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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