Guess what.  The Fed isn’t the only entity capable of creating money from thin air.  Your personal bank can do essentially the same thing.  To see how, consider the following scenario.  You receive $1,000 as a graduate gift from your Aunt Edna.  You promptly deposit her check into your own checking account.  What happens? 

First of all, the bank’s balance sheet is impacted.  They now have a $1,000 obligation to you.  And so, the value of your deposit is placed on the liability-side of their balance sheet.  But after you deposited the check, they sent it to Aunt Edna’s bank to have the funds transferred to them.  And so, they now have the actual $1,000 from Aunt Edna sitting in their vault and on the asset-side of their balance sheet. 

But it doesn’t stop there.  While you’re not looking, they lend $500 of that $1,000 to Stanley Lee so he can buy more comic books.  They can get away with this because they’re pretty sure you’re not going to actually come to the bank and ask for your money as cash.  You’ll probably just write a check or use your debit card.  And so, they can count on a certain amount of float to work with.  But this means you still have $1,000 in your checking account that you can spend at any time.  And, Stanley has $500 he can use to buy comic books.  Your bank just created money that wasn’t there before. 

The ability of banks to create money by making loans is referred to as the deposit expansion process.  Though at first blush it seems it should be, it’s not illegal.  But to keep the bank from becoming greedy and over-extending itself, the process is heavily regulated by the Federal Reserve System – another of its important roles. 

Curious how much money a bank can create?  The Federal Reserve dictates that banks must keep a certain percentage of checkable deposits available for depositors at all times.  This amount is roughly 10%.  But that means a bank can lend 90%.  And of the money that creates?  Only 90% of that must be held.  And so on.  In the end, the banking system can increase that original $1,000 roughly 10X. 

Here’s why this is important.  At the beginning of the Great Depression, roughly one-third of all banks failed.  But with the collapse of those banks went all of the deposits along with this deposit expansion process.  And finally, returning to your equation of exchange, an unexpected and very substantial decrease in the money supply, barring any change in velocity, must result in a proportional decrease in GDP.  The following graph shows the roughly 25% decrease in inflation-adjusted GDP coinciding with the monetary collapse.