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To recap, money serves three functions:
| Function of Money | Purpose |
|---|---|
| Medium of exchange | Used as an intermediary to facilitate non-barter-based trade, in other words, money allows us to get what we want (e.g., debit card, cash, and check) |
| Store of value | Has a recognized value that can be stored and retrieved |
| Unit of account | Allows comparison of the value of different items; used in financial transactions and record keeping |
So, what is money? Most people tend to think of money as bills and coins. However, if money is anything that fits those three functions and allows us to get what we want, would checks and debit cards also be considered money? What else could it be?
Let’s briefly touch upon the concept of liquidity. We can classify money into types based on to how easy or difficult it is to spend that type of money.
Some forms of money, like physical cash, are very easy to spend immediately. This is an extremely liquid form of money.
Other forms of money, like the money in a savings account, involve a few more steps before they can be spent. Again, this deals with the concept of liquidity.
Forms of money can be classified according to their liquidity.
M0 is the most liquid form of money. It is the narrowest definition of money and includes both physical cash in circulation and reserves held in banks.
M1 includes M0, but it also includes checking accounts. It is still liquid because you can, for instance, write a check or swipe a debit card to spend the money in your checking account.
M2 is M1 (which includes M0) plus all the time deposits. This is the broadest definition of money and also the least liquid. Time deposits include savings accounts and money market mutual funds.
We are discussing the different parts of the money supply because it is the FOMC that manages this money supply.
The FOMC is part of the Federal Reserve, and it meets eight times a year to manage our nation’s money supply.
The tools that the FOMC uses to control our M0, M1, and M2 are as follows:
How do banks make money?
As you are likely aware, if banks existed simply to store our money, they would not profit. When we deposit money into a checking account at a bank, we can demand that money at any time.
However, banks make money by lending out a portion of customer deposits and charging interest. So, for every dollar held in the vault or reserves, there could be multiple dollars in multiple checking accounts on which customers have the ability to write checks. This is called a fractional reserve system.
Now, this may sound a bit suspect, but the system works as long as certain things do not go wrong. What are the chances that everyone will show up at the bank/ATMs at the same time, demanding all of their money? The likelihood of that happening is not very high, and as long as the demand for cash on any given day is less than the cash that the bank is actually holding in reserve, this system functions. It allows banks to give more loans and earn more interest. This is essentially how banks create money in our economy.
However, if banks lend out too much money, or if people show up demanding all the cash in their accounts and the bank cannot meet these demands, the bank fails or goes bankrupt.
This used to happen a lot in our country’s history, so the Fed started regulating how much of these reserves the banks must hold in their vaults or at regional Fed banks.
Reserves are a portion of deposits required to be held by a bank. They are usually kept to maintain the reserve requirements set by the Fed.
The reserve requirement is the required amount of depository liabilities set by the Fed that a bank must hold. It is typically quoted as a percentage.
IN CONTEXT
Suppose you deposit $1,000 right now into your checking account and the reserve requirement set by the Fed is 10%. This means that your bank has to hold on to $100 of that $1,000 as reserves. It can lend out the rest, or $900.
If the reserve requirement goes up, the bank cannot lend out as much money. So, for instance, if it rises to 20%, it will have to hold on to $200 and can only lend out $800.
If the reserve requirement falls, it can lend out more money. If it falls to 5%, it will only have to hold on to $50 as reserves and cannot lend out $950.
Therefore, these changes in the reserve requirement change the ability of banks to give out loans.
In our economy, lending equals money creation.
EXAMPLE
When a bank makes a loan from the money that you have deposited, it has created money. This is because you still have the ability to write a check or demand the cash that you have deposited, but since it loaned out some of that money, someone else now has money that it did not have before. In that way, money is created.IN CONTEXT
Let’s walk through a real-world example, using a reserve requirement of 10%. Suppose you take out a loan for $1,000; now, you have $1,000 that you did not have before.
This is physical cash, representing money in M0. You deposit it into your checking account, so now it is in M1. What is your bank going to do next?
If the reserve requirement is 10%, your bank lends out $900 to somebody else and holds on to its required $100. The person who received the $900 now deposits their money into a bank, and that bank lends out $810, or 90% of what it is allowed to loan out. It holds on to 10%, or $90.
So, this process continues. Your initial deposit to the bank and the subsequent loans have caused the money supply to increase by $2,710 so far, which is $1,000 + $900 + $810. As long as banks are lending out a portion of the money, this will continue.
How do we figure out how far it continues? Well, we need to find the money multiplier, which is 1 divided by the reserve requirement.
In this case, we plug in 10%, or 0.10, as our reserve requirement, which gives us a money multiplier of 10.
1/0.10 = 10
This means that if we take our initial loan, the $1,000 in M0 times our multiplier of 10, this will lead to a potential $10,000 increase in checkable deposits in M1.
$1,000 × 10 = $10,000
The money multiplier is defined as the increase in the money supply resulting from the ability of banks to loan deposits. The value is equal to the reciprocal of the prevailing reserve ratio—or 1/R, where R is the reserve ratio.
Again, suppose you take out a loan for $1,000. With a reserve requirement of 50%, how much money will the bank lend out? Well, 50% of $1,000 is $500, so it needs to reserve that amount and can lend out the remaining $500.
The person receiving the loan now has money that they did not have before, and they deposit it. Their bank, then, lends out $250, holding onto the required 50%, or $250. Each time, there is less and less money available for the bank to relend because it has to hold on to more of it.
This process continues, and using the same equation, we can see that the money multiplier is 2.
1/0.50 = 2
Therefore, the initial $1,000 deposit can only create $2,000.
Now, if there was actually a reserve requirement of 100%, meaning banks had to hold onto all money deposited, banks would not have the ability to create money. There would be no multiplier effect. The greater the supply of funds that banks can loan out, the greater their ability to increase our money supply.
Therefore, if the Fed wants to increase the money supply, it makes it easier for banks to give loans and it lowers the reserve requirement. If it wants to decrease the money supply or contract it, it does the opposite and raises the reserve requirement.
So, the reserve requirement is a very powerful tool because in addition to giving the Fed the power to control the size of M1, it helps prevent bank runs, as banks must report on reserves every single day. Consumers can have confidence that their bank will have the money they can demand at any time.
Source: Adapted from Sophia instructor Kate Eskra.
