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A nation's money supply is based on either the production of a commodity or governmental fiat. Commodity money typically is based on valuable metals, particularly gold or silver. When a nation uses commodity money, the size of the money supply is determined by the cost of producing the commodity and the rate of production. During the late 1800s and early 1900s, U.S. currency was based on the gold standard, which is to say that the United States promised to redeem its currency for a specified amount of gold.
Fiat money, on the other hand, does not have intrinsic value. It has value because people are willing to accept it. To increase a fiat money's acceptability, a government may make the currency legal tender, which means people are required by law to accept the money at its face value. Today the United States is on a fiat money system, in which the national government through its central bank, the Federal Reserve System, controls the money supply. U.S. currency is legal tender.
Yet the money supply in the United States consists of more than just coins and paper money. Checking account deposits are considered a form of money because they are spent when people write checks. In fact, in the United States, about three-fourths of all payments are made by check. When commercial banks make loans, they can create checking deposit money by giving the borrowers additional credit in their deposit accounts. The Federal Reserve System maintains control over this money creation by administering reserve requirements, rules which require that commercial banks hold currency in their vaults -- or deposits with Federal Reserve Banks -- in a set minimum proportion to their deposit liabilities. By controlling the dollar amount of the reserves, the Federal Reserve thus controls the dollar volume of bank loans.
Economists measure the money supply in several ways that differ according to which assets are included in the measurements. One measure includes deposits in all interest-bearing accounts that can be used like checking accounts. Another includes savings accounts that cannot automatically be converted to make purchases. Banks can require advance notice of withdrawals from these accounts.
When the money supply increases, people have more money to spend, and demand for goods and services increases. As demand increases, businesses hire additional workers to increase output. This is an economic growth scenario. But, if output does not keep pace with demand, prices increase. When prices rise continuously, inflation results. This tends to cause problems for people whose incomes do not increase at a rate consistent with inflation.