How the money system works

Today, I want to give an overview of how the money supply system works. Money, in this context, means anything people use to pay for things-like cash or what’s in your checking account. It’s something we all agree can easily be used to buy stuff now or in the future.

Most of us probably know that when you deposit money into a bank, the bank doesn’t keep all of it in a vault. It’s only required to keep a small part-called reserves-and can lend out the rest. This is called a fractional reserve banking system, and it’s how banking works in every country today.

But have you ever thought about what happens to your money after it’s loaned out? That money eventually ends up in another bank, where the same thing happens again: some is kept, and some is loaned out. Every time money that is deposited is loaned out, new money is created.

Because of this system, the total amount of money in the economy ends up being much larger than the amount of physical cash created by the government. In the US, for example, the amount of money is around $18.7 trillion by one definition, but the amount of currency in circulation is only about $2.4 trillion. The monetary base, which also includes money that banks have in reserves, is only about $5.7 trillion.

Let’s go through a simple example of how this process works.

Say banks keep 10% of deposits and lend out the rest. If Anne deposits $100 in Bank A, the bank keeps $10 and loans $90 to Bob. Bob deposits the $90 in Bank B, which keeps $9 and lends $81 to Carol. Carol deposits the $81 in Bank C, and so on.

If you add it all up, Anne has $100 in her account, Bob has $90, Carol has $81-and the total keeps growing. Eventually, this process creates up to $1,000 in deposits from just that original $100 of cash. Of course, if people keep some of their money as cash and banks lend out less or more, the eventual amount of money in the system will differ, but in almost every case it will be larger than the amount of cash in the economy.

It’s important to note that this process isn’t fraudulent or harmful. Fractional reserve banking doesn’t create new stuff or new wealth-it just increases liquidity, or the amount of money available for spending. In other words, banks help stretch the same dollar across many transactions. And this kind of money creation is an ongoing process that’s generally smooth and happening constantly without us noticing. Of course, things can go wrong if banks suddenly decide to cut back on loans sharply or people start holding a lot more cash. But in that case, the Federal Reserve is very likely to take swift action to make sure the amount of money in the economy doesn’t fluctuate dramatically. We’ll see how the Fed controls money supply in another post.

Originally published at https://mytwocentsandcounting.substack.com.