How is Money Created in Economics?

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Though a dollar might have bought a week’s worth of groceries at one time, that same dollar buys just a candy bar today. So, how did the value of the dollar get diluted over the years? In part, this dilution occurs through the creation of money. The old adage that money doesn’t grow on trees is correct: Money is created for many reasons through a number of different institutions. Creating money can cause many consequences that must be kept in check as well.

Printing Money

  • At its simplest definition, money is created when it is printed through the Bureau of Printing and Engraving. According to Dave Kansas’s book, “The Wall Street Journal: Complete Money and Investing Guidebook,” the average dollar bill lasts just 24 months before it becomes too worn out for use. Often, banks trade the tender back to the Bureau of Printing and Engraving. In such circumstances, more money needs to be printed to replace this aged tender.

Government Spending

  • Money is often created through excess government spending. The U.S. Government can pay for projects and balance the budget by creating more money and lending it. Creating money in this fashion is not without risks: During World War I, Germany paid its war reparations by simply printing more money. The value of the deutschemark was so diluted it caused hyperinflation and wiped out the savings of the middle class. This propelled the country into a depression. Thus, creating money to pay off debts should be done with great caution.

Bank Lending and Borrowing

  • In the book, “Macroeconomics: Theory and Policy”, author Dwiveldi explains the complicated process of money creation through the banks. Banks can increase the money supply through loaning it in the form of credit, also known as “credit creation.” When banks make loans they do so using money from what’s called “primary deposits,” which comes from various sources like money other people place in their savings or deposits or overseas transactions. In actuality, banks hold onto only a very small portion of these deposits: The banks lend out most of the money. In lending this money, the money supply is expanded.

Currency Exchange

  • Money can be introduced into the economy (thus, “created”) by making a profit from currency exchange. The Federal Reserve Bank of New York explains that $1.2 trillion is traded on the foreign exchange market daily. If, for example, you buy a euro for $1.20 and sell it at a price of $1.30, 10 cents is introduced to the U.S. economy. One way governments keep this type of money creation in check is through the government selling and buying foreign reserves.

The Federal Reserve

  • The Federal Reserve plays a large role in the creation of money through its ability to regulate interest rates and monitor lending. The Fed determines how much money banks can lend out at any given time. Thomas Sowell, author of “Basic Economics: A Citizen’s Guide to the Economy” explains that The Fed also determines how much money is created (or lost) in the stock market: One statement about the tightening of the money supply can cause stocks to plummet.

References

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