Unclear on one aspect of money creation

Economics Economics Questions
1

I will be very grateful if anyone can help me resolve this question. I took a Money & Banking course in college, at which point I thought I understood how money was created by borrowing. Soon after the class was over, I got confused on one part of it, and the textbook explanation no longer satisfies me. I’ve been bugged by this issue for nearly 20 years now.

If the Fed creates money by buying a government security (or anything else), I can understand how that creates money: it credits the selling bank’s account, bang, new money exists.

If a bank creates money by issuing a bank note, I can understand that: it issues a bank note, the note circulates, bang, it serves as money that did not exist before.

Where I get confused is how a bank creates money by writing a check. The classic example is this: Bank A has $100 worth of deposits. It lends $90 to Joe in the form of a check, which Joe promptly deposits in Bank B. Now there is $190 in existence: $100 at Bank A, $90 at Bank B. Bank B lends out $81, subsequent banks keep lending out until they all have only 10% reserves, and gobs of money are created.

Only I don’t see how. In the very first step, there is supposed to be $100 left at Bank A. That’s true only if you count the loan as “money,” because Bank A really has only $10 worth of reserves. If the depositor who owns that money tries to spend $11 or more, Bank A is either bankrupt or has to borrow money or take some other action to get cash – it can’t meet the demand. It seems to me that there is still only $100 in circulation: $10 at Bank A, and $90 at Bank B.

It’s the same, effectively, as if I loaned someone $100. He has the $100; I don’t. I haven’t increased the amount of money in circulation, only moved it to a new owner. The only way new money could be created is if the form of debt itself somehow circulated, as in a bank note. Since every example I have read shows the loaned money being deposited directly, and hence subtracted from Bank A’s reserves, I don’t see where the new money comes from.

Obviously, I must be missing a step here, but I can’t figure it out, and it is driving me crazy. Thanks in advance for any assistance you can provide.

Sincerely,

Derek

2

Bank A isn’t handing out its reserves when it makes a loan to Joe for $90. They create $90 of new money when they make that loan. The amount of cash in reserves remains the same ($100). Now if owner of the deposit comes to withdrawal, the bank needs to borrow reserves from another bank or the fed to cover the reserve requirements, but the money that was originally deposited as reserves is still there.

Every time a bank makes a loan, brand new money is created.

3

Really? Where is that money coming from? Is the bank is just printing the money that it lends out? All the examples I have seen, including the one in my textbook and the one at Wikipedia (http://en.wikipedia.org/wiki/Fractional-reserve_banking), not to mention one of Rothbard’s papers that I read last week (don’t have the link handy), show the bank’s reserves diminishing by the amount of the loan.

4

Bank A gets $100 dollars deposited in a demand deposit account and lends out $90 which gets deposited in another account to be spent.

They now have $190 dollars in deposits and $90 in loans outstanding.

Bank B gets the check from the loan from whomever the loanee at Bank A bought $90 in goods from and presents it to Bank A for payment.

Bank A has $100 in demand deposits, $90 in loans and $10 sitting in the vault.

Bank B has $90 in demand deposits.

Bank B loans out $81 that ends up in Bank C.

Bank A: $100 in demand deposits, $90 in loans and $10 sitting in the vault.

Bank B: $90 in demand deposits, $81 in loans and $9 sitting in the vault.

Bank C: $81 in demand deposits.

Etc, etc…

The reason this is inflationary is because the demand deposits are available ‘on demand’ and act as money in their own right. People can write a check on them, use a debit card, whatever because they consider them to be money even though they are merely a fiction is some computer server. This fiction relies on the people with demand deposit accounts never withdrawing more that the amount in reserves or the bank is in violation of their contract with the depositor that their money is available ‘on demand’.

Now if someone deposited their money in a savings account with the full understanding that the money isn’t available on demand this doesn’t produce any new money since they are essentially loaning their money to the bank the same as if you loaned $100 to your friend.

5

Yes, technically speaking, the bank only has $10 in reserves. However, it acts as if it has the whole $100, and if it runs short, it either fails or it borrows from the Fed (“lender of last resort”). The implication of this is that the money in savings accounts, even if it isn’t fully backed up by physical money, still acts as money. I can still move $50 into another person’s account when I make a purchase, even though the bank only has $10 in reserves. As long as the other bank doesn’t demand the physical money, we’re in good shape.

However, as soon as there is a run on banks or something similar, we see those banks failing.

6

Thanks for your response.

In that case, it seems like the extra money is only in circulation during the time between (a) when someone writes a check that would overdraw the bank, and (b) when that check clears. If you’re not using the money in your account, it might as well be cash buried in your backyard for all it adds to the money supply. If MV=PY and V=0, there is no money supply – in other words, money only counts as such when it is used to buy goods. If you wallpaper your house with $100 bills, theoretically they are part of the money supply, but for practical purposes they are not.

Contrast that with bank notes. When a bank lends someone money in the form of a bank note, and that bank note circulates as money, there is extra cash in the economy – the bank note, plus any deposits the bank actually has. More money chasing the same amount of goods and services will inflate prices. Having $90 of money in a checking account that is not actually being used to purchase goods is not adding to inflation.

Sincerely,

Derek

7

Ah, if it borrows from the Fed, I can understand that that is creating money. All the Fed has to do is to credit the bank’s central deposit account, and, voilà, there is more money in circulation – the fact that the Fed has a “liability” is irrelevant, since it can always print money to cover its liabilities.

But then it would be the Fed creating money, wouldn’t it? As per my last message, if the money is sitting in the account not being spent, I don’t see why it should count. If it is spent, and the bank has to borrow from the Fed to stay solvent – well, I understand that, but it is a different issue, it seems to me.

Sincerely,

Derek

8

Not necessarily, because the bank doesn’t need to borrow money from the Fed (most of the time).

Take this example.

Person A deposits $100 in Bank 1.

Bank 1 lends out $90.

PA writes a check to Person B for $50.

Bank 1 transfers $50 “electronically” to PB’s account in Bank 2.

The bank just created $40 (100-90-50 = -40) even though it didn’t physically print the money. The reason this is possible is because of “electronic money,” that is, money that only exists on some computer somewhere, not real, physical money.

9

Thanks for sticking with me. I’m not trying to be difficult, I promise!

The example you provide only works if Bank 2 has permission to increase its reserves out of nothing. It’s not actually get anything from Bank 1 except an order that says, “Here, have $50.” If it is allowed to use that order to increase its assets, I get it. But the way it is usually explained (in explanations that go back to the Federal Reserve) is that, when the check clears, the Fed increases Bank 2’s reserve account by $50 and lowers Bank 1’s reserve account by the same amount. Since Bank 1 doesn’t have that much in reserve (it is only left with $10 after the loan to Person B), it would have to borrow the money from somewhere. If it comes from the Fed, we’re back to “I get it,” but we’re back to money coming from the Fed rather than from the bank.

What I suspect is that somehow, Bank 2 really is allowed to increase its reserves without subtracting from Bank 1 when it is dealing with a loan. That’s the only way I can make sense of it. But all the examples I have ever seen show Bank 1’s reserves being drawn down by the amount of the loan. That’s why, when it gets a $100 deposit, it only lends out $90 rather than $1000 (which would make more sense if it had a reserve requirement of 10% and didn’t run down its reserves by lending money). So I still have a disconnect somewhere.

The curious thing is, it makes perfect sense to me when dealing with physical bank notes. The minute the money becomes conceptual and goes in a T-account, however, I can’t see where any extra money is going into circulation.

Sincerely,

Derek

10

The bank writes a check(receipt redeemable for cash), but the cash(electronic or actual FR notes) remains in the banks computers until that check is deposited by someone. At that point the electronic money(typically) is transferred to the account of the depositor.

Let’s do an example:

You have 100$ of electronic money at your disposal from your debit card or checks.

They loan 90$ now to John. So now John has 90$ in his account and you have 100$ in your account. That’s an aggregate 190$.

So suppose John takes the check instead to bank B. Bank B is doing the same thing simultaneously. They have Jane’s 100$ on their accounts and have given a 90$ loan to Julie. Julie also takes that 90$ check to Bank A.

They wipe out the negative money really with negative money. So Bank A and Bank B just swap the 90$ checks essentially and the game continues.

Then both still have an aggregate positive reserve on hand.

The Federal Reserve in New York explains it well on their website:

I would like to mention on that page you will find that the current reserve requirement for most banks is around 3%. So that means the money supply from on demand deposits can be increased 33 times the original amount.

11

The problem is that the bank and everyone else counts both the money in your account and the money they loaned out.

‘New’ money (as in curculating currency) isn’t created per se but you end up with eight different people with a legal claim to the exact same dollar.

Oh, and don’t get me started on the Velocity of Money Fallacy…

12

This scenario does result in extra money, at least temporarily (as long as banks are exchanging equal amounts with each other). I wish I could find the link to that Rothbard paper I read last week. In it, he says that money creation through debt is limited by the size of the bank; money only gets created if the borrower’s check ends up getting deposited at the same bank from which the money was borrowed. He later says that the Federal Reserve doesn’t eliminate this problem, but it does allow all banks to expand together. That seems to be the scenario you have described. Unfortunately, it’s about the only place in his paper that Rothbard doesn’t provide t-accounts to demonstrate how things are different with the Federal Reserve; he just asserts that it works. I think your scenario is on the right track, but the Fed probably has some role.

Sincerely,

Derek

13

One thing that kind of economics fails to take into consideration is that the free market has a certain amount of resource reserves that need to be held of every kind of resource in the economy. Resources that are not used and that are reserved for times of emergency such as a natural disaster. If you take money and ‘increase it’s velocity’ artificially, then those resource reserves will be depleted and we will have a period of equal bust where the prices rise drastically until those resource reserves are replenished and their prices come back down to reflect the new money ‘velocity’(money supply).

So of course we can make a great party for a short time, but when the cellar gets close to empty, the party is over.

14

I’m not concerned with how the money gets counted or with who has a claim to it; I only want to know how many distinct dollars can be spent at any given time. Eight people might have a claim to a dollar, but they can’t all eight spend it at the same time, so it doesn’t seem like 8 dollars to me, only one. If we printed 8 dollars and gave each person one, they could all go to the store and buy something at the same time. If I have a single dollar and I give 8 people an IOU for $1 each, they can spend them all at the same time, too (presuming people will accept the IOU’s as cash).

Sincerely,

Derek

15

Except that if you keep $1000 cash in reserve, you aren’t actually reserving resources; you’re only reserving a demand for resources. That works fine as a model for individuals, but if there is a shortage of resources in an economy and everyone spends their reserves at once, nobody benefits; they just bid up prices.

But I wasn’t trying to argue in favour of increasing money’s velocity as a solution for anything; I was just pointing out that money that is not spent is not effectively “money” during that time. Of course, money is more often held than spent; I can only spend a dollar in an instant, but I can hold it for years. But there is certainly a distinction between circulating and non-circulating money. Let’s say we start a new country and give everyone $1000 to get started. Being prudent, everyone immediately buries $900 to keep for an emergency. If I open a store and try to sell a computer for $500, I’m not likely to get any takers, whereas if everyone had considered all their money disposable, I might. There’s nothing better one way or the other; in the first scenario, I could just as well sell the computer for $50 and not be any worse off. I’m just saying that, when we are talking about “creating money,” that money has to be available to be spent for it really to be money in a useful sense (i.e., in the sense that it will determine prices in the economy).

Sincerely,

Derek

16

That’s why you are having a problem understanding why this is inflationary.

You are confusing ‘curculating currency’ with ‘money’ (or as Mises calls it ‘fiduciary media’).

17

Money as was said is a entitlement to real property. Only when you sped it. If individual (x) deposits 100$ into bank (a) the bank only keeps a fraction of the 100$ as a reserve, the Federal Reserve sets what that fractional reserve must be. Most of time it is about 10%. So bank (a) keeps 10$ in the vault, sends and insurance fee for being FDIC of perhaps .1$. It then in turn loans out the other remaining money in the form of a loan. So bank (a) lends money out to individual (y). He gets his 90$ and buy lets say a used car from individual (z), individual (z) then deposits his 90$ into another bank, lets say bank (b), bank (b) must keep a fractional reserve on that of 9$ and can then lend out 81$. Lets say bank (b) lends out 81$ to individual (c) to buy a house. Individual (c) buys individual (d)'s home. Individual (d) then deposits that money into anther bank, and then gets lent out at 72 dollars and the reserve was 8. But lets go back to individual (c) and the bank that lent him the money for the mortgage, bank (b). Individual (c) makes payments on the loan for interest. Lets say 7%. The bank then has a security or an agreement that means individual (c) will repay 81$ plus interest. Bank (b) can then in turn sell this security on the market to investors. So maybe they sell it for 81$ plus 1% of the interest. Perhaps they get 100 dollars for that security. It then has profit. So in reality all dollars are backed by debt. 100 dollars turns into 1000, the banks own the property of the loans (until repayed), and they make profit by selling our own debt of 1000 to us as investment. The banks have 100 dollars but they lend out and make interest on 1000. FDIC is there to protect individual depositors, and would only work if there wasn’t a run on a lot of banks. There is more debt money in the market then there is cash. Everyone cannot pull out their own money. This is why it is fraud. They are creating more real property titles, but not more real property. So whoever is left holding the dollars loses. Because everyone else already pulled out their (real property titles) dollars and bought the real property. There is no more real property to buy the dollar is worthless.

18

derek i think the communication breakdown is that we’re trying to think of money only in terms of exchange, and we’re only valuing money in terms of itself. i believe the true mark of money is its ability to retain value, and its use in exchange results from such. think about it - money is always being saved by someone. exchange simply changes WHO is saving it.

Fractional reserve banking creates more money because it essentially assigns the most important property of money to two different people. When loaned to someone, he is given the power to spend it when he chooses, which is the same power given to the depositor, by the bank. The bank has created a double claim to both the ability to save the money, and the ability to spend the money. Just because the depositor and the borrower don’t simultaneously spend that money doesn’t mean more money doesn’t exist. Time of transactions are infinitesimally small, and thus are always unique. If two people believe they are ABLE to exchange their money for something else at the same time, the money supply has expanded, even if they choose to refrain from exchange at that time.

for exchange to occur, we would believe that there is a change in supply and demand. most often, it would occur because someone produced something. Artificial credit is credit created without a corresponding increase in material wealth, and it spurs exchange. In other words, exchange as the product of artificial credit is only sought because artificial credit transfers wealth from real credit.

if after a bank increased the money supply, everybody tried to use a check to empty their account, the price of goods would rise very substantially. in other words, everybody putting their wealth into a bank at the same time is a lot different from everybody attempting to withdraw their wealth from the bank. They would find they put in more than they are getting out.

thus, there is no means for banks in the system to ever be caught without enough ____ in relation to deposit withdrawals. It is the depositors themselves who must realize they are being given less money, in terms of value than they put in. Whether you fill in the blank with paper money or units of account with an institution such as a bank doesn’t matter. Neither are supply limited by the issuing institution.

19

Your point is very interesting. It is not entirely true, because I can understand money in a lot of forms other than circulating currency. However, it does give me something else to consider.

We are concerned with money because the supply of money helps determine prices. I was going to give an example previously by taking the case of our two hypothetical people, one (A) with a demand deposit of $100 (but only backed by $10 in the bank) and the other (B) with $90 from a loan. Let’s say they go to an auction for a car. I was going to say that they can’t both bid up the price, because if A bids more than $10, the bank has to get the money from B. But I was wrong about that; they can obviously both bid on it, since only one pays. The seller gets his price, and the money is available in the economy. They couldn’t both buy the good at $90 without some external money coming in, but they could bid each other up to $90.

The point is that I see what you mean about the checking account being “money” in a real sense. You count on the fact that you have that money in the bank; if you didn’t have it, you would certainly behave very differently, i.e. spend less, so it certainly contributes to driving up prices.

On the other hand…it still seems different from a bank note, which can be circulated at the same time as the money that backs it. If person B in the above example had a bank note for $90, and the bank still had all $100 of A’s deposit, then both A and B could buy the car for $90, no further agency necessary to introduce money.

This discussion has been very helpful. I can see now how the checking account can count as money without being spent, and, of course, it can always be spent so long as the bank can borrow money from the Federal Reserve. It doesn’t seem like this is precisely the same thing as bank notes, or borrowing directly from the Fed, and I’m not exactly sure how to explain the difference to myself; but it brings me a lot closer to accepting the money-as-debt paradigm.

Sincerely,

Derek

20

Certainly the money has 0 affect on anything in the free market when it’s not used within the free market. If the Fed printed 200 trillion dollars today but didn’t loan it or spend it, no one would be any worse off. It’s only when that money gets spent that the affects are felt soon after.

I suppose I’m ranting because I believe it’s important to clarify the negative affect of artificially increasing the money supply.

Also, the free market does have a preferred reserve amount of currency as well as any other commodity(individuals who “bury their money” as you put it). That’s a good thing and will result in the most productivity when it matches what the free market prefers. I am just pointing out the negative consequences of artificially increasing the ‘velocity’ of money(i.e. through fractional reserve banking).

It will also create negative responses and malinvestment from perception to the free market that resources are coming in faster then they are or there are more reserved resources then there really are.

If you set your computers too high in price, you will have less people purchasing your computers. It’s certainly not all or nothing. Then as you lower the price to find the best profitability people will spend their reserve currency which will in turn create scarcity of computers and so you may keep the price there or raise it up a bit and it will eventually balance out to a price that reflects what the free market deems best.