7.2 The banking system and money creation
6 min read•july 30, 2024
The banking system plays a crucial role in the economy, facilitating transactions and supporting growth. and work together to manage money supply, provide financial services, and maintain stability. This system is the backbone of modern finance.
Money creation occurs through , where banks lend out a portion of deposits. This process, along with central bank policies and public behavior, influences the money supply. Understanding these mechanisms is key to grasping monetary policy's impact on inflation, interest rates, and economic growth.
Structure and Functions of the Banking System
Composition of the Modern Banking System
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- The modern banking system consists of central banks and commercial banks, each with distinct roles and responsibilities
- Central banks (Federal Reserve in the United States) act as the bankers' bank and the government's bank
- Responsible for conducting monetary policy, regulating the banking system, and maintaining financial stability
- Commercial banks are financial institutions that accept deposits, provide loans, and offer various financial services to individuals and businesses
Roles and Responsibilities of Central Banks
- Central banks control the money supply, set interest rates, and act as lenders of last resort to commercial banks during financial crises
- Conduct monetary policy to achieve macroeconomic objectives (price stability, full employment, and economic growth)
- Regulate and supervise the banking system to ensure stability and prevent systemic risks
- Maintain financial stability by providing to the banking system during times of stress
Functions of Commercial Banks
- Commercial banks operate under a fractional reserve system, where they are required to hold a portion of their deposits as reserves and can lend out the remainder
- Accept deposits from individuals and businesses, providing a safe place to store money and earn interest
- Provide loans to borrowers, facilitating investment and consumption in the economy
- Offer various financial services (checking accounts, savings accounts, credit cards, and money transfers)
Importance of the Banking System in the Economy
- The banking system plays a crucial role in facilitating economic transactions, allocating financial resources, and supporting economic growth
- Acts as an intermediary between savers and borrowers, channeling funds from surplus units to deficit units
- Enables efficient allocation of capital to productive investments, fostering economic development
- Provides a payment system for individuals and businesses, facilitating the exchange of goods and services
Money Creation in Fractional Reserve Banking
The Fractional Reserve System
- In a fractional reserve banking system, commercial banks are required to hold a fraction of their deposits as reserves, while the remaining portion can be lent out to borrowers
- The reserve requirement ratio, set by the central bank, determines the minimum fraction of deposits that must be held as reserves
- Banks can lend out the excess reserves to borrowers, who then deposit the money back into the banking system, creating new deposits
The Money Creation Process
- When a bank receives a deposit, it keeps a portion as required reserves and lends out the excess reserves to borrowers
- Borrowers use the loans to make purchases or investments, and the money is deposited back into the banking system, creating new deposits
- This process of lending and re-depositing leads to the creation of new money in the economy, as the initial deposit is effectively multiplied
The Money Multiplier Effect
- The is the ratio of the change in the money supply to the change in the monetary base
- It determines the extent to which an initial deposit can lead to an expansion of the money supply
- The money multiplier is influenced by factors such as the reserve requirement ratio, the currency-to-deposit ratio, and the excess reserve ratio
Limitations on Money Creation
- The money creation process is not unlimited and is constrained by various factors
- The demand for loans, the willingness of banks to lend, and the monetary policies implemented by central banks can limit money creation
- Economic conditions, such as recessions or financial crises, can reduce the demand for loans and lead to a contraction in the money supply
Factors Influencing Money Supply
Central Bank Policies
- Central bank policies, such as , discount rates, and reserve requirements, have a significant impact on the money supply
- Open market operations involve the buying and selling of government securities by the central bank to influence the money supply and interest rates
- Buying securities increases the money supply, while selling securities decreases it
- Changes in the , which is the interest rate charged by the central bank on loans to commercial banks, can affect the cost of borrowing and the money supply
- Lowering the discount rate encourages borrowing and increases the money supply, while raising it has the opposite effect
Reserve Requirements and Bank Behavior
- Reserve requirements, set by the central bank, determine the fraction of deposits that commercial banks must hold as reserves
- Higher reserve requirements reduce the amount of money banks can lend out, limiting money creation, while lower requirements have the opposite effect
- The behavior of banks, such as their willingness to lend and their perception of economic conditions, can affect the money creation process
- During economic downturns, banks may become more cautious in their lending practices, reducing the money multiplier effect
Public Behavior and Technological Advancements
- The behavior of the public, including their preference for holding currency versus bank deposits (currency-to-deposit ratio) and their demand for loans, can influence the money supply
- A higher currency-to-deposit ratio reduces the money multiplier, while a lower ratio increases it
- Technological advancements, such as digital banking and electronic payments, can impact the velocity of money and the overall money supply
- Faster and more efficient payment systems can increase the velocity of money, leading to a higher effective money supply
Money Supply and Economic Variables
Inflation and Price Stability
- Changes in the money supply can have significant effects on inflation, which is the sustained increase in the general price level of goods and services
- An increase in the money supply, if not accompanied by a corresponding increase in the production of goods and services, can lead to inflation
- The increased money chases a limited supply of goods, driving up prices
- Hyperinflation, characterized by extremely high and rapid increases in prices, can occur when the money supply grows uncontrollably
- Examples include Germany in the 1920s and Zimbabwe in the late 2000s
Interest Rates and Economic Growth
- Expansionary monetary policies, such as lowering interest rates or increasing the money supply, can stimulate borrowing, investment, and consumption
- Lower interest rates reduce the cost of borrowing, encouraging businesses to invest and consumers to spend
- This can potentially lead to increased economic growth in the short run
- Contractionary monetary policies, such as raising interest rates or reducing the money supply, can help control inflation but may also slow down economic growth
- Higher interest rates make borrowing more expensive, discouraging investment and consumption
- This can lead to reduced economic growth and increased unemployment in the short run
Trade-offs and Policy Considerations
- The relationship between money supply and economic variables is complex and can be influenced by factors such as the stage of the business cycle, the credibility of the central bank, and the expectations of economic agents
- Policymakers need to carefully consider the trade-offs and potential consequences of changes in the money supply when making decisions
- Balancing the objectives of price stability, full employment, and sustainable economic growth
- The effectiveness of monetary policy depends on the transmission mechanisms, such as the interest rate channel and the credit channel, through which changes in the money supply affect the real economy
- Coordination between monetary policy and fiscal policy (government spending and taxation) is important for achieving macroeconomic objectives and promoting long-term economic stability
Key Terms to Review (18)
Basel III: Basel III is an international regulatory framework established to strengthen the resilience of banks and the banking system by introducing stricter capital requirements and improved risk management. It builds upon previous Basel accords by emphasizing the importance of maintaining higher quality capital, ensuring sufficient liquidity, and enhancing transparency in financial reporting. This framework is vital for understanding the banking system's stability and its role in money creation, as well as its influence on foreign exchange markets.
Capital adequacy ratio: The capital adequacy ratio (CAR) is a financial metric that measures a bank's capital in relation to its risk-weighted assets. It is crucial for ensuring that banks can absorb a reasonable amount of loss and comply with the statutory Capital requirements set by regulators. A higher CAR indicates a stronger financial position, which supports stability within the banking system and fosters confidence among depositors and investors, ultimately playing a vital role in money creation processes.
Central banks: Central banks are institutions responsible for managing a country's currency, money supply, and interest rates. They play a crucial role in maintaining economic stability by implementing monetary policy, regulating financial institutions, and serving as a lender of last resort. Central banks also influence foreign exchange markets and can affect currency values through their actions.
Commercial banks: Commercial banks are financial institutions that provide a range of services, including accepting deposits, making loans, and offering basic investment products. They play a critical role in the banking system by facilitating money creation through their lending activities, and they act as intermediaries between savers and borrowers in the capital markets.
Deposit creation: Deposit creation refers to the process by which banks generate new deposits through lending activities, effectively increasing the money supply in the economy. When a bank receives deposits, it is required to hold a fraction of those deposits as reserves while it can lend out the remainder, thus creating new money in the form of loans. This process is central to understanding how banks contribute to the overall money supply and economic activity.
Discount rate: The discount rate is the interest rate used by central banks to lend money to commercial banks, which impacts the overall cost of borrowing in the economy. It plays a vital role in influencing monetary policy decisions and serves as a key tool for managing money supply, controlling inflation, and stabilizing the financial system.
Dodd-Frank Act: The Dodd-Frank Act is a comprehensive financial reform legislation enacted in 2010 in response to the 2008 financial crisis, aimed at reducing risks in the financial system and protecting consumers. It introduced stricter regulations for banks and financial institutions, established the Consumer Financial Protection Bureau (CFPB), and implemented measures to increase transparency and accountability within the financial sector, thus playing a crucial role in stabilizing the banking system and influencing financial markets.
Fractional reserve banking: Fractional reserve banking is a banking system in which banks hold only a fraction of the total deposits as reserves, while using the majority of the funds for lending and investment purposes. This practice allows banks to create money through the lending process, effectively increasing the money supply in the economy. By holding reserves that are only a small percentage of their deposits, banks can facilitate economic growth while also managing liquidity.
John Maynard Keynes: John Maynard Keynes was a British economist whose ideas fundamentally changed the theory and practice of macroeconomics and economic policy. He is best known for advocating for government intervention to stabilize economic cycles and stimulate demand, especially during recessions, which connects directly to concepts such as GDP, fiscal policy, and inflation.
Keynesian Economics: Keynesian economics is an economic theory that emphasizes the role of government intervention in stabilizing the economy during periods of recession and unemployment. It suggests that active fiscal policy, including government spending and tax adjustments, is essential to stimulate demand and promote economic growth, especially in times of economic downturn.
Liquidity: Liquidity refers to the ease with which an asset can be quickly converted into cash without significantly affecting its market price. In finance, liquidity is a crucial concept because it determines how easily individuals and businesses can access cash when needed. High liquidity is often associated with cash and cash-equivalents, while assets like real estate are considered less liquid due to the time and effort required to sell them.
Loan creation: Loan creation refers to the process by which banks and financial institutions generate new loans, effectively increasing the money supply in the economy. When banks provide loans, they do not simply hand out existing deposits; instead, they create new deposits in the borrower's account, which contributes to the overall money supply. This process is a key function of the banking system and plays a significant role in influencing economic activity and growth.
M1: M1 is a measure of the money supply that includes the most liquid forms of money, specifically currency in circulation, demand deposits, and other liquid assets. This measure is crucial for understanding the economy's liquidity and how money moves within it, directly linking to the functions and types of money as well as the mechanisms of the banking system that facilitate money creation.
M2: M2 is a measure of the money supply that includes cash, checking deposits, and easily convertible near money. This metric is crucial for understanding the broader economic picture as it captures not just liquid cash but also savings accounts and other forms of money that can be quickly accessed, making it relevant in assessing liquidity in the economy and the banking system.
Milton Friedman: Milton Friedman was a renowned American economist known for his strong belief in free-market capitalism and minimal government intervention in the economy. His theories and writings have greatly influenced modern economic policies, particularly in the areas of monetary policy and fiscal policy.
Monetarism: Monetarism is an economic theory that emphasizes the role of governments in controlling the amount of money in circulation. This theory suggests that variations in the money supply have major influences on national output in the short run and the price level over longer periods. Monetarism connects with various economic aspects, such as the importance of money supply management for economic stability and growth, influencing banking practices and monetary policy decisions.
Money multiplier: The money multiplier is a concept that measures the maximum amount of money that can be created in the banking system for each unit of reserves held. It illustrates how banks can expand the money supply through lending, as they only need to keep a fraction of deposits as reserves while being able to loan out the rest. This concept is essential for understanding how banks operate and how monetary policy can influence the economy.
Open Market Operations: Open market operations refer to the buying and selling of government securities in the open market by a central bank to regulate the money supply and influence interest rates. These operations are essential for implementing monetary policy, as they directly affect the level of reserves in the banking system, thereby influencing the overall economy.