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Chapter 25: Problem 3

What does it mean to say that banks "create money"?

Short Answer

Expert verified
When we say banks 'create money', we refer to the process of lending. Banks create new money whenever they extend loans to individuals or businesses. The money is created not physically, but digitally in the borrowers' bank accounts. This process expands the economy's money supply.

Step by step solution

01

Definition of Banks

A bank is a financial institution licensed to receive deposits and make loans. Banks may also provide financial services, such as wealth management, currency exchange, and safe deposit boxes.
02

Understand How Money Is Created

The money that banks create is not about physical money (currency notes) but the digital money that flashes on the screen when we check our bank accounts. Banks create new money whenever they make loans. This is because money is really just an IOU. The role of the central bank is to preside over a legal order that effectively grants banks the exclusive right to create IOU’s of a certain kind, ones that the government will recognize as legal tender by its willingness to accept them in payment of taxes.
03

The Lending Process

When a bank provides a loan, for example to someone taking out a mortgage to buy a home, it does not give them thousands of pounds worth of bank notes. Instead, it credits their bank account with a bank deposit of the size of the loan. At that moment, new money is created.

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Most popular questions from this chapter

Suppose you withdraw \(\$ 1,000\) from a money market mutual fund and deposit the funds in your bank checking account. Briefly explain how this action will affect \(\mathrm{M} 1\) and \(\mathrm{M} 2 .\)

What is hyperinflation? Why do governments sometimes allow it to occur?

In the late \(1940 \mathrm{~s}\), the communists under Mao Zedong were defeating the government of China in a civil war. The paper currency issued by the Chinese government was losing much of its value, and most businesses refused to accept it. At the same time, there was a paper shortage in Japan. During those years, Japan was still under military occupation by the United States, following its defeat in World War II. Some of the U.S. troops in Japan realized that they could use dollars to buy up vast amounts of paper currency in China, ship it to Japan to be recycled into paper, and make a substantial profit. Under these circumstances, was the Chinese paper currency a commodity money or a fiat money? Briefly explain.

Suppose that Congress passes a new law that requires all firms to accept paper currency in exchange for whatever they are selling. Briefly discuss who would gain and who would lose from this legislation.

What is the main difference between the \(\mathrm{M} 1\) and \(\mathrm{M} 2\) definitions of the money supply? Why does the Federal Reserve use two definitions of the money supply rather than one?
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