Chapter 5R, Problem 2CTQ

To determine

The process of money creation along with the reason that money created should be less than the largest possible amount.

Explanation of Solution

Money Creation process is as follows:

• To create money it is not necessary to print notes rather it can be created by the bank by granting loans.
• For instance, Person A was granted a loan of $1000 from the bank out of which she deposited the whole amount to the bank.
• Reserve requirement is 10% (assumed) then the amount kept by the bank will be $100 (10% of $1000) and the rest is lent out to other Person B.
• Person B also deposited the whole amount of $900, then the bank kept 10% as a reserve and lent out the remaining amount further.
• In such a way, the amount kept in reserve will be equivalent to $1000 and no further lending is possible.
• Further lending will not be possible as there the total amount injected will be held in the bank’s reserve which is controlled by the Fed.

The reason for not issuing further includes the money multiplier. There will be a low money multiplier if someone holds back the cash or made expenses on imports, etc. In this example, Person A borrowed $1000 and further lending includes $9000 which sum up to $10,000. The multiplier for this was 10%. (1/% of reserve amount).

Economics Concept Introduction

Federal Reserve: Federal Reserve is the central bank that is responsible for controlling the country’s financial banking system. It has a basic tool by which it can regulate the money in the market which is referred to as open market operations.