How is new money generated?
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You have $100. You take it to Chase and put it in a savings account. I go to chase and take out a mortgage. They give me your $100. I now have $100, but as far as you and Chase are concerned, you still have $100. So if we each have $100, that means there’s $200.
I can take my $100, buy the house, and give that $100 to the seller, Jim. Jim now deposits the $100 I gave him at Wells Fargo. Now Bob goes to Wells Fargo and takes out a mortgage. Wells Fargo now gives Bob the $100 that Jim deposited. But Bob and Wells Fargo both still agree that he has $100 in his savings account, so now there is $300 in the economy. You, Bob, and Jim all have $100, right?
That’s how banks create money. How does it not all fall apart like a house of cards? A couple ways: Traditionally there was something called a “reserve ratio,” which meant that the bank had to keep a certain percentage of your money and couldn’t lend it out. As long as only a few people try to take money out of their savings account at any one time, this is fine.
But what happens if everyone wants to take their money out? Chase doesn’t actually have your $100 any more. First, the Federal government created an insurance system guaranteeing that your deposited money was safe. That reduced the likelihood that everyone would come running to the bank at once to take their money out, like if the bank was going out of business or something. Second, the Federal Reserve will lend money to the banks day-to-day at rock-bottom rates in order to cover situations like this.
The Federal Reserve can manipulate things like the rate they charge banks or the reserve ratio in order to make it easier or harder to lend money, and that’s how they can control the money supply.
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