THE COMMERCIAL BANKING SYSTEM
GOAL OF A BANK: MAXIMIZE PROFITS
Commercial banks are private corporations
Owned by individual stockholders
Banks earn profits by borrowing money from depositors and lending the money to borrowers at higher interest rates than
they pay to depositors
Banks also earn profits by charging fees for services
Checking account fees, ATM fees, estate and trust planning
FUNCTIONS OF BANKS:
1. PROVIDE SAFEKEEPING FOR DEPOSITORS’ MONEY:
2. MAKE LOANS
3. AS A GROUP, BANKS CREATE MONEY
FRACTIONAL RESERVE BANKING
Banks lend out most of the money that has been deposited.
Banks retain some of the deposits in its vault.
Some of the deposits might be deposited at the local branch of the Federal Reserve System for safety purposes.
The cash that a bank has in its vault plus any deposits that a bank has at the Federal Reserve
Banks earn no interest on reserves sitting in the vault or at the Fed.
Thus, holding money as reserves is unprofitable.
To generate profits, banks lend most of the money that has been deposited.
Every bank is required (by the Federal Reserve System) to keep a certain percentage of deposits as reserves in its vault
or at the local Federal Reserve Branch Bank to satisfy any customer withdrawals of deposits.
Depositing reserves at the Fed promotes safety of deposits and limits the potential loss during a bank robbery.
REQUIRED RESERVE RATIO
The minimum percentage of deposits that a bank must keep as reserves
This percentage is set by the Federal Reserve Board of Governors.
The minimum amount of reserves that a bank must hold
Required Reserves = Total Deposits x Required Reserve Ratio REQUIRED RESERVE RATIOS
10% on deposits over 45.4 million
3% on deposits of $6.6 million to $45.4 million
0% on deposits less than $6.6 million
= Actual reserves - Required reserves
Banks earn no interest on excess reserves
Banks increase profits by expanding their lending
THE MONEY MULTIPLIER
The multiple by which the total supply of money can increase for every $1 increase in reserves.
A $1 increase in bank reserves leads to a multiple increase in the money supply
The amount of the ultimate increase depends on the required reserve ratio
The maximum value of the money multiplier is:
Money multiplier = 1 / r
Where r is the required reserve ratio
EXAMPLE: THE MONEY MULTIPLIER
Assume the required reserve ratio is r = .10
Assume the Fed purchases $1,000 of securities from the public
ΔM = $1,000
The money is deposited in a bank
Required reserves increase by $100 and excess reserves increase by $900
(Assume all excess reserves are loaned out.)
The bank lends $900 to borrowers
The money supply increases by $900
ΔM = $900
The borrower buys something with the $900, and the seller deposits the $900 in a checking account
(We assume all money is deposited in a bank. No cash is held.)
Required reserves increase by $90
($900 x .10 = $90),
Excess reserves are $810
($900 - $90 = $810).
The bank lends $810 to borrowers
(I.e., all excess reserves are loaned out)
The money supply increases by $810
ΔM = $810 STEP 4:
The borrower buys something with the $810, and the seller deposits the $810 in a checking account
(I.e., all money is re-deposited in a bank.)
Required reserves increase by $81
($810 x .10 = $81)
Excess reserves are $729
($810 - $81 =