14.6 Fractional Reserve Banking and the Money Supply

What do M1 and M2 include?

Currency (coins and Federal Reserve Notes) and checkable deposits.

Who creates coins and paper currency?

The U.S. Mint creates coins; the Bureau of Engraving and Printing creates Federal Reserve Notes.

Who creates checkable deposits?

Bank and thrift loan officers — through lending.

Why is this surprising (that they are made by banks and thrift loan officers)?

Because it means private institutions create a major part of the money supply.

What is fractional reserve banking?

A system where banks keep only a fraction of deposits as reserves and lend out the rest.

What counts as reserves today?

Currency in vaults and reserve balances at the Federal Reserve.

Why can banks create money?

Because lending creates new checkable deposits, which are part of M1 and M2.

What limits how much money banks can create?

The amount of reserves they keep — either by law or by choice.

What did goldsmiths originally do?

Stored gold and issued paper receipts backed 100% by gold.

What changed over time?

Goldsmiths realized people rarely redeemed gold, so they issued more receipts than gold held.

How did goldsmiths create money?

By lending out paper receipts not fully backed by gold.

What does this illustrate? (the goldsmith scenario)

That money can be created through lending, even with limited reserves.

What is a bank run?

When many depositors try to withdraw money at once, and the bank runs out of reserves.

Why are bank runs dangerous?

Banks can collapse if they can’t meet withdrawal demands.

How does deposit insurance prevent bank runs?

It guarantees deposits, so people don’t panic and rush to withdraw.

Why are banks highly regulated?

To prevent risky lending and protect the financial system from collapse.

How do banks create money?

By making loans that add new checkable deposits to the economy.

How is money destroyed?

When loans are repaid, the checkable deposits disappear.

What determines the total volume of checkable-deposit money?

The total amount of outstanding loans.

Why does the Fed monitor bank lending?

Because lending affects the money supply, interest rates, and economic activity.

What happens when the Fed encourages lending?

More loans, lower interest rates, more spending, and economic growth.

What happens when the Fed discourages lending?

Fewer loans, higher interest rates, less spending, and slower economic activity.

What four things change when the Fed influences lending?

(1) Checkable-deposit money, (2) Money supply, (3) Interest rates, (4) Economic activity.

Why is the Fed both a monetary authority and banking supervisor?

So it can directly influence lending and effectively manage the economy.

Banks operating on the basis of ________ reserves are vulnerable to "panics" or "runs."

Fractional

Fed policy changes that prompt banks to ______ will result in easier access to credit.

increase their lending

The Fed is able to influence changes in interest rates, the overall money supply, and the total amount of checkable-deposit money with policy changes that increase or decrease bank______

Lending

What are the two significant characteristics of fractional reserve banking?

• Banks operating on the basis of fractional reserves are vulnerable to "panics" or "runs."

• Banks can create money through lending.

How are individuals and firms accessing credit affected by a Fed policy that prompts a decrease in bank lending?

• They will have a lower volume of loans available to them.

• They will need to pay a higher interest rate on loans.

The Fed is effective at managing the money supply, interest rates, and economic activity, because it can directly influence bank and thrift lending as the nation's central ________

Bank

Removing the incentive to withdraw one's deposit before anyone else can is the purpose of _______

Deposit insurance

Deposit _______ helps prevent banks runs by guaranteeing depositors that they will always get their money.

Insurance