The banking system is a complex network of many parties with diverse financial interests. Most countries have nationalized central banks that regulate the for-profit banking systems and control interest rates and currency. The central bank of the United States is the Federal Reserve. The Federal Reserve determines monetary policy that will bring about stable prices and full employment. Commercial banks practice fractional reserve banking, wherein they reserve a portion of deposits and use the remainder to grow revenue through investments and loans in a process called the expansion of deposits. The expansion of deposits process causes growth in the money supply. The amount of growth is represented by the money multiplier. The Federal Reserve influences the amount of money banks have available to lend through various policy tools. The three main tools are open market operations, changing the discount rate, and changing reserve requirements.
At A Glance
- The Federal Reserve is the central bank of the United States, responsible for ensuring stable monetary policies.
- The Federal Reserve is managed by the Board of Governors, of which the Chair is the head.
Fractional reserve banking is the system by which banks set aside a portion of their deposits and loan out the remainder or invest it in other ways, which creates money.
Expansion of deposits refers to the money created by fractional reserve banking, wherein money deposited in a bank is expanded by lending out some fraction of it.
- The money multiplier describes the amount of money added to the circulating money supply by the lending of excess reserves in an economy.
- The Fed has three main policy tools: open market operations, reserve requirements, and the discount rate.