Fractional Reserve Banking
largest means of payments are savings accounts
savings accounts, money market mutual funds, and small-time deposits require extra work to be used as payment
typically must transfer the money to a checking account before you can use it
money supply can be defined in different ways depending on which liquid assets are included
3 most important definitions:
monetary base (MB): currency + total reserves held at the Federal Reserve
M1: currency + checkable deposits
M2: M1 + savings deposits, money market mutual funds, and small time deposits
what makes Federal Reserves job difficult/interesting?
the Federal Reserve ultimately aims to influence aggregate demand by using its control over the money supply
which money supply does the Federal Reserve have control over?
monetary base
which money supplies have the most significant effects on aggregate demand?
M1 and M2
the central bank tries to use its control over the monetary base to affect M1 and M2
many other influences on M1 and M2
are also other influences on aggregate demand
in order to understand how the Federal Reserve influences M1 and M2 and aggregate demand, and why its influence is sometimes weak, we need to understand:
fractional reserve banking
reserve ratio
money multiplier
fractional reserve banking: a system in which banks hold only a fraction of deposits in reserve, lending the rest
when money is deposited into an account, the bank holds a fraction of the account balance in reserve and uses the rest to make loans
banks earn profit on these loans
reserve ratio (RR): the ratio of reserves to deposits
RR= reserves/deposits
if banks make profit from making loans, why do they keep any money in reserve?
banks need those reserves to meet depositor demands for currency and payment services
the law and the Federal Reserve require banks to keep some reserves
often referred to as the “required reserve ratio” or reserve requirement
reserves involve opportunity costs
money held in reserve is not being lent, and lending is where banks earn most of their profits
banks balance these benefits and costs when deciding on the ratio between reserves and deposits
largest means of payments are savings accounts
savings accounts, money market mutual funds, and small-time deposits require extra work to be used as payment
typically must transfer the money to a checking account before you can use it
money supply can be defined in different ways depending on which liquid assets are included
3 most important definitions:
monetary base (MB): currency + total reserves held at the Federal Reserve
M1: currency + checkable deposits
M2: M1 + savings deposits, money market mutual funds, and small time deposits
what makes Federal Reserves job difficult/interesting?
the Federal Reserve ultimately aims to influence aggregate demand by using its control over the money supply
which money supply does the Federal Reserve have control over?
monetary base
which money supplies have the most significant effects on aggregate demand?
M1 and M2
the central bank tries to use its control over the monetary base to affect M1 and M2
many other influences on M1 and M2
are also other influences on aggregate demand
in order to understand how the Federal Reserve influences M1 and M2 and aggregate demand, and why its influence is sometimes weak, we need to understand:
fractional reserve banking
reserve ratio
money multiplier
fractional reserve banking: a system in which banks hold only a fraction of deposits in reserve, lending the rest
when money is deposited into an account, the bank holds a fraction of the account balance in reserve and uses the rest to make loans
banks earn profit on these loans
reserve ratio (RR): the ratio of reserves to deposits
RR= reserves/deposits
if banks make profit from making loans, why do they keep any money in reserve?
banks need those reserves to meet depositor demands for currency and payment services
the law and the Federal Reserve require banks to keep some reserves
often referred to as the “required reserve ratio” or reserve requirement
reserves involve opportunity costs
money held in reserve is not being lent, and lending is where banks earn most of their profits
banks balance these benefits and costs when deciding on the ratio between reserves and deposits