Fiat money (paper currency and coins), however, makes up only a small part of America’s money supply. A much greater part consists of demand deposits, such as checking accounts, and “near money.” We may not think of checking accounts as money in the traditional sense, but almost half of all transactions today do not involve currency at all. Instead, they are completed through a transfer of funds initiated by the use of a check or a debit card. Near money includes things like savings accounts, certificates of deposit (CDs), and money market mutual funds. You can’t actually buy something with these; a retailer can’t subtract his charge from your savings account book. But these can be easily converted to cash or transferred to a checking account. In other words, they are not exactly but near money.
The amount of money in a nation’s money supply is crucial to the health of its economy. If there is not enough money in circulation, the economy cannot grow. Consider how difficult it would be to get a loan to start a business or buy a car if there was only $10,000 circulating in the entire American economy. On the other hand, too much money in circulation can also cause serious problems. If we all have too much money, and loans are too easy to obtain, the money itself loses value and inflation results. Think about what would happen to the price of a Coke if we all carried thousands of dollars in our wallets.
Therefore economists carefully monitor the amount of money in circulation. One measurement economists use to do so is labeled M1. This measurement of the money supply includes only fiat money (paper currency and coins) and demand deposits like checking accounts. M2 consists of fiat money, demand deposits, and near money. M1 represents the portion of the money supply with the highest liquidity—that is, it is most easily spent. But it represents only about 18% of the larger money supply or M2. In 2008, M1 totaled $1.4 trillion; M2 totaled $7.7 trillion. Breaking M2 down further: the amount of currency in circulation equaled about $800 billion, checks totaled about $600 billion, savings accounts represented about $3.6 trillion, CDs added another trillion dollars, and money market funds added about $1.7 trillion.
Now if you’re paying close attention you've noticed that the money supply contains more money in the form of checks, savings deposits, CDs and money market funds than in actual currency. And if you are really inquisitive you are wondering how that is possible. How can there be more “money” in the form of checking and saving accounts than there is currency? Isn’t there a pile of currency lying behind every check? When you write a check for $100 doesn’t the bank simply transfer your currency to someone else? And when you deposit money in a savings account doesn’t the bank stash it in a box with your name on it and keep it there for your later use?
In fact, the bank is only required by law to keep a small percentage (around 10%) of its customers’ deposits in reserve. The bank is allowed to lend out the rest of your money to borrowers. Subsequently, recipients of these loans deposit their new money into their accounts and, once again, the bank is required to keep only a portion in reserve before lending out the rest. This process is repeated over and over again until your original deposit has been loaned out several times. The math looks something like this.
Original deposit by A=$100
$10 (10%) in reserve, $90 loaned to and deposited by B
$9 in reserve, $81 loaned to and deposited by C
$8.10 in reserve, $72.90 loaned to and deposited by D
$7.29 in reserve, $65.61 loaned to and deposited by E
$6.56 in reserve, $59.05 loaned to and deposited by F
$5.91 in reserve, $53.15 loaned out and deposited by G
We are only about halfway through the process, but look how much money has been created by the bank already. Your original $100 has been turned into $421.71 in loans. We could continue our chart here to find out how much the bank could create with your original $100 deposit, or we could get clever and use some math. If you multiply the amount of the original deposit by the inverse of the reserve requirement, the result will be the total amount of money that your original deposit could create. In other words, $100 x 1/.10=$1000. If the bank was required to keep a reserve of 15%, the equation would look like this: $100 x 1/.15= $666.67.
Economists apply a specific set of terms to this process through which banks create money. The process is based on the fact that the American banking system is a ”fractional reserve banking system”—banks are required to keep only a fraction of their reserves on hand before lending out the rest. This fraction that they must keep on hand is the reserve requirement or minimum reserve requirement. The formula that enables us to determine how much money banks can create from its deposits is called the deposit expansion multiplier.
Why It Matters Today
When you go down to the bank to open your first savings account, you're actually creating money, doing your (presumably very small, unless you've got one heck of a trust fund) part to boost the money supply.
How does that work, exactly? Isn't the bank just holding onto your money until you need to use it?
The bank will hold a small percentage -- something around 10%, usually -- of your funds in reserve. But the rest will go out to other customers in loans, allowing it to circulate through the economy.
In technical terms, you'll be adding to the M2 money supply. Of course, there's currently more than $8 trillion floating around in M2, so your personal contribution is probably a bit of a drop in the bucket. But a lot of people's drops add up to a pretty big bucket -- and economic recovery depends upon that bucket continuing to grow. So thanks for doing your part!
The O’Jays sing of all the bad things people will do for money.