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How money is created

When money is deposited in a bank it can then be lent out to another person. If the initial deposit was $100 and the bank lends out $100 to another customer the money supply has increased by $100. However, because the depositer can ask for the money back, banks have to maintain minimum reserves to service customer needs. If the reserve requirement is 10% then in the earlier example the bank can only lend out $90 and thus the money supply increases only to $90. This relationship between increase in money supply and reserve requirement is expressed as:

m = 1 / RR

where

m = money multiplier
RR = reserve requirement

Federal Reserve and money supply

The Federal Reserve has three main mechanisms for manipulating the money supply. It can sell treasury securities, which reduces the money supply (because it accepts money in return for a promise to pay in the future). It can also purchase treasury securities, which increases the money supply (because it pays out hard currency in exchange for accepting securities). Finally, the Federal Reserve can adjust the reserve requirement. The reserve requirement is directly related to the money multiplier as shown above.

How money is created - Process Overview

Below is an outline of the process which is currently used to expand the monetary base of the Economy in order to accommodate the growth of production. Much of the movement of the US Economy is artificially engineered through the monetary policy crafted by the Board of Directors of the Federal Reserve System - a group of private banking corporations which are chartered by the national government to influence the ].

1. One This first step is required for processes which occur later. Prior to expansion of the amount of money in the US Economy, we'll assume that Congress has - at some point - needed more money than it had taken in through taxes. In order to raise money, it increases the amount of the National Debt by ordering the creation of an I.O.U. - typically, this will be a Treasury Bond (Further information: Treasury security). It offers the IOU for sale, and someone pays cold, hard cash to the government for the IOU. The IOUs generally do pay about 5% interest to the owner. It is these IOUs that will play a role later in the process. Note that sometimes your local bank is the one to buy these IOUs.

1. Two The 12-person Board of Directors who head the Federal Reserve System meet and determine how they would like to influence the economy. They create a plan called the country's "monetary policy" which sets targets for things such as interest rates.

1. Three Your local bank goes through it's daily transactions. Of the total money deposited at banks, only a small bit of it ever is removed. So, banks decide to make use of this bulk of "non-moving" money by loaning it out. Banks do have a legal requirement to keep a certain percentage of money on-hand at all times.

1. Four According to it's estimates for it's plan for the US Economy, the Federal Reserve places an order for money with the US Treasury Department. The Treasury Department sends these requests to its operations called the Bureau of Engraving and Printing (to make the paper dollar bills) and the Bureau of the Mint (to stamp the coins).

1. Five The US Treasury sells this newly printed money to the Federal Reserve for the cost of printing. This is about 4 cents per bill (even the 100 dollar bills)!"Money Facts". Retrieved 2008-01-06. Aside from the minimal costs, the only other obligation made is that the Federal Reserve has to simply pledge collateral for the money received.

1. Six Every business day, the Federal Reserve System engages in what is called "Open market operations." If the monetary policy has planned to increase the amount of US dollars floating around, then they will hold small bidding contests to buy US Treasury Bonds from banks. So, the banks will send those government IOUs to the Federal Reserve and the Federal Reserve will send that newly printed money to the local bank. The reverse is often done as well, but generally, at the end of the year, there will be more money sent out to local banks, than money taken in from them.

1. Seven Now that the local bank has more cold hard cash, it loans out the money, and this is how money reaches the hands of the public --- through bank loans. In 2003, bank loans averaged an interest rate of 9%."FDIC Banking Review". Retrieved 2008-01-06., which also closely matches the 9.84% average interest rate drawn from FDIC data spanning the 21 years from 1980 through 2001 .

In, summary, every single US Dollar anywhere in the world represents a current outstanding loan of some American somewhere.

Ramifications of the Economic Regulation Process

Occassional Deficit Spending is a requirement in a growing economy. The current economic process uses Treasury Securities which only exist when the nation is in debt. The Federal Reserve is said to hold approximately 45% of the National Debt"An $800 billion freebie, hidden in the national debt". Retrieved 2008-01-06. in order to support the monetary base, although that number should generally increase every year. The economy gradually transiotioned away from gold into the use of the National Debt as the basis of the economy. Experts are hopeful that other assets could take the place of National Debt as the fundamental basis, but there Alan Greenspan reports that there is no clear or easy plan."What will happen to the Fed if the national debt is paid off?". Retrieved 2008-01-06.

Despite the arguments of many "myth debunkers," Americans actually do have to pay for the money that is printed by our government. This payment is in the form of the interest that is charged on the bank loans - loans which are required in order for money to be injected into the economy (as noted in "Step 7" in the above process).

Additionally, the fact that economic growth must be coupled with debt is argued to create a social conflict.

Finally, the involvement of bank loans ties the economy to the problems of compounding interest. Many people theorize (including those at the Federal Reserve) that the amount of money is directly related to the value of each dollar . Thus, this exponential need for more and more money may be contributing directly to inflation in the US. Inflation raises the cost-of-living for everyone, and if inflation exceeds the growth of income, then people are effectively made poorer over time through no fault of their own.

Money supply, interest rates and the economy

When interest rates go down, money supply increases. Businesses and consumers have a lower cost of capital and can increase spending and capital improvement projects. This is encourages growth. Conversely, when interest rates go up, the money supply falls and reins in the economy. The Federal reserve increases interest rates to combat inflation.

Criticism of monetary policy

Some free market economists, especially those belonging to the Austrian School criticise the very idea of monetary policy, believing that it distorts investment. In the free market interest rates will be set by saver's time preference. If there is a high time preference this means that savers will have a strong preference for consuming goods now rather than saving for them. Thus interest rates will rise due to the low supply of savings. With low time preference interest rates will fall. The interest rates send signals to businessmen as to what is worth investing in, low interest rates will mean that more capital is invested.

Monetary policy means that the interest rates no longer represent consumer time preferences and so investments are made by businessmen with the wrong signals. Lower than market interest rates will therefore mean a higher investment than the economy desires. This will mean that there will be capital goods that have been over invested, and will need to be liquidated. This liquidation is the cause of the depression that makes for the business cycle.

See also

• Monetary policy
• Money supply

External links

• Savings rate viz Fed rate from 1954 Historical relationship between the savings rate and the Fed rate - since 1954
• USA Fed rate behavior under various presidencies since 1954

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1. Wasow, Bernard, Fiscal Hangover; AScribe Newswire, Dec 11, 2007

• Orphaned articles from July 2007
• Articles lacking sources from July 2007
• Monetary policy