in an initial deposit results in $333.3 million of total deposits. $323.3
million has been created!
The real lesson here is this: A lower Required Reserve Ratio causes a lot more money
to be created. But it also causes reserves to be low which can threaten the health of
the bank. If reserves are low and we all come calling for our deposits…they will not
have them! A balance must be found…many developed countries require banks to
hold around 10% of deposits in reserve.
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19. Calculating money creation
There is an easier way
to calculate money
creation.
= 1/.03 = 33.3333
= $10 million * (1-.03)= $9.7 million
= $9.7 million * 33.33 = $323.3 million
Step one:
Calculate the money
multiplier
Step two:
Calculate the initial
excess reserves
Step three:
Multiply the money
multiplier by the initial
excess reserves
Understanding how the
banking system creates
money is a Key Learning
Outcome!
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20. You try it!
Please fill in all blank cells and answer the question below.
In which Scenario is more money created and why? ___________________
Scenario#1:Required
ReserveRatiois50%
Scenario#2:Required
ReserveRatiois25%
The second because the
reserve requirement is lower!
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21. More practice!
$90 million
Less
Please fill in the blank cells and answer the questions below.
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22. So how much money is there?
That depends on how you measure it.
If you count currency only, there is about
$1.1 trillion in circulation.
But what about all that “created” money?
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23. Includes M1 and:
Savings deposits
Small time deposits
(CDs)
Money Markets and
Mutual Funds
Money (what we will call the Money Supply)
is measured two ways: M1, and M2
Includes
Currency in circulation
(coins and bills)
and Money in
checking accounts
M1
M2
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24. Definition Type Value, in Billions Percent of Total
Currency $1,109.6 11.9%
Traveler's Checks $3.8 0.0%
Demand Deposits $811.7 8.7%
Checkable Deposits $443.5 4.7%
Savings Deposits $5,729.0 61.4%
Small Time Deposits $603.9 6.5%
Money Market Funds $635.4 6.8%
M1 + M2 $9,336.9 100.0%
U.S. Money Supply- as of March 2013
M1
M2
M2 = $9.4 trillion
Current Money Supply
M1 = $2.37 trillion
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25. Money creation…we need it!
Let’s take a quick review
Our government has allowed $1.1 in bills
and coins to circulate.
But our banking system has expanded
that supply of money to $9.4 trillion
through the money creation process.
All that money floating around facilitates
commerce – it lets us trade with each
other and makes our economy go!
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26. As an economy grows, it requires
more currency to facilitate trade.
Over time, the money supply has grown to
accommodate a larger economy
So who manages it?
As can be seen here, the U.S. money
supply (M2) increased from around $3
trillion in 1990 to $11 trillion in 2013!
Changes in this measure can also be used
to offset shocks.
For example, as the 2008 financial crisis
occurred, the money supply was increased
to help soften the economic impact.
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27. The U.S. Federal Reserve “The Fed”
A Review of the U.S. Federal Reserve System
If you have ever been to Washington D.C., You may have seen this
building. It is the U.S. Federal Reserve headquarters, located across the
street from the Lincoln Memorial on Constitution Ave.
27

28. What is the Federal Reserve System?
The Federal Reserve System is the monetary
authority in the United States.
That means that they are in charge of determining
how big the money supply should be.
“The Fed” was created by Congress in the Federal
Reserve Act of 1913 after a banking crisis in 1907.
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29. How is the Fed Organized?
• Part One: Board of governors
• The central governing body
• Consists of 7 members-Presidentially appointed Senate
confirmed
• Every 2 years a term expires
• One member is appointed as chairman for 4 year term,
and can be reappointed
• A full term is 14 years and cannot be reappointed
• Current Chairman is Ben Bernanke
These long terms are key – they are
designed to insulate Fed officials from
political pressure.
Any president would want the money
supply expanded as it might “rev up” the
economy.
But doing so could cause a lot of inflation
and might not be in the American people’s
interest.
Fed Governors have long terms so that
they can resist this pressure. Something
tells me it is still applied though!
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30. How is the Fed Organized?
• Part Two: Federal Reserve District Banks
• U.S. is divided into 12 districts, each has a district bank
• Each acts as a central bank for its district
Our Federal Reserve District
Bank is in Richmond.
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31. How is the Fed Organized?
• Part Three: Federal Open Market Committee
• Consists of 19 member: 12 with a vote, 7 non voters.
– Voters:
» Seven Governors from the B.O.G.
» NY District Bank President
» Four other members rotate through the remaining eleven
districts
• The FOMC assesses the economy to determine if
changes in the money supply are needed.
We will learn in a future module how this works.
For now think of it this way:
If the Fed believes the economy is
in recession, it can increase the
money supply, allowing more
money to circulate. That will
increase spending!
If the Fed believes inflation is the
main worry, it can decrease the
money supply, allowing less
money to circulate. That will
reduce price pressures!
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32. In Summary
Money has many functions including
facilitating commerce.
Money has historically been backed by
precious metal but in the U.S. and all other
developed countries, that is no longer true.
Over time, the money supply can be
altered to facilitate more trade and to
manipulate an economy.
It is the job of the U.S. Federal
Reserve (The Fed) to manage our
money supply.
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