Money and the Banking System
Money is the most liquid asset in the economy, serving as a medium of exchange, a unit of account, and a store of value. This explanation shows how money is created, how the banking system multiplies it, and why controlling the money supply lies at the heart of macroeconomic policy.
Last updated: 10 September 2026
Definition
DefinitionMoney fulfills three fundamental functions: medium of exchange (it facilitates transactions by eliminating barter), unit of account (it provides a common reference for expressing prices), and store of value (it allows purchasing power to be transferred over time).
A distinction is drawn between fiat money (with no intrinsic value, accepted by convention and by force of law) and commodity money (with intrinsic value, like gold). Modern economies operate exclusively with fiat money.
The money supply is measured by aggregates of increasing liquidity:
M1 = banknotes + coins in circulation + demand deposits (checking accounts)
M2 = M1 + savings deposits + short-term time deposits
M3 = M2 + repurchase agreements + money market fund shares/units + debt securities with an original maturity up to 2 years
Why it matters
Mankiw stresses that understanding the money creation process is essential to grasping the transmission mechanism of monetary policy. The central bank directly controls only the monetary base; it is the banking system that creates most of the money supply, by granting loans. Mind the direction of the arrow: a bank does not wait to receive reserves before lending — it writes a claim and a deposit at the same time, then refinances itself. Loans create deposits. The Bank of England spelled this out in 2014 (McLeay, Radia and Thomas, Quarterly Bulletin): banks do not "multiply up" central bank money, and reserves cannot be turned mechanically into loans. In normal times the central bank acts through its policy rate, then supplies the reserves the system asks for.
The quantity equation MV = PY directly links the money supply to the price level. Mankiw uses it to demonstrate that inflation is "always and everywhere a monetary phenomenon" (Milton Friedman's quote) — that is, excessive growth in the money supply relative to real output inevitably leads to inflation.
The money multiplier in its full form is:
m = (1 + cr) / (rr + cr)
In practice, with a reserve ratio rr = 0.01 (1%) and a currency ratio cr = 0.15, one obtains m = 1.15/0.16 ≈ 7.2. Read that number as the observed ratio between money supply and monetary base, never as the creating power of one euro of base: causality runs from credit to reserves, not the other way round.
Key points
Most money in circulation is deposit money created by commercial banks, not money issued by the central bank. Banknotes and coins represent only about 10% of M1 in advanced economies
The money multiplier is neither fixed nor causal: it varies with banks' behavior (excess reserves) and households' (preference for banknotes), and it is read after the fact. In times of financial crisis, banks accumulate excess reserves and the ratio drops — a sign that the binding constraint is not the monetary base but the demand for creditworthy borrowing
The quantity equation MV = PY implies that if the velocity V is stable, the inflation rate is approximately: π ≈ ΔM/M − ΔY/Y. If real output Y is also constant (ΔY/Y = 0), all money creation translates fully into inflation: π ≈ ΔM/M
The fractional reserve system makes banks intrinsically fragile in the face of bank runs. Modern safety nets (deposit insurance, lender of last resort) stabilize the system at the price of moral hazard (protected banks take more risks)
Concrete example
ExamplesDuring the 2008 crisis, the Fed tripled the monetary base (from $800 bn to $2,400 bn) via QE. Yet M2 only rose moderately because the money multiplier dropped: banks accumulated massive excess reserves rather than lending, out of fear of counterparty risk. This phenomenon illustrates the limits of the simple multiplier model and explains why QE did not immediately produce inflation. In the eurozone, the ECB injected more than €4 trillion between 2015 and 2022 via its asset purchase program, without generating significant inflation until the post-Covid and post-Ukraine supply shock of 2022.
Mankiw anecdote
MankiwMankiw tells the story of the island of Yap in the Pacific, where giant stones (fei) served as money. Inhabitants did not physically move them: ownership changed through verbal agreement, exactly like modern deposit money. He uses this example to show that money is fundamentally a social convention, not a physical object. He also quotes Friedman: "inflation is always and everywhere a monetary phenomenon" to introduce the quantity theory.
Market impact
MarketsMoney creation directly influences the liquidity of financial markets. A high money multiplier and an accommodative monetary policy increase the mass of liquidity seeking placements, which raises asset prices (equities, real estate, bonds). The reverse holds during tightening. Traders watch monetary aggregates (M1, M2) and the monetary base as leading indicators of liquidity conditions. Rapid growth in M2 can signal an excess of liquidity likely to trigger future inflation and therefore a rise in rates.
This concept as guided courses
The mechanism walked through in 7 steps, with simulators and exercises.