Modern Money Mechanics

If money is viewed simply as a tool used to facilitate transactions, only those media that are readily accepted in exchange for goods, services, and other assets need to be considered. Today, in the United States, money used in transactions is mainly of three kinds:

• Currency - Paper money and coins in the pockets and purses of the public
• Demand deposits - Non-interest-bearing checking accounts in banks
• Other checkable deposits - Such as negotiable order of withdrawal (NOW) accounts

Since $1 in currency and $1 in checkable deposits are freely convertible into each other and both can be used directly for expenditures, they are money in equal degree.

In the United States neither paper currency nor deposits have value as commodities. Intrinsically, a dollar bill is just a piece of paper, deposits merely book entries. Coins do have some intrinsic value as metal, but generally far less than their face value.

What makes these instruments acceptable at face value is mainly the confidence people have that they will be able to exchange such money for other financial assets and for real goods and services whenever they choose to do so. Money, like anything else, derives its value from its scarcity in relation to its usefulness.

Control of the quantity of money is essential if its value is to be kept stable. Money's real value can be measured only in terms of what it will buy.

Changes in the quantity of money may originate with actions of the Federal Reserve System (the central bank), depository institutions (principally commercial banks), or the public. The major control, however, rests with the central bank.

The actual process of money creation takes place primarily in banks. As noted earlier, checkable liabilities of banks are money. These liabilities are customers' accounts. They increase when customers deposit currency and checks and when the proceeds of loans made by the banks are credited to borrowers' accounts.

This unique attribute of the banking business was discovered many centuries ago. It started with goldsmiths who initially provided safekeeping services, making a profit from vault storage fees for gold and coins deposited with them.

If deposit money can be created so easily, what is to prevent banks from making too much - more than sufficient to keep the nation's productive resources fully employed without price inflation?

The modern bank must keep available, to make payment on demand, a considerable amount of currency and funds on deposit with the central bank. The bank must be prepared to:

1. Convert deposit money into currency for depositors who request currency
2. Make remittance on checks written by depositors and presented for payment by other banks
3. Maintain legally required reserves, in the form of vault cash and/or balances at its Federal Reserve Bank

The legal reserve ratio together with the dollar amount of bank reserves are the factors that set the upper limit to money creation.

Currency held in bank vaults may be counted as legal reserves as well as deposits (reserve balances) at the Federal Reserve Banks. Both are equally acceptable in satisfaction of reserve requirements.

Because either can be used to support a much larger volume of deposit liabilities of banks, currency in circulation and reserve balances together are often referred to as 'high-powered money' or the 'monetary base.' Reserve balances and vault cash in banks, however, are not counted as part of the money stock held by the public.

For individual banks, reserve accounts also serve as working balances. Banks may increase the balances in their reserve accounts by depositing checks and proceeds from electronic funds transfers as well as currency.

Let us assume that expansion in the money stock is desired by the Federal Reserve to achieve its policy objectives. One way the central bank can initiate such an expansion is through purchases of securities in the open market. Payment for the securities adds to bank reserves. Such purchases (and sales) are called 'open market operations.'

When the Federal Reserve Bank purchases government securities, bank reserves increase. This happens because the seller of the securities receives payment through a credit to a designated deposit account at a bank which the Federal Reserve effects by crediting the reserve account of that bank.

Expansion takes place only if the banks that hold these excess reserves increase their loans or investments. Loans are made by crediting the borrower's deposit account, i.e., by creating additional deposit money. This is the beginning of the deposit expansion process.

The total amount of expansion that can take place is illustrated in the booklet. Carried through to theoretical limits, the initial $10,000 of reserves distributed within the banking system gives rise to an expansion of $90,000 in bank credit (loans and investments) and supports a total of $100,000 in new deposits under a 10 percent reserve requirement.

The deposit expansion factor for a given amount of new reserves is thus the reciprocal of the required reserve percentage (1/.10 = 10). The multiple expansion is possible because the banks as a group are like one large bank in which checks drawn against borrowers' deposits result in credits to accounts of other depositors, with no net change in total reserves.