The fund thus makes retirement saving available for other spending. Insurance companies are also financial intermediaries, because they lend some of the premiums paid by their customers to firms for investment. Mutual funds make money available to firms and other institutions by purchasing their initial offerings of stocks or bonds. Banks play a particularly important role as financial intermediaries. With the interest they earn on their loans, banks are able to pay interest to their depositors, cover their own operating costs, and earn a profit, all the while maintaining the ability of the original depositors to spend the funds when they desire to do so.
One key characteristic of banks is that they offer their customers the opportunity to open checking accounts, thus creating checkable deposits. These functions define a bank A financial intermediary that accepts deposits, makes loans, and offers checking accounts. Over time, some nonbank financial intermediaries have become more and more like banks.
For example, brokerage firms usually offer customers interest-earning accounts and make loans. They now allow their customers to write checks on their accounts. The fact that banks account for a declining share of U. We will see that banks are more tightly regulated than are other financial institutions; one reason for that regulation is to maintain control over the money supply.
Other financial intermediaries do not face the same regulatory restrictions as banks. Indeed, their relative freedom from regulation is one reason they have grown so rapidly. As other financial intermediaries become more important, central authorities begin to lose control over the money supply. As home prices in the United States began falling, many of those mortgage loans went into default.
Investment banks that had made substantial purchases of securities whose value was ultimately based on those mortgage loans themselves began failing. Bear Stearns, one of the largest investment banks in the United States, required federal funds to remain solvent.
Another large investment bank, Lehman Brothers, failed. In an effort to avoid a similar fate, several other investment banks applied for status as ordinary commercial banks subject to the stringent regulation those institutions face.
One result of the terrible financial crisis that crippled the U. Bank finance lies at the heart of the process through which money is created. To understand money creation, we need to understand some of the basics of bank finance. Banks accept deposits and issue checks to the owners of those deposits. Banks use the money collected from depositors to make loans.
Assets Anything of value. Liabilities Obligations to other parties. Net worth Assets less liabilities. The sum of liabilities plus net worth therefore must equal the sum of all assets. On a balance sheet, assets are listed on the left, liabilities and net worth on the right.
The main way that banks earn profits is through issuing loans. Because their depositors do not typically all ask for the entire amount of their deposits back at the same time, banks lend out most of the deposits they have collected—to companies seeking to expand their operations, to people buying cars or homes, and so on. Banks keep only a fraction of their deposits as cash in their vaults and in deposits with the Fed.
These assets are called reserves Bank assets held as cash in vaults and in deposits with the Federal Reserve. Banks lend out the rest of their deposits. A system in which banks hold reserves whose value is less than the sum of claims outstanding on those reserves is called a fractional reserve banking system System in which banks hold reserves whose value is less than the sum of claims outstanding on those reserves.
Table 9. Commercial Banks, January " shows a consolidated balance sheet for commercial banks in the United States for January Banks hold reserves against the liabilities represented by their checkable deposits. Notice that these reserves were a small fraction of total deposit liabilities of that month. Most bank assets are in the form of loans. Commercial Banks, January This balance sheet for all commercial banks in the United States shows their financial situation in billions of dollars, seasonally adjusted, in January In the next section, we will learn that money is created when banks issue loans.
To understand the process of money creation today, let us create a hypothetical system of banks. The quantity of reserves banks are required to hold is called required reserves The quantity of reserves banks are required to hold. The reserve requirement is expressed as a required reserve ratio The ratio of reserves to checkable deposits a bank must maintain. Banks may hold reserves in excess of the required level; such reserves are called excess reserves Reserves in excess of the required level.
Excess reserves plus required reserves equal total reserves. Because banks earn relatively little interest on their reserves held on deposit with the Federal Reserve, we shall assume that they seek to hold no excess reserves.
Finally, we shall ignore assets other than reserves and loans and deposits other than checkable deposits. To simplify the analysis further, we shall suppose that banks have no net worth; their assets are equal to their liabilities. The balance sheet for one of these banks, Acme Bank, is shown in Table 9.
The required reserve ratio is 0. Because reserves equal required reserves, excess reserves equal zero. Each bank is loaned up. Acme Bank, like every other bank in our hypothetical system, initially holds reserves equal to the level of required reserves. At this stage, there has been no change in the money supply. Because Acme earns only a low interest rate on its excess reserves, we assume it will try to loan them out. Now you know where money comes from—it is created when a bank issues a loan.
That customer will write a check to someone else, who is likely to bank at some other bank. Bellville Bank now has a check written on an Acme account. Like the magician who shows the audience that the hat from which the rabbit appeared was empty, Acme can report that it has not created any money.
There is a wonderful irony in the magic of money creation: banks create money when they issue loans, but no one bank ever seems to keep the money it creates. That is because money is created within the banking system, not by a single bank. The process of money creation will not end there. Let us go back to Bellville Bank. The banknote would be rendered useless.
I would certainly feel poorer. Yet, contrary to what might be expected, the supply of money in the economy would not permanently decrease. Central banks can simply replace any money taken out of circulation in the economy by printing out more. At core, they could print out as much money as they wish, with no real limit other than the fear of inflation.
Due to the relative insignificance of such action for the economy, destroying currency is not even illegal in Britain. In countries where it is illegal, like in the United States, it is primarily due to the inconvenience and marginal costs associated with printing out money.
This is because most money nowadays is fiat money, defined as money which has no intrinsic value. It is a financial asset, valuable as long as people believe we can exchange it for something else. With the gold standard abolished, the government can increase the supply of money without increasing its gold reserves. Yet for the sake of understanding how money really is created and destroyed in the banking system, it might be helpful to suppose that money can in fact be created out of thin air.
Does money creation seem too easy? It effectively disappears from the economy entirely. This video explains how. For example, suppose a consumer has spent money in the supermarket throughout the month by using a credit card. This is vitally important because it means that if we, the public, start reducing our debts by collectively borrowing less and repaying more, then the amount of money in the economy will actually start to shrink.
If we significantly reduce the debt then the shrinkage in the money supply could actually cause the economy to slow down or grind to a halt. Just think of the problems caused when banks refused to lend during the credit crunch.
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