Banking and the Money Supply

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Case: Banking on the Net
To explore banking on the Internet, visit First Security National Bank or Wells Fargo. For more about banking software, visit Microsoft's MoneyZone or the Quicken Financial Network. To learn more about security on the Internet, visit the National Computer Security Association (NCSA), an independent organization addressing computer security issues.

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Study Guide Tutorial

In the past, banks operated very conservatively and worked hard at maintaining liquidity. Liquidity was achieved by stocking up on such liquid assets as short-term government securities. Beginning in the 1960s, banks altered their behavior and began relying increasingly on liabilities to maintain liquidity rather than on assets. Banks would take on short-term liabilities, such as loans in the federal funds market or repurchase agreements, to maintain liquidity, which allowed them to earn higher interest on their reserves by using them to extend longer-term loans. As inflation and interest rates increased, banks did not want to be holding only short-term government securities - the opportunity costs of doing so were too great. Instead, they extended loans that generated higher interest payments and handled short-term liquidity problems by borrowing in the federal funds market or by entering the negotiable CD market.

Question to Think About: Does the change in banking behavior imply that deposits in banks are not as safe today as they were thirty years ago?

Cash, Excess Reserves, and Money Creation

Banks generally cannot create money to the extent implied by the simple money multiplier, for two reasons. First, people usually carry some money in the form of currency. When a bank makes a loan and creates checkable deposits for a borrower and the borrower writes a check against the checkable deposits, the recipient of the check may not deposit the entire amount in his or her checking account. Instead, the recipient may hold some of the amount in cash and deposit the rest. Consequently, the deposit in the second bank is less than the check written against the checkable deposits in the first bank, and there has been a loss of reserves to the banking system. Second, banks generally do not loan out all of their excess reserves. Instead, they often hold a fraction of their excess reserves to protect against an unexpected demand for reserves.

Question to Think About: What factors are likely to affect a bank's decision concerning the amount of excess reserves to maintain?