Principles of Economics- Mankiw (5th) 598

Principles of Economics- Mankiw (5th) 598 - 618 PA R T T E...

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618 PART TEN MONEY AND PRICES IN THE LONG RUN Yet when First National makes these loans, the money supply increases. The depositors still have demand deposits totaling $100, but now the borrowers hold $90 in currency. The money supply (which equals currency plus demand deposits) equals $190. Thus, when banks hold only a fraction of deposits in reserve, banks create money. At first, this creation of money by fractional-reserve banking may seem too good to be true because it appears that the bank has created money out of thin air. To make this creation of money seem less miraculous, note that when First Na- tional Bank loans out some of its reserves and creates money, it does not create any wealth. Loans from First National give the borrowers some currency and thus the ability to buy goods and services. Yet the borrowers are also taking on debts, so the loans do not make them any richer. In other words, as a bank creates the as- set of money, it also creates a corresponding liability for its borrowers. At the end
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