BU.220.610 Chap.3 Money Supply, Credit and Banks
Money Supply, Credit and Banks
Module 3 turns to money: what it does, who creates it, and why banking trouble quickly becomes a macroeconomic problem. The module asks how a system that moved from gold and silver coins to paper, checks, cards and digital balances still manages to have a money supply the central bank can influence, and what commercial banks contribute along the way. Money performs three functions.
It is the medium through which goods are bought, a store that carries purchasing power into the future, and the unit in which prices and contracts are written. Modern money is fiat money, valued because people expect others to accept it, in contrast with commodity money that has value of its own but is costly to hold and move.
Measured aggregates widen step by step: currency, then M1 with checkable deposits, then M2 with savings and small time deposits. The key mechanism is fractional-reserve banking. When banks keep only part of each deposit as reserves and lend the rest, the loan is spent and redeposited, and each round creates new deposits. With no currency leakage the deposit total is the initial deposit divided by the reserve ratio.
Allowing households to hold some cash gives the general money multiplier, which depends on how much cash households keep per dollar of deposits and how much of each deposit banks hold back as reserves. The money supply equals that multiplier times the monetary base, the currency and reserves the central bank controls directly. This split explains who controls what.
The Federal Reserve sets the base through open market operations and influences the reserve ratio through reserve requirements and the interest it pays on reserves; it can also lend to banks at the discount rate. Its policy rate is the federal funds rate, targeted by the committee that meets roughly every six weeks.
Households and banks, however, decide the ratios, so fear that makes people hold cash or makes banks sit on reserves can shrink the money supply without any change in Fed policy. The chapter also explains why banks are fragile. A bank's capital is the owners' stake, the gap between its assets and its liabilities, and leverage, assets divided by capital, magnifies losses.
A highly leveraged bank can be wiped out by a modest fall in the value of its loans, which is how mortgage losses in the sub-prime crisis cut bank capital, slowed lending and deepened the recession. By the end you should be able to compute a multiplier, trace an open market operation to the money supply, and explain why regulators require capital.
What this chapter covers
- 01
Functions of money and fiat money
- 02
Currency, M1 and M2
- 03
Fractional-reserve banking and deposit creation
- 04
The money multiplier and the monetary base
- 05
Federal Reserve policy tools
- 06
Bank capital and leverage
Worked example · free
Trace an open market purchase to the money supply
- 1State the effect on the base: the purchase adds $40 billion of reserves, so B rises by 40.
- 2Compute m = (cr + 1) divided by (cr + rr) = 1.25 divided by 0.40 = 3.125.
- 2Multiply: the money supply rises by 3.125 times 40 = $125 billion, assuming the two ratios stay put.
Key terms
- Monetary Base
- Currency held by the public plus bank reserves, the part of the money stock the central bank controls directly.
- Money Multiplier
- The ratio of the money supply to the monetary base, equal to (cr + 1) divided by (cr + rr) in the course model.
- Reserve-Deposit Ratio
- The share of deposits a bank holds as reserves rather than lending out, set by regulation and bank policy.
- Open Market Operations
- Central bank purchases or sales of government bonds that add reserves to, or drain them from, the banking system.
- Leverage Ratio
- A bank's assets divided by its capital; a higher ratio means a smaller fall in asset values can make the bank insolvent.
Money Supply, Credit and Banks FAQ
Why does a bank run shrink the money supply even if the Fed does nothing?
Depositors withdraw cash, which raises the currency-deposit ratio, and nervous banks hold more reserves. Both ratios sit in the multiplier's denominator, so the money supply contracts although the monetary base has not changed.
How do commercial banks and the Federal Reserve divide the job of creating money?
Commercial banks take deposits and make loans, and in doing so create deposit money. The central bank issues currency, holds banks' reserves and sets the monetary base and the policy rate that influence how much lending takes place.
Why do regulators care about bank capital?
Capital absorbs losses before depositors and creditors are hit. With high leverage, a small percentage fall in loan values can exhaust capital, forcing a bank to cut lending or fail, which spreads the damage to firms that depend on credit.
Exam move
Drill the multiplier formula until you can compute m and the change in M from any pair of ratios in under a minute. Then rehearse each Fed lever as a one-line chain from the tool to the base or the ratio to the money supply, and check the sign at the end.
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