Banks, Money, and the Federal Reserve System

Introduction

Banks play a central role in the modern economy by facilitating the flow of money, providing loans, and supporting economic stability. The Federal Reserve (the Fed) oversees the banking system and implements monetary policy to achieve macroeconomic goals.

Functions and Types of Money

Definition and Importance of Money

• Money is any asset that people are generally willing to accept in exchange for goods and services.

• Without money, economies rely on barter, which requires a double coincidence of wants (e.g., you must find someone who has what you want and wants what you have).

• The existence of money greatly simplifies trade and economic activity.

Functions of Money

• Medium of Exchange: Money is widely accepted as payment for goods and services.

• Unit of Account: Money provides a standard measure of value, making price comparisons possible.

• Store of Value: Money can be saved and used for future purchases, allowing people to defer consumption.

• Standard of Deferred Payment: Money enables transactions over time, as its value is expected to remain relatively stable.

Characteristics of Good Money

• Acceptability: Must be accepted by most people.

• Standardized Quality: All units are alike.

• Durability: Should not wear out easily.

• Valuable Relative to Weight: Easy to transport in large quantities.

• Divisibility: Can be used for both small and large transactions.

Types of Money

• Commodity Money: Goods used as money that have intrinsic value (e.g., gold, silver, animal skins, shells, cigarettes in prisons).

• Fiat Money: Money authorized by a central bank or government that has no intrinsic value and is not backed by a commodity. Its value depends on public confidence.

Example: Modern paper currency is fiat money, while gold coins are commodity money.

Measuring the Money Supply

Definitions of Money Supply

• M1: The sum of currency in circulation, checking account deposits, and savings account deposits in banks. (Note: Savings accounts are typically included in M2, not M1; see additional info.)

• M2: A broader measure that includes M1 plus other assets such as savings deposits, small-denomination time deposits, and money market mutual funds.

Additional info: Officially, M1 includes currency, checking deposits, and traveler's checks; M2 includes M1 plus savings deposits, small time deposits, and retail money market funds.

Credit Cards and Money

• Credit cards are not considered money; they represent short-term loans, not a medium of exchange or store of value.

The Role of Banks in the Economy

Bank Functions and Profitability

• Banks accept deposits and make loans, playing a critical role in the money supply process.

• Banks do not keep all deposits on hand; they lend out a portion to earn profits.

• Depositors earn a low rate of interest, while banks earn higher rates from loans and investments.

Reserves and Reserve Requirements

• Reserves: Deposits that banks keep as cash in their vaults or on deposit with the Federal Reserve.

• Historically, banks were required to hold a fraction of checking deposits as reserves (e.g., 10%).

• During the COVID-19 pandemic, the reserve requirement was reduced to zero, allowing banks to lend out all deposits.

Deposit Multiplier

• The deposit multiplier shows how an initial deposit can lead to a greater increase in the total money supply.

Formula:

where is the reserve requirement (as a decimal).

Why the Money Supply Fluctuates

• Changes in the amount of reserves banks hold relative to deposits.

• Changes in the amount of currency households and firms hold relative to deposits.

Bank Lending and Economic Importance

• Banks reduce information problems (asymmetric information) between borrowers and lenders.

• They provide loans for consumption and investment, including student loans for young people.

Bank Regulation and the Federal Reserve

Bank Supervision and Risk

• Banking involves significant risks, making government supervision essential for economic stability.

• Central banks, like the Federal Reserve, act as lenders of last resort to prevent bank runs and panics.

Bank Panics and the Feedback Loop

• During a panic, depositors lose confidence in banks' assets and demand their funds.

• Banks may run out of cash, leading to asset sales, reduced lending, and further economic decline.

• This can create a negative feedback loop, causing more bank failures and economic contraction.

Federal Reserve Structure and Policy Tools

• The Federal Open Market Committee (FOMC) is responsible for open market operations—buying and selling government securities to influence the money supply.

• The FOMC meets eight times a year to set monetary policy.

• Since 2008, the Fed pays interest on reserve balances, influencing banks' willingness to hold reserves.

Goals of Monetary Policy

• Price Stability: Keeping inflation low and predictable.

• High Employment: Promoting maximum sustainable employment.

• Stability of Financial Markets and Institutions: Ensuring the soundness of the financial system.

• Economic Growth: Supporting long-term increases in real GDP.

Summary Table: Types of Money and Their Characteristics

Summary Table: Money Supply Measures

Additional info: Savings accounts are officially part of M2, not M1, according to the Federal Reserve's definitions.