How does money come to be and who controls how much money is available within the economy and why? When asking those questions we need to look at the system of Fiat Money and Central Banking.

What is Money?
That answer seems obvious at first but let’s define it a little more.
Money is a medium of exchange - rather than swapping my goat for your bags of flour, money is a more convenient method of buyer paying a seller.

Money is a unit of account - rather advertising the price of a bag of flour as ‘3 goats’ or entering into barter at every sale we can simply say it’s value in dollars which everyone immediately understands. It also gives us a way to establish records of transactions.

Money is a store of value - You can sell your goods and services and store the proceeds for future use. Rather than having a herd of goats that might run away!

Different Types of Money
Commodity Money - Is when a commodity such as gold is used as the means of exchange. This is commonly known as the Gold Standard. Although paper or plastic money was used, the value of that money in the economy never exceeded the value of the gold reserves in that country, paper money was merely an easy means to carry gold to exchange for goods and services. Therefore, money has intrinsic value.

Fiat Money - Fiat Money is established by government order or decree. If you grab a note out or your wallet you will see something written along the lines of “This note is legal tender throughout Australia and it’s Territories..”. It is backed by the government not by a commodity.

Central Banking
Whenever an economy relies on a system of Fiat Money an agency or authority must be responsible for it’s regulation. Remember with Commodity Money it’s relative the amount of gold in store, so, the amount of money in the economy is regulated.

The Central Bank, which in Australia is the Reserve Bank of Australia (RBA), has the job of determining Monetary Policy.

Monetary Policy - is the management, by a Central Bank, of liquidity conditions in the economy. Liquidity Conditions - refers to the price and availability of funding.

In simple terms, the central bank, usually independent of the government, controls the Money Supply, or Liquidity, within the economy and is guided by a charter agreed upon with the government. The charter for a central bank usually contains objectives including maintaining full employment, ensuring the prosperity and welfare of the public and contributing to a stable economy. It also has a predetermined target for the rate of inflation.

Before we delve deeper into Monetary Policy we need to look at…

Fractional Reserve Banking
At an everyday consumer bank that you and I use, the bank primarily has two customers being a depositor and a borrower.

Lets say a deposit is made of $100 at this bank, therefore the bank has $100 in it’s vault and a liability to the depositor of $100.

In walks a borrower and asks for a loan and the bank approves and offers the borrower $90, which the borrower accepts.

So the bank now has $10 in it’s vault(or reserve), it’s owed $90 and has a liability to the depositor of $100.

Now lets take a look at the money supply in the economy. At the start of the day there was one person with $100 and at the end of the day we have a depositor with $100, held by the bank, and a borrower with $90. Therefore, the bank has created money.

What we need to understand here is that no one has become wealthier. As the bank created the $90 for the borrower, it also created a debt that the borrower must repay. The bank has created more liquidity or, if you like, increased the supply of money within the economy.

And, let’s say that the borrower buys $90 worth of goods and the seller deposits that money into another bank who keeps 10% of the deposit in reserve and lends out $81. The supply of money in the economy is increased again.

But, if all the banks are required to keep 10% of their deposits in reserve effectively the amount of money creation is limited. For every dollar deposited, the money supply increases by a multiple of the amount deposited which is called the Money Multiplier (Money Multiplier = 1/reserve ratio). If the reserve ratio is 10% the money multiplier is 10 (1/.10).

Monetary Policy
The main instrument that a central bank uses for monetary policy is the overnight interest rate in the short term money market - which is referred to as the cash rate.

The cash rate is the interest rate that financial institutions can earn on overnight loans of their currency or reserves and this market reacts to supply and demand forces to set the interest rate. The central bank buys and sells securities within this market, in effect managing the supply and demand, to keep the interest rate at their desired rate.

When the cash rate rises interest rates in the wider market rise (ie. home loan rates, business loan rates etc.). So, the effect would be that potential borrowers may put off finance-required purchases, thus, slowing demand for goods and services, also, decreasing the money multiplying effect of fractional reserve banking mentioned earlier (or the speed of multiplication).

The central bank may seek to raise rates when inflation pressures are high and decrease rates to stimulate the economy when demand is low and unemployment is high within the economy.

That introduces Money Supply, Monetary Policy and Central Banking.

Further resources:
Monetary Policy at the RBA
Monetary and Fiscal Policy - US Economy - usinfo.state.gov

Features, Macroeconomics
central banking, inflation, monetary policy, money supply