Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed.
PART 10 Money and Prices in the Long Run
Chapter 29 of 36 The Monetary System
Section 11 of 22
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Banks play a central role in the monetary system.
The amount of money you hold includes both
· currency, the paper and coin money you have in your wallet
· demand deposits, the balance in your checking account
Because of the demand deposits held in banks the behavior of banks can influence the quantity of demand deposits in the economy and therefore influence the money supply.
Here we will look at how banks affect the money supply and how they complicate the Fed's job of controlling the money supply.
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Imagine an economy where there are no banks and currency is the only form of money.
Suppose the total economy currency quantity is $100, therefore the money supply is $100.
Then, someone opens a bank, “First National Bank.”
First National Bank is only a depository institution.
It accepts deposits and checking accounts but does not make loans
The bank’s purpose is to give depositors a safe place to keep their money.
Whenever a person deposits money the bank keeps it in its vault until the depositor comes to withdraw it or writes a check taking money out of their balance.
The money banks have received and remain as deposits are called reserves.
In our imaginary economy all deposits are held as reserves, none are loaned out.
This system is called 100-percent reserve banking
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Per Figure T1 we can express the financial position of First National Bank with a T-account
This is a simplified accounting statement that shows changes in a bank's assets and liabilities.
On the left side of the T-account are the bank's assets of $100, these are the reserves it holds in its vaults.
On the right side of the T-account are the bank's liabilities of $100, this is the amount it owes to its depositors.
The assets and liabilities of First National Bank exactly balance, here at $100.
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Now consider the money supply in this imaginary economy.
Before First National Bank opened the money supply was $100, the amount of currency people held in their homes.
After First National Bank opens people deposit all their currency in the bank which puts it in its vault.
The money supply becomes the $100 of demand deposits in the bank.
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Each deposit in the bank reduces currency and raises demand deposits by the same amount.
The money supply is unchanged.
Bank depositors write checks simply to move cash out of the bank to pay expenses.
So, if First National Bank holds all deposits in reserve does not make any loans
and it does not influence the money supply.
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assets and liabilities
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