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The Mystery of Banking

Chapter I
Money: Its Importance and Origins
1. The Importance of Money
Today, money supply figures pervade the financial press. Every Friday, investors breathlessly watch
for the latest money figures, and Wall Street often reacts at the opening on the following Monday. If the money
supply has gone up sharply, interest rates may or may not move upward. The press is filled with ominous
forecasts of Federal Reserve actions, or of regulations of banks and other financial institutions.
This close attention to the money supply is rather new. Until the 1970s, over the many decades of the
Keynesian Era, talk of money and bank credit had dropped out of the financial pages. Rather, they
emphasized the GNP and government's fiscal policy, expenditures, revenues, and deficits. Banks and the
money supply were generally ignored. Yet after decades of chronic and accelerating inflation—which the
Keynesians could not [p. 2] begin to cure—and after many bouts of"inflationary recession," it became obvious
to all—even to Keynesians—that something was awry. The money supply therefore became a major object of
But the average person may be confused by so many definitions of the money supply. What are all the
Ms about, from M1-A and M1-B up to M-8? Which is the true money supply figure, if any single one can be?
And perhaps most important of all, why are bank deposits included in all the various Ms as a crucial and
dominant part of the money supply? Everyone knows that paper dollars, issued nowadays exclusively by the
Federal Reserve Banks and imprinted with the words "this note is legal tender for all debts, public and private"
constitute money. But why are checking accounts money, and where do they come from? Don't they have to
be redeemed in cash on demand? So why are checking deposits considered money, and not just the paper
dollars backing them?
One confusing implication of including checking deposits as a part of the money supply is that banks
create money, that they are, in a sense, money-creating factories. But don't banks simply channel the savings
we lend to them and relend them to productive investors or to borrowing consumers? Yet, if banks take our
savings and lend them out, how can they create money? How can their liabilities become part of the money

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 Additional Info
 No. 129
 Posted on 7 June, 2006
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