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Many have heard the phrase "Money makes the world go round", but where does money come from? The United States, like most other countries today, has a fractional reserve banking system in which only a fraction of the total money supply is held in reserve as currency. Early traders began to use gold in making transactions; they soon realized that it was both unsafe and inconvenient to carry gold and to have it weighed every time they negotiated a transaction. By the late sixteenth century, they had begun to deposit their gold with goldsmiths, who would store it in vaults for a fee. On receiving a gold deposit, the goldsmith would issue a receipt to the depositor. Soon people were paying for goods with goldsmiths' receipts, which served as the first kind of paper money. On receiving a gold deposit, the goldsmith would issue a receipt to the depositor. Soon people were paying for goods with goldsmiths' receipts, which served as the first kind of paper money. The goldsmiths observed that the amount of gold being deposited with them in any week or month was likely to exceed the amount that was being withdrawn. Someone came up with the idea that paper receipts could be issued in excess of the amount of gold held. Goldsmiths would put these receipts, which were redeemable in gold, into circulation by making interest-earning loans to merchants, producers, and consumers. Borrowers were willing to accept loans in the form of gold receipts because the receipts were accepted as a medium of exchange in the marketplace. This was the beginning of the fractional reserve system of banking, in which reserves in bank vaults are a fraction of the total money supply. The fractional reserve has two significant characteristics: money creation and reserve which is defined as Banks can create money through lending, and bank panics and regulation: Banks that operate on the basis of fractional reserves are vulnerable to "panics" or "runs" (McConnell & Brue 2005).
Money creation is the process by which the money supply of a country is increased. There are several ways that a government, in coordination with the country's commercial banks, can increase or decrease the money supply of a country. If a country follows a fractional-reserve banking regime, as virtually all countries do, not all of the money in circulation needs to be backed by other currencies, physical assets such as gold, or government assets.
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The money supply affects the macroeconomic idicators in three ways: Real Gross Domestic Product (Real GDP), the inflation rate, and the unemployment rate. The Real GDP increases with increasing money supply. High levels of money in the system act as a spur for both investment and industrial/consumer demand. This in turn increases the nation's Real GDP. Similarly, any measure that drains money out of the system acts as a disincentive to lower spending and investment and tends to lower Real GDP. The Inflation Rate is increased when the money supply is increased. When the amount of money in the system is increased, the norminal value of money remain the same, but, as more money chases the same quantity of goods and services, the real value of money is decreased. As a result, prices go up there by signaling greater inflation rates. The unemployment rate is invesrely related to the Real GDP. Due to the increased investment and spending, the demand and employment and opportunties for the work force tends to go up since labor is required for production of goods anad services. As they go up, unemployment tends to go down. As money is drained out of the system and Real GDP tends to fall, unemployment opportunnites and demand for work force to fall, thus putting pressure on unemployment ratio (Monetary Policy Simulation).
McConnell, Campbell R. & Brue, Stanley L. (2005). Economics: Principals, Policies,
and Problems. New York: McGraw-Hill, Chapter 14.
Monetary Policy Simulation, 2006. Retrieved from University of Phoenix Online EResource on 01/22/07.
Wikipedia, the free encyclopedia. Online. www.wikipedia.org/moneycreation.
Retrieved on November 23, 2006.