Zimbabwe suffers from inflation of about 231 million percent a year. (Roughly, 5.5% a day.) There are many reasons for this, the most obvious being that the government keeps printing money. Like other goods, the value of money depends on the interaction of supply and demand. If the world is flooded with dollars, dollars fall in value.
The traditional first step toward slowing or stopping inflation is to stop printing money. Zimbabwe's central bank had a different idea... they'll keep the presses running, but the money will be printed with a built-in expiry date.
Very clever, even if didn't work.
Friday, February 6, 2009
Do banks create money?
(This is Tuesday's post, delayed due to midterms.)
There is a lingering belief among certain sections of the general public that the business of banks is to keep money safe. This belief is held alongside the knowledge that banks are in the business of lending money for profit. The money they lend is, in large part, that which they receive from their depositors.
The end result is that the sum of deposits is almost always greater than the sum of hard currency - banks 'expand' the money supply.
Often, this is explained as banks 'creating money' - while in some sense true, this is a very misleading description. Money is no more created by the banking system than water is created by freezing a lake. The density of water changes with heat, so that ice occupies a volume about 9% greater than the same mass of water at room temperature. While one could argue that this represents an increase in the 'amount' of water, to say water was created would be misleading.
Unfortunately, few articles take the time to explain in detail how the expansion of money works. This article, available free of charge from the Richmond Fed, is an exception. From its abstract:
"Beginning students of banking must grapple with a curious paradox: the banking system can multiply deposits on a given base of reserves yet none of its member banks can do so. Let the reserve-to-deposit ratio be, say, 20 percent and the system can, by making loans, create $5 of deposit money per dollar of reserves received. By contrast, the individual bank receiving that same dollar on deposit can lend out no more than 80 cents of it. How does one reconcile the banking system's ability to multiply loans and deposits with the individual bank's inability to do so?"
The article then explains the historical development of our understanding of the concept, and does it all with a minimum of algebra. Highly recommended reading.
There is a lingering belief among certain sections of the general public that the business of banks is to keep money safe. This belief is held alongside the knowledge that banks are in the business of lending money for profit. The money they lend is, in large part, that which they receive from their depositors.
The end result is that the sum of deposits is almost always greater than the sum of hard currency - banks 'expand' the money supply.
Often, this is explained as banks 'creating money' - while in some sense true, this is a very misleading description. Money is no more created by the banking system than water is created by freezing a lake. The density of water changes with heat, so that ice occupies a volume about 9% greater than the same mass of water at room temperature. While one could argue that this represents an increase in the 'amount' of water, to say water was created would be misleading.
Unfortunately, few articles take the time to explain in detail how the expansion of money works. This article, available free of charge from the Richmond Fed, is an exception. From its abstract:
"Beginning students of banking must grapple with a curious paradox: the banking system can multiply deposits on a given base of reserves yet none of its member banks can do so. Let the reserve-to-deposit ratio be, say, 20 percent and the system can, by making loans, create $5 of deposit money per dollar of reserves received. By contrast, the individual bank receiving that same dollar on deposit can lend out no more than 80 cents of it. How does one reconcile the banking system's ability to multiply loans and deposits with the individual bank's inability to do so?"
The article then explains the historical development of our understanding of the concept, and does it all with a minimum of algebra. Highly recommended reading.
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