Fractional Reserve Banking

Savings Accounts

  • 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

  • money supply can be defined in different ways depending on which liquid assets are included

  • 3 most important definitions:

    1. monetary base (MB): currency + total reserves held at the Federal Reserve
    2. M1: currency + checkable deposits
    3. 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:

    1. fractional reserve banking
    2. reserve ratio
    3. money multiplier

Fractional Reserve Banking

  • 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