MODERN MONETARY
SYSTEM
The money supply is made up of two components: cash and
credit. But the amount of credit is much
larger than the amount of cash.
This is the real
magic of money creation! This is where the modern (and also magical!)
monetary system comes into play.
The Central Bank controls-either directly or
indirectly-total supply of money in the economy. The money that the Central
Bank prints is only a small portion of total money circulating in the economy
at any point in time. The bulk of the money supply consists of deposits that
the public holds at financial instituions-i.e in their bank accounts.
Bank deposits are LIBILITIES for the bank. Banks act as
FINANCIAL INTERMEDIARIES, by making these surplus funds from savers/suppliers
available to users/demanders of fund. By law, banks are allowed to loan out a major part of these deposits
to creditors. This process is known as CREDIT CREATION.
It is this credit
creation process that constitutes bulk of the money supply.
CREDIT CREATION: USE
OF FRACTIONAL RESERVE BANKING
The
process of credit creation is done by FRACTIONAL RESERVE BANKING. What it means
simply is that, banks can create credit
or loan against the amount deposited in their bank, by keeping a fraction
of the deposit as RESERVE with the Central Bank, and lending out the remaining
amount. The additional amount that is
created through loans, then becomes part of money supply (reserve amount with
central bank is NOT part of money supply). This amount lent then become
additional loanable fund (after keeping a part of it as reserve) and so on. So,
initial money supply keeps growing through
the process of CREDIT CREATION and multiplying the money supply in the economy.
This
is the root of expansion of money supply by multiple times from the initial
money created and circulated by the Central Bank, which is done through the
mechanism called the fractional reserve banking.
A SIMPLE EXAMPLE|
Individual Bank
|
Amount deposited ($)
|
Reserves
|
Lent Out
|
|
A
|
100
|
10
|
90
|
|
B
|
90
|
9
|
81
|
|
C
|
81
|
8.1
|
72.9
|
The amount of $90 lent to individuals is then deposited in Bank B. It
lends out $81, after keeping fractional reserve of $9. This amount becomes
circulated and available in the economy. Eventually this amount then is
deposited in Bank C, which again creates credit of $72.9.
This money creation process goes on, although initially it was only $100
that was created. But there is a limit of how much money can grow in the
economy from the initial cash money. This is calculated by using the MONEY
MULTIPLIER.
MONEY MULTIPLIER:
The money multiplier, m, is the
inverse of the reserve requirement, R
m = 1
R
Example
For example, with
the reserve ratio of 10 percent, this reserve ratio, R, can also be
expressed as a fraction:
R =
1/10
So then the
money multiplier, m, will be calculated as:
m
= _1_
1/10
= 10
It is clear then, that most of the money supply in the economy occurs
through the creation of credit.
WHAT’S THE BIG DEAL ABOUT FRACTIONAL RESERVE BANKING?
Fractional Reserve Banking is by definition expansionary,
i.e. it is bound to produce inflation in the economy. Since this money creation
is not backed by any tangible resource/asset, but by the dictum of the central
bank, it can keep expanding indefinitely. By simply tweaking the reserve
requirement (i.e percentage of R in the above example), the central bank can
determine how much money it can grow. It breed a highly rich moneyed class of
people, those who have control and access to this money! So traditionally, the
bankers by default control the money, and in reality, they have the real power
in the society. The savers, get only a fraction of return from this money
circulation cycle (through a tiny percentage of interest income), whereas the
users/borrowers take out this money, grows it in business/venture (through return on investment) and exploit
the real power of money! So, this is the
borrowers who make money from other peoples’ money! Those who understand this magic,
they get rich.
