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KW_Macro_Ch_13_Sec_02_The_Monetary_Role_of_Banks

KW_Macro_Ch_13_Sec_02_The_Monetary_Role_of_Banks - chapter...

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>> Money, Banking, and the Federal Reserve System Section 2: The Monetary Role of Banks chapter 13 About half of M1, the narrowest definition of the money supply, consists of curren- cy in circulation—$1 bills, $5 bills, and so on. It’s obvious where currency comes from: it’s printed by the U.S. Treasury. But the other half consists of bank deposits, and deposits account for the great bulk of M2 and M3, the broader definitions of the money supply. Bank deposits, then, are a major component of the money supply. And this fact brings us to our next topic: the monetary role of banks. What Banks Do As we learned in Chapter 9, a bank is a financial intermediary that uses liquid assets in the form of bank deposits to finance the illiquid investments of borrowers. Banks can create liquidity because it isn’t necessary for a bank to keep all of the funds deposited with it in the form of highly liquid assets. Except in the case of a bank run —which we’ll get to shortly—all of a bank’s depositors won’t want to withdraw his or her funds at the same time. So a bank can provide its depositors with liquid assets yet still invest much of the depositors’ funds in illiquid assets, such as mortgages and business loans.
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2 C H A P T E R 1 3 S E C T I O N 2 : T H E M O N E TA RY R O L E O F B A N K S Banks don’t, however, lend out all the funds placed in their hands by depositors because they do have to satisfy any depositor who wants to withdraw his or her funds. In order to meet these demands, banks keep substantial quantities of liquid assets on hand. In the modern U.S. banking system, these assets take the form either of cur- rency in the banks’ vaults or deposits held in the bank’s own account at the Federal Reserve. The latter can be, as we’ll see shortly, converted into currency more or less instantly. The currency and Federal Reserve deposits held by banks are called bank reserves. Because bank reserves are held by banks and the Federal Reserve, and not by the public, they are not considered part of currency in circulation. To understand the basic role of banks in determining the money supply, let’s con- sider a hypothetical example. Figure 13-2 shows the financial position of First Street Bank, which is the repository of $1 million in bank deposits. The bank’s financial position is described by the T-account, a type of financial spreadsheet, as shown in the figure. On the left side are First Street’s
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