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

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