Money, Banking, and the Financial System
A structured guide to how money, banks, financial markets, and the Federal Reserve work together to transfer funds, create deposits, and influence financial conditions.
How the Connects Savers and Borrowers
The connects households, businesses, governments, and the central bank. Its central function is to move funds from savers to borrowers so that savings can support business investment, home construction, education, and public infrastructure. It also helps participants make payments and manage risk.
Major participants include:
Commercial banks, which accept deposits, make loans, process payments, and create deposit when they lend.
Credit unions, which are member-owned depository institutions offering many services similar to banks.
Insurance companies, which collect premiums and pay claims when covered losses occur, thereby pooling risk.
Pension funds and mutual funds, which collect savings and invest in financial assets.
Investment banks and securities markets, which help firms and governments raise funds by issuing stocks and bonds.
The , which serves as the central bank of the United States.
A is a claim on future income or wealth. Stocks represent partial ownership of a corporation, bonds represent loans to corporations or governments, bank deposits are claims against banks, and reserves are balances held by depository institutions as cash or at a Bank.
Takeaway: Financial institutions and markets channel savings toward borrowing and investment while supporting payments and risk management.
The Three Functions of
makes exchange easier because people generally accept it in payment for goods and services. Without , trade would require barter and a double coincidence of wants: each person would have to want what the other person offers.
has three related functions:
As a , is used by buyers to purchase goods and services and accepted by sellers as payment. For example, a student can buy a sandwich with dollars without the restaurant needing to want tutoring services.
As a , provides a common way to measure value. A textbook priced at $30 and one priced at $60 can be compared directly because both prices use dollars.
As a , allows people to transfer purchasing power from the present to the future. It is convenient and highly liquid, although inflation can reduce its purchasing power.
These functions are connected. Because is accepted in exchange, prices can be stated in , and people can hold between transactions. is not the same as wealth: wealth also includes assets such as stocks, real estate, and durable goods, which are not normally accepted directly as payment.
Takeaway: is valuable for exchange, measurement, and preserving purchasing power, but its purchasing power can decline with inflation.
Measuring the
The is measured using monetary aggregates that differ in liquidity. More liquid assets can be used more directly or quickly for payments.
The consists of currency in circulation and reserve balances:
includes currency held by the public and transaction deposits and other liquid deposits at depository institutions. These assets can be used directly or nearly directly for payments.
is broader than because it adds selected assets that can be converted into spendable funds relatively easily:
The distinction between and wealth is important. A stock may be valuable and part of a person's wealth, but it is not usually counted as because people do not generally accept it as payment for everyday purchases.
Takeaway: The , , and measure different groups of liquid assets; a broader aggregate includes assets that are less directly usable for daily transactions.
How Banks Create Deposit
Commercial banks perform by accepting deposits and making loans. A simplified bank balance sheet separates assets from liabilities and net worth.
Assets are resources or claims owned by the bank, such as reserves, loans, and securities.
Liabilities are amounts the bank owes, especially deposits owed to customers.
Bank capital, or net worth, equals assets minus liabilities.
When a bank approves a loan of $1,000 and credits the borrower's checking account, it records both sides of the transaction:
The bank gains a $1,000 asset because the borrower owes repayment.
The bank gains a $1,000 liability because it owes the new deposit to the borrower.
The bank has therefore created a new deposit rather than simply transferring existing currency. When the borrower spends the deposit, funds may move to another bank, and repeated lending and redepositing can expand deposits throughout the banking system.
Banks cannot create unlimited . Lending is limited by bank capital, available reserves and liquidity, regulations, credit risk, demand for loans, and the willingness of banks and borrowers to enter additional transactions.
Takeaway: A bank loan creates a bank asset and a matching deposit liability, but practical constraints limit how far deposit creation can expand.
Reserves: Traditional Model and Current Practice
In the traditional banking model, a reserve is cash held by a bank or a balance held in its account at the . Reserves help banks meet withdrawals and settle payments with other banks.
Required reserves are the minimum reserves a bank must hold in the traditional model.
Excess reserves are reserves held above the required amount.
The is the fraction of deposits held as required reserves.
The traditional relationships are:
For example, if deposits equal $10,000 and the is 20%, required reserves are:
If actual reserves equal $3,000, excess reserves are:
In the simplified model, the bank could lend the $1,000 of excess reserves. However, the reduced reserve requirement ratios to zero percent effective March 26, 2020. Therefore, the positive-reserve-ratio framework is best treated as a simplified analytical model rather than a description of the current U.S. reserve-requirement rule. Banks still hold reserves for payment settlement, liquidity management, and risk management.
Takeaway: Required and excess reserves are useful for understanding the traditional deposit-expansion model, but the current U.S. system does not use a positive reserve requirement ratio.
The and Its Roles
The is the central bank of the United States. Its responsibilities include conducting monetary policy, supervising and regulating certain financial institutions, providing payment and settlement services, issuing and distributing currency, serving as a lender of last resort under appropriate conditions, and promoting financial stability.
The System includes the Board of Governors, 12 regional Banks, and the Federal Open Market Committee. The Federal Open Market Committee determines the stance of U.S. monetary policy.
The influences financial conditions through tools such as open market operations, interest paid on reserve balances, and lending facilities. In a modern ample-reserves system, interest paid on reserve balances and related administered rates are more central to policy implementation than a required-reserve ratio. The required-reserve tool remains useful for understanding the traditional AP Macroeconomics model.
Commercial banks interact directly with households and businesses, while the provides the central-bank framework within which those institutions operate.
Takeaway: The supports the stability and operation of the and uses monetary-policy tools to influence interest rates and broader economic conditions.
The and Deposit Expansion
The illustrates how repeated lending and redepositing could expand deposits in a simplified banking system. The model assumes that banks lend all excess reserves, borrowers redeposit all loan proceeds, and no currency is withdrawn from the banking system.
The traditional simple is:
If the is 10%, the multiplier is:
Under the model, an increase of $1 in excess reserves could support up to $10 of total deposit expansion.
Suppose a bank receives $1,000 in new reserves and the is 20%. The first round can support a potential loan of $800 after holding $200 as required reserves. A redeposit of that $800 can support a potential loan of $640 after holding $160, and later rounds continue in the same pattern.
The maximum total increase in deposits is:
The initial $1,000 is included in the total deposit expansion. The additional loans created in later rounds total $4,000.
The actual multiplier may be smaller because banks may hold excess reserves, households may hold currency, borrowers may not want or qualify for loans, and banks face credit risk, capital constraints, liquidity concerns, and weak loan demand. Payments may also leave the banking system or reach institutions that do not immediately expand lending.
Takeaway: The is a theoretical maximum under strict assumptions, not a mechanical prediction that every dollar of reserves creates a fixed amount of .