APMacro: Money Supply and Banking Review


  • Anything that is accepted as (a) a medium of exchange, (b) a unit of monetary account, and (c) a store of value can be used as money.
  • There are several definitions of the money supply. M1 consists of currency and checkable deposits; M2 consists of M1 plus savings deposits, including money market deposit accounts, small time deposits (less than $100,000) plus money market mutual fund balances held by businesses.
  • Money represents the debts of government and institutions offering checkable deposits and has value because of the goods, services, and resources it will command in the market. Maintaining the purchasing power of money depends largely on government’s effectiveness in managing the money supply.
  • The U.S. banking system consists of (a) the Board of Governors of the Federal Reserve System, (b) the 12 Federal Reserve Banks, and (c) some 7600 commercial banks and 11,400 thrift institutions (mainly credit unions). The Board of Governors is the basic policymaking body for the entire banking system. The directives of the Board and the Federal Open Market Committee (FOMC) are made effective through the 12 Federal Reserve Banks, which are simultaneously (a) central banks, (b) quasi-public banks, and (c) banker’s bank.
  • The major functions of the Fed are to (a) issue Federal Reserve Notes, (b) set reserve requirements and hold reserves deposited by banks and thrifts, (c) lend money to banks and thrifts, (d) provide for the rapid collection of checks, (e) act as the fiscal agent of the Federal government, (f) supervise the operations of the banks, and (g) regulate the supply of money in the best interests of the economy.
  • The Fed is essentially an independent institution, controlled neither by the president of the united States nor by Congress. The independence shields the Fed from political pressure and allows it to raise and lower interest rates (vi changes in the money supply) as needed to promote full employment, price stability, and economic growth.
  • Modern banking systems are fractional reserve systems. Only a fraction of checkable deposits is backed by currency.
  • The operation of a commercial bank can be understood through its balance sheet, where assets equal liabilities plus net worth.
  • Commercial banks keep required reserves on deposit in a Federal Reserve Bank or as vault cash. These requires reserves are equal to a specified percentage of the commercial bank’s checkable deposit liabilities. Excess reserves are equal to actual reserves minus required reserves.
  • Banks lose both reserves and checkable deposits when checks are drawn against them.
  • Commercial banks create money, checkable deposits or checkable deposit money, when they make loans.The creation of checkable deposits by bank lending is the most important source of money in the U.S. economy. Money is destroyed when bankers repay bank loans.
  • The ability of a single commercial bank to create money by lending depends on the size of its excess reserves. A commercial bank can lend only an amount equal to its excess reserves. Money creation is therefore limited because checks drawn by borrowers will be deposited in other banks, causing a loss of reserves and deposits to the lending bank equal to the amount of money that a bank has lent.
  • The commercial banking system as a whole can lend by a multiple of its excess reserves because the system as a whole cannot lose reserves. However, individual banks can lose reserves to other banks in the system.
  • The multiple by which the banking system can lend on the basis of each dollar of excess reserves is the reciprocal of the reserve ratio. The multiple credit expansion process is reversible.

Learnerator
1. Central Bank & Money Supply #1-40
2. Money Banking & Financial Markets #1-31
3. Loanable Funds Market #1-30

Arrows-02-june

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