Bank Money refers to the portion of the money supply that is created by commercial banks when they make loans in a fractional reserve system. This process involves banks issuing more money in the form of loans than they actually hold in reserves, based on the amount of deposits received from customers.
Understanding the Fractional Reserve System
Definition and Function
A fractional reserve banking system allows banks to hold only a fraction of their deposit liabilities in reserves. The remaining funds can be loaned out to borrowers, effectively multiplying the amount of money in the economy. The central tenet of fractional reserve banking is that not all depositors will withdraw their money simultaneously, allowing banks to use deposits to extend credit.
Formula for Money Creation
The money supply created (M) from a given amount of new reserves (R) can be expressed using the money multiplier (m):
Where the reserve ratio is the fraction of deposits that a bank is required to hold in reserve.
Types of Bank Money
Demand Deposits
These include checking accounts which customers can access on demand through checks or electronic transfers. They are used for everyday transactions and are counted as part of the M1 money supply.
Savings and Time Deposits
These accounts may offer higher interest rates and limit the number of withdrawals or require notice before withdrawal. They contribute to the M2 and M3 money supply measures.
Historical Context
The concept of bank money has been fundamental to modern banking systems and has evolved significantly since its inception. The practice of fractional reserve banking began in medieval Europe when goldsmiths started issuing receipts for gold deposits, which led to the creation of banknotes and eventually to the complex banking systems we see today.
Applicability and Importance
Bank money plays a critical role in economic growth and stability. By enabling banks to provide loans, it facilitates investments in businesses, infrastructure, and personal consumption. However, it also requires careful regulation to ensure stability, prevent bank runs, and control inflation.
Comparison with Central Bank Money
While bank money is created by commercial banks, central bank money is issued by a nation’s central bank (like the Federal Reserve in the U.S.) and includes both physical currency and central bank reserves.
Related Terms
- Central Bank: A national institution that oversees monetary policy, regulates the banking industry, and provides financial services including the management of the country’s currency, money supply, and interest rates.
- Money Multiplier: A formula that determines the amount of money a bank can create based on the reserve ratio. It magnifies the impact of reserves on the total money supply.
- Liquidity: The ease with which an asset can be converted into cash without significant loss of value. Higher liquidity implies that bank money can facilitate quick and efficient transactions.
FAQs
How does bank money affect inflation?
What happens if banks don't maintain adequate reserves?
Can bank money be considered ‘real’ money?
Summary
Bank Money is a crucial aspect of the modern financial system, created through the banking practices within a fractional reserve system. It enables economic activities by providing loans far exceeding the physical reserves held by banks. Understanding this concept reveals the underlying mechanics of money supply and the pivotal role commercial banks play in economic dynamics. The stability and efficacy of this system rely heavily on regulations and careful management to prevent financial crises and support sustained economic growth.
References
- Mishkin, F. S. (2007). The Economics of Money, Banking, and Financial Markets.
- Gates, D. (2014). Banking and Financial Systems.
- Federal Reserve System. (www.federalreserve.gov)
In this comprehensive entry, we have covered the definition, types, historical context, significance, and related terms associated with Bank Money, providing readers with an in-depth understanding of this key financial concept.
