Banks

This example is a bit simplified, like the story of "the Bank of Fred," but like that story it illustrates the working of a fiduciary money system -- in this case the modern American one. Details, such as the required reserve ratio and the specific assets that can be counted as reserves, may change from time to time. But the principles of the system are those illustrated in the example. The key points are

• Checking accounts are money, fiduciary money created by banks
• Creation of fiduciary money is limited by the supply of bank reserves
• Bank reserves are obligations of the Federal Reserve, including deposits and vault cash
• Checks are "cleared" by the Federal Reserve by transferring deposits from the bank that issued the check to the bank that deposits it
• A bank that has excess reserves may be able to create money and loan it, by establishing a checking account in the amount of the loan
• Nevertheless, banks have to limit their lending to allow for "clearing" through the Federal Reserve.
• An increase in reserves, for example by importing currency from abroad, increases the total money supply by a multiple of the increase in reserves
• The multiple is the inverse of the required reserve ratio.

The Federal Reserve system thus can control the total supply of money by controlling the supply of bank reserves. Let's see how this is done.

Controlling Reserves