Essential Concepts in Banking, Reserves, and Monetary Economics

Essential Concepts in Banking and Monetary Economics

Understanding Bank Reserves and Requirements

Bank reserves are fundamental to the fractional reserve banking system. They serve multiple definitions and functions:

• Reserves Definition 1: Reserves are equal to vault cash plus bank deposits at the Federal Reserve.
• Reserves Definition 2: Reserves are equal to required reserves plus excess reserves.
• Classification: Reserves are classified as an asset to banks.

Required Reserves and Calculations

Required reserves are the amount of reserves a bank must hold against its deposits as mandated by the Federal Reserve.

Example 1: Calculating Excess Reserves

A bank has $10 million in checkable deposits and $2.5 million in reserves. If the required-reserve ratio is 15 percent, the bank has excess reserves of $1.0 million.

(Calculation: Required Reserves = $10M × 0.15 = $1.5M. Excess Reserves = $2.5M - $1.5M = $1.0M.)

Example 2: Calculating Required Reserves

Bank A has deposits of $5,000 and reserves of $1,800. If the required-reserve ratio is 0.20, the bank has required reserves of $1,000.

(Calculation: $5,000 × 0.20 = $1,000.)

The Simple Deposit Multiplier

The simple deposit multiplier is defined as the reciprocal of the required-reserve ratio.

Money Supply Components and Functions

The Nature of the U.S. Dollar

• The U.S. dollar has value primarily because people have confidence that it will continue to be accepted as a medium of exchange in the future.
• The U.S. money supply is backed by nothing (it is fiat currency).

Functions of Money

Which of the following is a correct listing of money's functions?

1. Store of value
2. Medium of exchange
3. Unit of account

The defining function or characteristic of money is the medium of exchange.

M1 and M2 Money Supply

M2 includes M1 plus all of the following except: short-term U.S. government securities.

Regarding components and classification:

• A savings account functions primarily as a store of value.
• A savings deposit is a type of deposit that allows depositors immediate access to their funds, although checks cannot be written on these accounts.

Banking Operations and Liquidity

Liquidity refers to the ease with which an asset, without a loss in its value, can be converted into cash (purchasing power).

Classification of Bank Items:

• To a bank, a checkable deposit is classified as a liability.
• To a bank, a loan is classified as an asset.

When a check is written on an account at one bank and deposited into an account at a second bank, the first bank will lose checkable deposits and reserves.

Money Versus Barter

Barter is the exchange of goods and services for goods and services without the use of money.

Transaction costs are best defined as the costs associated with the time and effort necessary to make an exchange.

Money's basic advantage compared to barter is that money reduces transaction costs.

Because money reduces transactions costs, people are more likely to specialize their work in a money economy than in a barter economy.

Common Misconceptions

Which of the following statements is false? Currency (which is a component of the M1 money supply) is the same as vault cash. (This statement is false because M1 currency refers primarily to currency held by the public, while vault cash is currency held by banks.)