7.2 The banking system and money creation

The banking system plays a crucial role in the economy, facilitating transactions and supporting growth. Central banks and commercial banks work together to manage money supply, provide financial services, and maintain stability. This system is the backbone of modern finance.

Money creation occurs through fractional reserve banking, where banks lend out a portion of deposits. This process, along with central bank policies and public behavior, influences the money supply. Understanding these mechanisms is key to grasping monetary policy's impact on inflation, interest rates, and economic growth.

Structure and Functions of the Banking System

Composition of the Modern Banking System

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• The modern banking system consists of central banks and commercial banks, each with distinct roles and responsibilities
• Central banks (Federal Reserve in the United States) act as the bankers' bank and the government's bank
  • Responsible for conducting monetary policy, regulating the banking system, and maintaining financial stability
• Commercial banks are financial institutions that accept deposits, provide loans, and offer various financial services to individuals and businesses

Roles and Responsibilities of Central Banks

• Central banks control the money supply, set interest rates, and act as lenders of last resort to commercial banks during financial crises
• Conduct monetary policy to achieve macroeconomic objectives (price stability, full employment, and economic growth)
• Regulate and supervise the banking system to ensure stability and prevent systemic risks
• Maintain financial stability by providing liquidity to the banking system during times of stress

Functions of Commercial Banks

• Commercial banks operate under a fractional reserve system, where they are required to hold a portion of their deposits as reserves and can lend out the remainder
• Accept deposits from individuals and businesses, providing a safe place to store money and earn interest
• Provide loans to borrowers, facilitating investment and consumption in the economy
• Offer various financial services (checking accounts, savings accounts, credit cards, and money transfers)

Importance of the Banking System in the Economy

• The banking system plays a crucial role in facilitating economic transactions, allocating financial resources, and supporting economic growth
• Acts as an intermediary between savers and borrowers, channeling funds from surplus units to deficit units
• Enables efficient allocation of capital to productive investments, fostering economic development
• Provides a payment system for individuals and businesses, facilitating the exchange of goods and services

Money Creation in Fractional Reserve Banking

The Fractional Reserve System

• In a fractional reserve banking system, commercial banks are required to hold a fraction of their deposits as reserves, while the remaining portion can be lent out to borrowers
• The reserve requirement ratio, set by the central bank, determines the minimum fraction of deposits that must be held as reserves
• Banks can lend out the excess reserves to borrowers, who then deposit the money back into the banking system, creating new deposits

The Money Creation Process

• When a bank receives a deposit, it keeps a portion as required reserves and lends out the excess reserves to borrowers
• Borrowers use the loans to make purchases or investments, and the money is deposited back into the banking system, creating new deposits
• This process of lending and re-depositing leads to the creation of new money in the economy, as the initial deposit is effectively multiplied

The Money Multiplier Effect

• The money multiplier is the ratio of the change in the money supply to the change in the monetary base
• It determines the extent to which an initial deposit can lead to an expansion of the money supply
• The money multiplier is influenced by factors such as the reserve requirement ratio, the currency-to-deposit ratio, and the excess reserve ratio

Limitations on Money Creation

• The money creation process is not unlimited and is constrained by various factors
• The demand for loans, the willingness of banks to lend, and the monetary policies implemented by central banks can limit money creation
• Economic conditions, such as recessions or financial crises, can reduce the demand for loans and lead to a contraction in the money supply

Factors Influencing Money Supply

Central Bank Policies

• Central bank policies, such as open market operations, discount rates, and reserve requirements, have a significant impact on the money supply
• Open market operations involve the buying and selling of government securities by the central bank to influence the money supply and interest rates
  • Buying securities increases the money supply, while selling securities decreases it
• Changes in the discount rate, which is the interest rate charged by the central bank on loans to commercial banks, can affect the cost of borrowing and the money supply
  • Lowering the discount rate encourages borrowing and increases the money supply, while raising it has the opposite effect

Reserve Requirements and Bank Behavior

• Reserve requirements, set by the central bank, determine the fraction of deposits that commercial banks must hold as reserves
• Higher reserve requirements reduce the amount of money banks can lend out, limiting money creation, while lower requirements have the opposite effect
• The behavior of banks, such as their willingness to lend and their perception of economic conditions, can affect the money creation process
  • During economic downturns, banks may become more cautious in their lending practices, reducing the money multiplier effect

Public Behavior and Technological Advancements

• The behavior of the public, including their preference for holding currency versus bank deposits (currency-to-deposit ratio) and their demand for loans, can influence the money supply
  • A higher currency-to-deposit ratio reduces the money multiplier, while a lower ratio increases it
• Technological advancements, such as digital banking and electronic payments, can impact the velocity of money and the overall money supply
  • Faster and more efficient payment systems can increase the velocity of money, leading to a higher effective money supply

Money Supply and Economic Variables

Inflation and Price Stability

• Changes in the money supply can have significant effects on inflation, which is the sustained increase in the general price level of goods and services
• An increase in the money supply, if not accompanied by a corresponding increase in the production of goods and services, can lead to inflation
  • The increased money chases a limited supply of goods, driving up prices
• Hyperinflation, characterized by extremely high and rapid increases in prices, can occur when the money supply grows uncontrollably
  • Examples include Germany in the 1920s and Zimbabwe in the late 2000s

Interest Rates and Economic Growth

• Expansionary monetary policies, such as lowering interest rates or increasing the money supply, can stimulate borrowing, investment, and consumption
  • Lower interest rates reduce the cost of borrowing, encouraging businesses to invest and consumers to spend
  • This can potentially lead to increased economic growth in the short run
• Contractionary monetary policies, such as raising interest rates or reducing the money supply, can help control inflation but may also slow down economic growth
  • Higher interest rates make borrowing more expensive, discouraging investment and consumption
  • This can lead to reduced economic growth and increased unemployment in the short run

Trade-offs and Policy Considerations

• The relationship between money supply and economic variables is complex and can be influenced by factors such as the stage of the business cycle, the credibility of the central bank, and the expectations of economic agents
• Policymakers need to carefully consider the trade-offs and potential consequences of changes in the money supply when making decisions
  • Balancing the objectives of price stability, full employment, and sustainable economic growth
• The effectiveness of monetary policy depends on the transmission mechanisms, such as the interest rate channel and the credit channel, through which changes in the money supply affect the real economy
• Coordination between monetary policy and fiscal policy (government spending and taxation) is important for achieving macroeconomic objectives and promoting long-term economic stability