Money & Banking
High SchoolMoney is one of civilisation's great inventions, yet most of it is not printed by any government — it is created by commercial banks with a keystroke when they lend. This chapter explains what money really is, how the banking system multiplies it, and why central banks sit at the centre of the modern economy.
At a glanceFunctions of money and how banks create it
Anything counts as money if it performs four functions: a medium of exchange (avoiding the "double coincidence of wants" that cripples barter), a unit of account (a common measuring rod for value), a store of value (purchasing power carried into the future), and a standard of deferred payment (settling debts over time).
Modern banks operate fractional reserve banking: they keep only a fraction of deposits as reserves and lend the rest. When a bank makes a loan it credits the borrower's account — creating new deposit money. That money is spent, redeposited elsewhere, and lent again, so the banking system as a whole multiplies the original deposit:
The central bank (the Federal Reserve, Bank of England, etc.) sits above the commercial banks. Its roles: sole issuer of notes, banker to the banks and lender of last resort, manager of monetary policy, and guardian of financial stability. Money supply is measured in tiers: M0/base money (cash + bank reserves) up to broader aggregates like M4 (including most bank deposits).
The multiplier, trust, and bank runs
Because banks lend out most of what they hold, the system rests on confidence. If depositors all demand cash at once — a bank run — no fractional-reserve bank can pay, because the money has been lent out and exists elsewhere as loans. This is why central banks act as lender of last resort and why governments offer deposit insurance: both stop panic from turning a liquidity problem into insolvency.
The classic link between money and prices is the Quantity Theory of Money, Fisher's equation of exchange:
If velocity V and real output Y are roughly stable, then increasing the money supply M raises the price level P proportionally — the monetarist claim that "inflation is always and everywhere a monetary phenomenon." Hyperinflations (Weimar Germany 1923, Zimbabwe 2008) are extreme cases where governments printed money to fund spending, destroying money's store-of-value function.
The 1 ÷ r formula gives the maximum expansion. In practice it's smaller: people hold some cash (currency drain), and banks hold excess reserves — especially in a crisis, when they'd rather sit on liquidity than lend. This is why flooding banks with reserves (quantitative easing) after 2008 did not cause runaway inflation: the money multiplier collapsed as lending stalled.
Worked example: the money multiplier in action
Q1Why did societies abandon barter for money?
Barter needs a double coincidence of wants: to trade, I must find someone who has what I want and wants what I have. That is hugely costly in search time and makes complex specialisation impossible. Money as a medium of exchange breaks the trade into two easy halves (sell for money, buy with money), and as a unit of account lets every good be priced on one scale — unlocking large-scale trade and the division of labour.
Q2Do banks lend out existing deposits, or create new money?
In the modern system, mostly the latter. When a bank grants a loan it simultaneously creates a new deposit in the borrower's account — assets (the loan) and liabilities (the deposit) rise together. It is constrained by capital rules, reserve requirements, and the demand for loans, not by a pile of pre-existing cash it "lends out." This is why the central bank influences, but does not mechanically control, the broad money supply.
Q3Bitcoin: is it money?
Judge it by the four functions. As a medium of exchange it is accepted only narrowly; as a unit of account almost nothing is priced in it; as a store of value it is extremely volatile. It partly satisfies these functions but weakly, so it behaves more like a speculative asset than money in the full sense. Its fixed supply also makes it prone to deflation, undermining the deferred-payment role.
Q4How can a solvent bank still be brought down by a run?
Through a liquidity–solvency gap. A bank's assets (long-term loans) are worth more than its liabilities (it is solvent), but those assets can't be turned into cash quickly. If all depositors demand cash at once, the bank must dump assets at fire-sale prices, which can turn a temporary liquidity shortage into actual insolvency. The lender of last resort breaks this by lending against good collateral, and deposit insurance removes depositors' reason to run in the first place.
Q5If M × V = P × Y, why didn't post-2008 money printing cause hyperinflation?
Because V (velocity) collapsed and the newly created reserves largely sat idle. Quantitative easing swelled base money, but frightened banks held it as excess reserves rather than lending, and cautious households and firms didn't spend — so the money multiplier and velocity fell sharply. With M up but V down and Y depressed, P barely moved. The equation holds as an identity, but only naïve readers assume V is constant.
How the ideas connect
Every key idea in this chapter, branching from the core concept — use it to see the whole picture at a glance.
The process, step by step
Worked problems, step by step
Follow each solution line by line, then try to reproduce it on paper before moving on.
Example 1The reserve ratio is 20%. What is the money multiplier and the max deposits from $500?
- Money multiplier = 1 / reserve ratio = 1 / 0.20 = 5.
- Max deposits = initial x multiplier.
- $500 x 5 = $2500.
Example 2A bank has $1000 deposits and must hold 10% reserves. How much can it lend?
- Required reserves = 10% x 1000 = $100.
- Lendable = deposits - required reserves.
- $1000 - $100 = $900.
Now you try
Work each one out first, then tap to reveal the worked answer.