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Economics - Money and Banking

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    Study Guide Economics – Money and Banking 1. Supply of Money The supply of money refers to the total amount of money available in an economy at a given time. Economists use different definitions to measure it, depending on how broadly they want to define “money.” Types of Money Supply • M1 (Narrowest and most common measure) • This includes: o Currency in circulation (notes and coins) o Checkable deposits in banks (bank money) o Traveler’s checks • M2 (Broader measure) • This includes everything in M1 , plus: o Savings deposits o Time deposits held in banks • M3 (Broadest measure) • This includes everything in M2 , plus: o Large, long - term time deposits (such as certificates of deposit over $100,000) In most discussions, economists focus on M1 , because it represents money that can be used immediately for spending. 1.1 Banking Business and the Role of Banks To understand how money is created, we first need to understand what banks do . Banks perform two main functions : 1. Accepting deposits

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    Study Guide 2. People deposit money in banks. In return, banks offer: o A safe place to store money o Easy access through checks or debit cards o Sometimes interest payments 3. Making loans 4. Banks use deposited money to lend to borrowers. 5. In this way, banks act as intermediaries between savers and borrowers. 1.2 Reserves and the Reserve Requirement Banks do not keep all deposited money in their vaults. Why? Because they know that not all customers will withdraw their money at the same time . • The portion of deposits that banks keep is called reserves • Reserves are used to meet withdrawal demands • The reserve requirement is the fraction of deposits that banks must keep as reserves • This requirement is set by the country’s central bank Money that is not kept as reserves is loaned out to borrowers. Banks earn profits by: • Paying low or zero interest on deposits • Charging higher interest on loans 1.3 Balance Sheet of a Typical Bank

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    Study Guide A balance sheet shows what a bank owns and what it owes . • Assets (what the bank owns): o Reserves o Loans • Liabilities (what the bank owes): o Deposits made by customers In this example: • Total assets = $1,000,000 • Total liabilities = $1,000,000 ✔ Assets must always equal liabilities. From this table, we can see that: • Reserves = $100,000 • Deposits = $1,000,000 So, the reserve requirement is 10% . 1.4 How Banks Create Money Now let’s see how banks expand the money supply . Suppose a bank receives a new deposit of $100,000 . • The bank must keep 10% ($10,000) as reserves • The remaining $90,000 is loaned out If borrowers deposit this $90,000 back into the bank: • The bank keeps $9,000 as reserves • It loans out $81,000 This process continues again and again.

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    Study Guide 1.5 Multiple Expansion of Deposits This table shows each round of: • New deposits • New reserves • New loans When the process is complete: • Total deposits increase by $1,000,000 • Total loans increase by $900,000 • Total reserves increase by $100,000 All of this started from the original $100,000 deposit .

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