Ever wonder how many dollars there are? Where do they come from, where do they go? Why are they losing value so rapidly? A good friend has asked this question and found satisfactory answers elusive.
The question of “money supply” is one that economists have been wrangling with for a long time. You’d think there would be a simple, straightforward number, but it turns out there are multiple ways to define money, leading to names like M1, M2, MZM, etc. What’s more, it’s a moving target … the numbers are constantly changing.
For an official answer, a good place to start is with the agency that issues dollars, the United States Federal Reserve.
The absolute number of dollars, however, is less important than changes in the number. Kinda like if you live on the beach, you don’t care what sea level is but if it changes it’s a big deal.
Furthermore, there’s more than one way that dollars are created.
One is very simple: The Federal Reserve creates them from nothing in the act of buying Treasury securities. It takes the treasuries into its balance sheet as assets and virtually prints the money to pay for them as liabilities. The dollars the seller received didn’t exist before the transaction.
Another is when banks make loans. For this example let’s assume the banks maintain 10% (0.1) reserves. You deposit $1000 in the bank. The bank lends out $900 of it. So now someone else has $900 to spend, but you have not relinquished your claim on that money. (You can get it back on demand. Hence the name “demand deposits”.) So this has effectively increased the money supply by $900. What’s more, the $900 loaned can be deposited in the bank, upon which the bank can now lend $810. This can in turn be deposited in the bank, etcetera … with the result that when you tote everything up the original $1000 is now $10,000.
This is the so-called “money multiplier” effect of fractional reserve banking. The multiplier is the reciprocal of the reserve ratio. With this mechanism (unlike with direct Fed creation), the amount of money created is open ended, a function of both the reserve ratio and interest rates, as well as other financial factors. But it is for this reason that the number of dollars extant is not easily nailed down … they’re constantly being created and destroyed in the process of being lent by and repaid to banks.