You probably think that some federal government agency makes all of the money in the United States (or whatever country you reside in). That is completely wrong. The government makes only a small portion of the money in circulation.
First, let's consider the definition of money. To an economist, "money is as money does." Simply put, money is not money because Benjamin Franklin is printed on it. Money, in general, is something that will be accepted in return for goods and services. According to economists, in the strictest definition of the money supply, called M1, is made up of three components. M1 is what you can go to the supermarket with and purchase groceries.
The currency, in the economy, or coins and paper money, makes up one of these three parts. In fact, not all currency is part of the money supply. The second part, and the largest part of the money supply is composed of "demand deposits." Demand deposits are all balances in banks that people can, at any time, make claims against. Demand deposits are also called checkable deposits because the usual method of making a claim against one is through use of a check or a cheque if you're in the United Kingdom. Travelers' checks are the third type of money composing M1.
I said that not all currency is part of the money supply. Here is the reasoning behind that statement: when you deposit currency in the bank into a checking account, you gain that amount of demand deposits, but lose the currency. The bank must still keep the currency in its vaults for the time that you wish to withdraw it. That currency is taken out of circulation. Therefore, the amount of demand deposits in M1 increased by the amount that currency decreased in M1. Currency held by banks as reserves (as in this case), as well as currency held by the federal reserve bank, and currency held by federal government agencies are not part of M1. All other currency is part of M1.
Now, then, how is most money created, if most money is not printed or minted by federal agencies? Most money is created by the banking system, a term describing all the banks in the country, as well as the Federal Reserve Bank, or the Fed, as it is more commonly called. The reason money can be created by the banking system is called fractional reserve banking. The system of fractional reserve banking is based on the principle that it is extremely unlikely that a large percentage of people holding demand deposits against a bank will claim them at the same time. The Fed requires every bank to only keep a fraction of the value of its demand deposits as reserves.
In order to better illustrate how this happens, a tool called double-entry bookkeeping is used. Double-entry bookkeeping was developed by the Medici banking family in Italy long ago, and is still in use today. The principle behind double entry bookkeeping is that for everything listed on the left column there's something else on the right column. The left column contains assets, traditionally, and the right column contains liabilities. Assets are generally claims the bank has against other people and banks, whereas liabilities are generally claims that other banks and people have against the bank. Observe this generalized banking statement:
Assets | Liabilities
= = = = = = = = = | = = = = = = = = = = = =
Reserves $250 | Demand Deposits $200
| Net Worth $ 50
- - - - - - - - - | - - - - - - - - - - - -
Total Assets $250 | Total Liabilities $250
This bank has reserves of $250. "Reserves" is the title given to what cash the bank holds in its vault, as well as deposits it has at the Federal Reserve Bank. In general, most reserves are deposits at the Fed, but banks do usually keep some vault cash. Because the bank has no other assets, its total assets are also $250. The bank has demand deposits of $200. The bank holds these for other people: because other people have claims against the bank, they are liabilities. The bank in essence owes people the $200 of demand deposits that are listed on the balance sheet. The net worth is not truly a liability, but is calculated to make total assets equal total liabilities. A net worth of $50 means that if the bank used all of its assets to pay off all of its liabilities, it would have $50 worth of assets left.
No real bank has all of its assets in reserves. Reserves do not earn the bank any money, and the demand deposits usually cost the bank money. Because of fractional reserve banking, they must only retain a certain portion of their outstanding demand deposits as reserves. This portion is called the reserve ratio. If you multiply the demand deposits of a bank by the reserve ratio, you will obtain the required reserves of the bank. If you subtract the required reserves of the bank from the total reserves, you will obtain the excess reserves of the bank. The excess reserves of the bank can be used for a category called "Other Assets," composed primarily of loans and securities, such as bonds.
Moving back to our example, the bank has demand deposits of $200, and reserves of $250. If the reserve ratio is 1/5, the bank will need to have 1/5 of $200 as reserves (required reserves). The bank's required reserves are therefore $40 ($200*1/5). The bank has excess reserves of $210 ($250-$40). Because the bank has excess reserves of $210, it can make loans of $210. The bank's balance sheet now looks like this, after making the loans:
Assets | Liabilities
= = = = = = = = = | = = = = = = = = = = = =
Reserves $250 | Demand Deposits $410
Loans $210 | Net Worth $ 50
- - - - - - - - - | - - - - - - - - - - - -
Total Assets $460 | Total Liabilities $460
WOW! Look at what just happened! The bank just made money! By loaning out $210, reserves didn't change, but demand deposits increased by $210. The bank just increased the money supply by $210. You might think that the bank can loan out more money because $250 is still more than the required reserves ($410/5=$82). However, the person who decided to take out the loan probably wants to use the loan to purchase something, and will write a check against the bank for $210. The bank must expect a check against it to be written for $210 in the near future. Here is what happens once the check is written and processed:
Assets | Liabilities
= = = = = = = = = | = = = = = = = = = = = =
Reserves $ 40 | Demand Deposits $200
Loans $210 | Net Worth $ 50
- - - - - - - - - | - - - - - - - - - - - -
Total Assets $250 | Total Liabilities $250
Now the bank has no excess reserves and cannot make out any loans. Now let's examine the money multiplier. The money multiplier is to the money supply what the multiplier effect is to gross national product. An individual bank can expand the money supply by only its excess reserves, but the banking system can expand the money supply by the value of the money multiplier. By examining a few banks' balance statements, it can become clear what happens when extra money is deposited in the banking system. Four banks, Bank A, Bank B, Bank C, and Bank D, will demonstrate this process. Each bank starts out with no assets and no liabilities, and the reserve ratio is 1/5:
Banks A-D at the beginning:
Assets | Liabilities
= = = = = = = = = | = = = = = = = = = = = =
Reserves $0 | Demand Deposits $0
Loans $0 | Net Worth $0
- - - - - - - - - | - - - - - - - - - - - -
Total Assets $0 | Total Liabilities $0
Someone deposits $100 in Bank A.
Bank A after a $100 deposit:
Assets | Liabilities
= = = = = = = = = | = = = = = = = = = = = =
Reserves $100 | Demand Deposits $100
Loans $0 | Net Worth $0
- - - - - - - - - | - - - - - - - - - - - -
Total Assets $100 | Total Liabilities $100
Bank A's required reserves are $20, so its excess reserves are $80. Bank A can therefore loan out $80.
Bank A after loaning out $80:
Assets | Liabilities
= = = = = = = = = | = = = = = = = = = = = =
Reserves $100 | Demand Deposits $180
Loans $80 | Net Worth $0
- - - - - - - - - | - - - - - - - - - - - -
Total Assets $180 | Total Liabilities $180
The person who took out a loan for $80 in Bank A writes a check against Bank A and deposits the $80 in Bank B. This effectively transfers $80 in both reserves and demand deposits from Bank A to Bank B.
Bank A after transaction:
Assets | Liabilities
= = = = = = = = = | = = = = = = = = = = = =
Reserves $20 | Demand Deposits $100
Loans $80 | Net Worth $0
- - - - - - - - - | - - - - - - - - - - - -
Total Assets $100 | Total Liabilities $100
Bank B after deposit of $80:
Assets | Liabilities
= = = = = = = = = | = = = = = = = = = = = =
Reserves $80 | Demand Deposits $80
Loans $0 | Net Worth $0
- - - - - - - - - | - - - - - - - - - - - -
Total Assets $80 | Total Liabilities $80
Because Bank B has demand deposits of $80, it has required reserves of $16 and excess reserves of $64. It can loan out $64.
Bank B after loaning out $64:
Assets | Liabilities
= = = = = = = = = | = = = = = = = = = = = =
Reserves $80 | Demand Deposits $144
Loans $64 | Net Worth $0
- - - - - - - - - | - - - - - - - - - - - -
Total Assets $80 | Total Liabilities $80
The person who took the loan of $64 out writes a check and deposits the balance in Bank C.
Bank B after transaction:
Assets | Liabilities
= = = = = = = = = | = = = = = = = = = = = =
Reserves $16 | Demand Deposits $80
Loans $64 | Net Worth $0
- - - - - - - - - | - - - - - - - - - - - -
Total Assets $80 | Total Liabilities $80
Bank C after transaction:
Assets | Liabilities
= = = = = = = = = | = = = = = = = = = = = =
Reserves $64 | Demand Deposits $64
Loans $0 | Net Worth $0
- - - - - - - - - | - - - - - - - - - - - -
Total Assets $64 | Total Liabilities $64
Bank C has demand deposits of $64, which means it has required reserves of $12.80 and can loan out $51.20, which it does.
Bank C after loaning out $51.20:
Assets | Liabilities
= = = = = = = = = = = | = = = = = = = = = = = = =
Reserves $64.00 | Demand Deposits $115.20
Loans $51.20 | Net Worth $0.00
- - - - - - - - - - - | - - - - - - - - - - - - -
Total Assets $115.20 | Total Liabilities $115.20
The person who took the loan of $51.20 out writes a check and deposits the balance in Bank D.
Bank C after transaction:
Assets | Liabilities
= = = = = = = = = = = | = = = = = = = = = = = = =
Reserves $12.80 | Demand Deposits $64.00
Loans $51.20 | Net Worth $0.00
- - - - - - - - - - - | - - - - - - - - - - - - -
Total Assets $64.00 | Total Liabilities $64.00
Bank D after transaction:
Assets | Liabilities
= = = = = = = = = = = | = = = = = = = = = = = = =
Reserves $51.20 | Demand Deposits $51.20
Loans $0.00 | Net Worth $0.00
- - - - - - - - - - - | - - - - - - - - - - - - -
Total Assets $51.20 | Total Liabilities $51.20
The money supply is currently the sum of the demand deposits. Because all the currency is deposited in banks as reserves, it is not part of M1. The money supply is therefore $100.00+$80.00+$51.20, or $231.20. If we add banks E, F, G, H, I, this is what happens:
$100.00 A
80.00 B
51.20 C
40.96 D
32.768 E
26.2144 F
20.97152 G
16.777216 H
+ 13.4217728 I
------------
$446.3129088
This goes on until infinity (although pennies are not split like this, immensely larger quantities of money are usually dealt with).
$446.3129088
+ 53.6870912 == All other banks
------------
$500.0000000
The sum of all the banks' expansion will yield a total of $500 in the money supply from the banking system from a single deposit of $100 in a single bank. The money multiplier is equal to the reciprocal of the reserve ratio. Because our reserve ratio was 1/5, the money multiplier is 5.
Most of the money in the economy is created in this manner. All the currency in the economy, both in circulation and held by the banking system, compose the monetary base. The theoretical maximum money supply is equal to the monetary base divided by the reserve ratio. However, banks wish to keep slightly more reserves than are required to allow for liquidity, and people wish to keep some money as cash, so the money supply is always lower than this theoretical maximum. The currency deposit ratio is the fraction of their money that people wish to keep as cash. Factoring in these two corrections, the following is a more accurate expression of the money supply:
r = reserve ratio
c = currency deposit ratio
l = ratio of excess reserves desired to be kept
by the bank, as a percentage of total demand
deposits, less the reserve ratio, also known
as the liquidity ratio
1 + c
money supply = ---------
c + r + l