money

Two Kinds of Money
Money is a token that is widely accepted as a medium of exchange.  The token can be tangible like a coin or note, or intangible like a bank deposit.  If the token is convertible on demand into a valuable commodity like gold, the token is known as commodity money.  The exchange value of commodity money varies, but is normally greater than its value as a commodity.  A precious metal coin is simply a token potentially convertible into the bullion that comprises it.
If the tokens are intrinsically worthless and inconvertible, the government must endow them with a special status to make them viable as money.  Such tokens are known as fiat money.  Except for collector’s items, all government-issued tokens today are fiat money.  One must therefore avoid thinking in terms of commodity money to understand modern money. 
In the era of commodity money, the issuer was constrained by the need to hold a sufficient supply of the underlying commodity.  There is no such constraint in the case of fiat money.  The value of fiat money therefore depends on the policies and actions of the issuer, normally the central bank of a country.  The remainder of this essay applies to the monetary system of the U.S. and not necessarily to other countries.
Fiat Money as a Tax Credit
The general acceptance of the government’s fiat money derives from its status as legal tender and from the fact that it is required in payment of federal taxes.  Those who have no tax liability have reason to acquire fiat money because it is of value to those who do.  Thus fiat money can be viewed as a tax credit, which will be used as a medium of exchange as long as the government widely enforces tax collection.
Base Money
Fiat money held by the private sector is known as the monetary base, which we will refer to as base money.  The Fed issues base money when it buys securities from the public for its own portfolio, mainly Treasury debt.  It pays by simply creating a deposit at the Federal Reserve Bank for the seller’s own bank.  This is known as monetizing the debt.
Bank Money
Banks create deposits, known as bank money, when they issue loans by simply crediting the borrower’s account with a new deposit.  The total amount of bank money increases when a bank issues a loan.  When a loan is paid off, that amount of bank money vanishes. 
The value of bank money is based on the promise that it can be converted on demand into base money at par.  Current rules require a bank to hold reserves of base money equal to at least 10% of its transaction deposits.  Reserves can be held in any combination of vault cash and deposit at the Fed.  There is no required reserve for other bank liabilities, such as savings accounts or certificates of deposit.
Controlling the Price of Reserves
Even if there were no reserve requirement, a bank would have to hold enough reserves at the Fed to cover its depositors' checks, and enough vault cash to meet the demand for withdrawals by depositors.  The need for reserves thus creates an active interbank market in which banks lend or borrow reserves among themselves.  The interest rate on these short-term transactions is called the Fed funds rate. 
The Fed steers the Fed funds rate toward its target through its open market operations.  These involve buying or selling securities in the open market to add or drain system reserves as needed to balance the supply and demand at its target for the Fed funds rate.
Any bank in good standing and with adequate collateral can borrow on a short-term basis at the Fed’s discount window.  The interest rate the Fed charges is 100 basis points above its target rate for Fed funds.  With that large a spread, the discount window is used by banks to cover temporary liquidity problems rather than as a source of reserves to back further lending.