Hello Palm Beach…Every wonder where money actually comes from….

Have you ever wondered where money comes from that you spend each day?  Each day we go about our business in Palm Beach spending money but have you really given any thought as to what is really backing all of those bank balances.   Those luxury vacations at area resorts or new cars you buy…what actually backs the money system in the United States.

The creation of money within the United States is mostly controlled by the Federal Reserve Bank.   Although the Federal Reserve is the main control mechanism the money multiplication process takes place within the commercial banking system where excess reserves are used to create new loans and inject more money into the economy.  The monies that are being injected into the economy can cause an out of balance affect and lead to increased inflation and an unbalanced economy.  The balancing of the economy is the main responsibility of the Federal Reserve.  The Federal Reserve employs techniques such as open-market operations, reserve ratio adjustments, and discount rate changes to keep the economy in equilibrium.  The equilibrium results in a controlled inflation rate, decreased unemployment, appropriate gross domestic product growth, and an overall efficient economy

Money in the United States is not created as many people might think through paper printing methods.  Although money is printed in the United States, the majority of our money exists only as IOU’s and agreements between customers and banks.  The Untied States uses a system of banking known as the fraction reserve banking system in which they are required to hold a specific percentage of checkable deposits on site at the commercial banks vault or at the Federal Reserve in the event that the owner would like to withdrawal their funds (McConnell & Brue, 2005).  This system allows the commercial banks to extend credit to its customers without physically having the money on hand that they are borrowing.  The fractional reserve banking system allows for the paper creation of money through lending.

The commercial bank is only required to maintain on site or at the Federal Reserve a small portion of checkable deposits for which the commercial bank is liable.  The reserve ratio is dictated by the Federal Reserve and stands at 10% and was last changed in 1992 (McConnell & Brue, 2005).  At the 10% reserve ratio, the commercial banks are able to lend 90% of their checkable deposits to potential customers.  Hence, as the entire amount of the deposit is held at the banks vault or at the Federal Reserve in their district, they will have an excess reserve ration of 90% allowing them to extend the excess reserves as credit to new customers through loans.  As the initial excess reserve is lent to a new customer the money creation process truly begins.

The money creation process starts to multiply as the 90% of excess reserves are giving to prospective lenders to reinvest and spend in the economy.  After the initial deposit of $100 was given to the bank, there is a reserve of $90 to lend to a new customer.   As this $90 was given to a new customer as currency, this currency was taken to a new bank and deposited as a checkable deposit.  The system multiplies itself throughout the banking process creating money along the way.  This multiplication process is known as the monetary multiplier and is explained as the spending of one household becomes the spending of another household and magnifies the effects of the original deposit (McConnell & Brue, 2005).  The multiplier equates to the reserve ratio divided by one and multiplied by the excess reserves of the checkable deposit.

The multiplication process is a process that involves all commercial banks in coordination with the Federal Reserve banking system.  The required reserves are mostly maintained at the Federal Reserve and as the borrowers of the multiplied monies deposit their checks, they allow the Federal Reserve to transfer money from one lender’s reserves to another.  As they banking system creates money, the Federal Reserve must regulate the creation process to protect against increased inflation, allow appropriate cash flows for the optimal economic conditions, and maintain equilibrium Gross Domestic Product.

The federal government passed a law in 1946 known as the Employment Act of 1964 in which it was stipulated that the federal government must use all practical resources that follow the market system to create economic conditions that enable employment opportunities to become available (McConnell & Brue, 2005).  In essence, the federal government has the responsibility to maintain prosperous economic conditions through its monetary policies and spending.  This law led to the creation of the Council of Economic Advisors who advice the President on the economic matters of the nation (McConnell & Brue, 2005).  The federal government uses governmental spending and tax changes to fulfill its responsibility created by this law.  Although the federal government plays a role in maintaining economic equilibrium, the Federal Reserve tends to control the economic production of the nation more quickly with its implemented monetary policies.

Although the Federal Government uses policies to stimulate and control economic conditions, the Federal Reserve must also maintain polices that lead to increased production and promote economic stability (United States of America: Economic Policy, 2007).  The Federal Reserves main control mechanisms to influence nation’s economy include open-market operations, adjusting the reserve ratio, and changing the discount rate.  These mechanisms can be used to administer easy money or a tight money policy for the nation depending on which policy best fits the adjustments needed during current economic conditions.  The main methods of developing an easy money strategy include buying securities from commercial banks, lowering the reserve ratio, and lowering the discount rate (McConnell & Brue, 2005).  These policies are mostly used when the nation is not running at full potential in relations to Gross Domestic Production, experiencing lower inflation, and are showing higher than normal unemployment rates.  A tight money policy dictates that the Federal Reserve should sell securities to commercial banks, increase the reserve ration, and raise the discount rate (McConnell & Brue, 2005).  These policies are usually implemented when the nation is facing increased inflation created from a demand pull in spending.  The ultimate goal of the Federal Reserve is to maintain equilibrium economic growth through these policies.

The combinations necessary to maintain a proper balance between economic growth, low inflation, and a reasonable rate of unemployment change within each economic cycle of our economy.  As the economy moves from peaks to troughs during an economic cycle different stimulus is needed to correct the market equilibrium.  In order to achieve the correct balance between equilibrium growth and recession the Federal Reserve must ensure its policies are not offset by other economic factors such as lags, changes in velocity, and cyclical asymmetry (McConnell & Brue, 2005).

The most used policy to maintain economic growth, low inflation, and optimal unemployment rates is the open market operations which include the buying and selling of government securities to limit or increase the available money supply.  As the Federal Reserve buys securities from the commercial banks, the reserves for these banks are increased allowing for the commercial banking system to increase the monetary supply of the country.  The increased monetary supply leads to increased spending by the consumers, increased capital investment by corporations, and higher employment rates as the economy has a high influx of funds and the interest rates will be lowered enticing investors to spend their money rather than investing (McConnell & Brue, 2005).  Adversely, the added cash flow into the economy will also eventually lead to inflation as their will be a higher demand for goods and services due to the increased money supply.

Open-market operations can also be used to decrease spending, increase the interest rate, and slow inflation.   The Federal Reserve accomplishes this end by selling securities to the commercial banking system and the public.  The resulting affect is attributed to the fact that the reserves of the commercial banking system is lowered allowing for less money to be created through loans.  Beyond the commercial banking system spending for the public will also decrease as their disposable income is lowered due to investments.  A security selling policy used by the Federal Reserve will result in a higher interest rate, higher unemployment, lower inflation, and slowed economic growth due to the decrease in cash available to the country.

The reserve ratio is another tool available to the Federal Reserve to control the equilibrium conditions of the nation.  As the Federal Reserve has not changed the reserve ratio since 1992, this method is less used by still effect in changing monetary policy (McConnell & Brue, 2005).  The Federal Reserve can increase or decrease the required reserves held by the commercial banking system.  When the reserve ratio is lowered it allows the commercial banking system to use excess reserves as new loans infusing the economy with new money.  The infusion of money creates more jobs which lowers unemployment, decreases the interest rate, and allows for strong economic growth.  Conversely, raising the reserve ratio requires the commercial banking system to reduce loans and increase reserves slowing the lending process.  This slowdown effectively reduces the money supply, increases the interest rate, increases unemployment, and slow economic growth.

The discount rate is another effective medium to control the economic output of the country.  As the Federal Reserve raises the rate it charges commercial banks for loans and are less likely to borrow from the Federal Reserve and turn to other commercial banks for loans decreasing the money supply lending to a slow down in economic growth.  Adversely, when the Federal Reserve decreases the discount rate commercial banks are encouraged to borrow money from them increasing the money supply available to make new loans and inject new money into the economy.

The money in the United States economy is generated mostly through the commercial banking system.  The United States uses a fractional banking system in which the commercial banks are only required to keep a percentage of demand deposits on hand at any given time.  The excess reserves allow these banks to loan customer’s money and increase the money supply.  An increase in money can have both positive and negative effects.  The Federal Reserve uses open-market operations, reserve ratio requirements, and discount rate adjustments to control these effects and steer the American economy toward growth, decreased inflation, and full natural employment.

Author: Jason Bloom, in Palm Beach Gardens, Jupiter, and all of Palm Beach County

References

McConnell, Campbell R., & Brue, Stanley L. (2005). Economics: Principles, Problems, and

Policies (16th ed.). New York: The McGraw Hill Companies.

United States of America: Economic Policy. (2007). The Economist Intelligence Unit, (), 34-

  1. Retrieved October 21, 2007 from EBSCOhost database.

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