Money is created by two methods. The fractional reserve method creates money when a commercial bank lends money. A bank only needs to keep a fraction of the money it lends in reserve so it can lend $980.00 and keep $20.00 on reserve as cash on hand.

If $200.00 is paid back the bank can lend $198.00 and retain $2.00 in its reserve.

When governments need money and cannot obtain enough by taxation it offers to borrow money. This is accomplished by printing a bond. A bond is an IOU so the government may print a bond valued at $10,000.00. A bank or other institution will purcase the bond on the open market. The bond has to be redeemed by the government at some point in the future and in the meantime pays interest.

Government borrowing does not create new money it sells one financial asset, a bond for another, bank deposits. The government uses the depsits to pay its expenses.

When the government wishes the economy to expand it gets the Central Bank to buy bonds from the lending banks. This gives the lending banks more money to lend and this puts more money into the economy.

If interest rates drop and still the private sector will not increase their debt the government can borrow on the strength of the bonds it sells, the banks get money to lend by selling the bonds to the Central Bank.

 

Contracting Economy:

If the economy is contracting loans are being paid back. Businesses and individuals deposit money in lending banks and reduce their debits. If this money cannot be loaded out it accumulates in the banks vaults, at some point in time the bank will package it up and ship it to the Central Bank.

The Central Bank will reduce the debt of the lending bank by the amount returned. If too much money is being returned the Central Bank can reduce the rate it charges the lending banks to encourage them to reborrow the money.

Lower inter-bank rates allow the lending banks to offer loans at lower rates of interest. But if the economy is not doing well even low rates of interest may not encourage more borrowing by the private sector. In this case government borrowing may increase.

 

Expanding Economy:

In an expanding economy the lending banks need more money. Money is an infinitely divisible asset. It is the capacity to be divided into precise numerical units that allow an asset to be treated as money. Governments back paper money which makes it an asset but it is its capacity to be produced as multiples of each other that makes fiat currency money.

When an asset cannot be divided into precise multiples it has to be bartered. Cars are bartered for money. Money is bartered for all types of goods and services including other forms of money because as money it can be packaged into an infinite range of sizes.

Money normally enters the economy as debt. Banks lend businesses and individuals money. If the economy is expanding more and more loans will be made until the bank has no more funds. Central banks can reduce the level of reserves needed to increase the amount of money available for loans. If the resrve is 100% no money can be loaned. IF the reserve is 50% then have of the money the banks have can be provided in loans. If the reserve is 80% then 80% of all money the banks have or get can be loaned out.

But the factional reserve cannot be set at 0% because banks have to hold back a certain amount of currency for day to day expenses. People and businesses have to have access to the money they have on deposit.

When the Central Bank sees the economy slowing down and interest rates increasing it can make more money available to the system by purchasing debt from the lending banks. When a Central Bank purchases $10 million in bonds from the lending banks, the lending banks have $10 million minus the reserve limit to lend.

This does not necessarily means that $10 million in new bills are printed. Bills are printed as the system needs cash. If cash is not required and the money lent is used by writing cheques or using debit cards then no more paper dollars need by put into the system.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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Creation Of Money