In a market economy, money serves a critical function in facilitating exchanges and specialization, thus permitting increased output. "Money" in this context may refer to anything that serves as a medium of exchange, store of value, and standard of value.
The most common measure of the money supply (M1) includes both cash and balances people hold in transactions accounts (e.g., checking, accounts).
Banks have the power to create money simply by making loans. In making loans, banks create new transactions deposits, which become part of the money supply.
The ability of banks to make loans—create money—depends on their reserves. Only if a bank has excess reserves—reserves greater than those required by federal regulation—can it make new loans.
As loans are spent, they create deposits elsewhere, making it possible for other banks to make additional loans. The money multiplier (1 _ required reserve ratio) indicates the total value of deposits that can be created by the banking system from excess reserves.
The role of banks in creating money includes the transfer of money from savers to spenders as well as deposit creation in excess of deposit balances. Taken together, these two functions give banks direct control over the amount of purchasing power available in the marketplace.
The deposit-creation potential of the banking system is limited by government regulation. It is also limited by the willingness of market participants to hold deposits or borrow money. At times, banks themselves may be unwilling to use all their lending ability.
