Lecture: Money & the Banking System
Lecture script · about 15–20 minutes spoken · Week 9
Opening
Here's a question that sounds easy until you try to answer it. Where does money come from? Most people say the government prints it. That's part of the story, but most of the money you spend was never printed at all.
Think about an illustrative week of your own. You might tap a card for a 3-dollar coffee, pay a 2-dollar bus fare, and move 50 dollars from checking into savings. Not one of those moves needs a paper bill. A café owner depositing the evening's cash and a nursing student choosing a checking account are both standing inside the system we'll take apart in this lecture.
Here's where we are. In Week 7, Fiscal Policy, you met the spending multiplier, a chain of spending rounds that adds up to more than the first burst. In Week 8, Midterm Review & Exam, you built the flow-vs-stock habit. This week opens a new unit on money and the central bank. We'll use both of those earlier tools, because banks build a chain of their own, and money turns out to be a stock.
Here's the plan. I'll name the three jobs money does and separate money from wealth and income. Then we'll count the money supply in layers, open a bank's ledger, follow one loan through a chain of banks, and add up the chain with a shortcut. We'll finish with an honest warning about that shortcut. The numbers come from an illustrative banking system built for this course, measured in dollars.
1. The three jobs money does
Picture a small town with no money at all. A baker wants a haircut, but the barber wants eggs, not bread. So the baker has to find a farmer who wants bread, trade for eggs, and carry the eggs to the barber. That roundabout hunt is barter. Barter is trading goods or services directly for other goods or services with no money in between, which works only when each side wants what the other has.
Money ends the hunt, and the dollar amounts in the examples that follow are illustrative. Money is any asset that people generally accept in payment for goods, services, and debts; it does three jobs, serving as a medium of exchange, a store of value, and a unit of account.
A medium of exchange is the job money does when people hand it over to buy goods and services, which spares them the search for a trading partner who wants exactly what they have to offer. When you pay a 2-dollar bus fare, the driver doesn't need to want anything you own.
A store of value is the job money does when it holds purchasing power over time, so that money earned now can still buy things later. Say you save 300 dollars from a summer job and spend it on books in the fall. The money carried its buying power across the months.
A unit of account is the job money does as the common measuring stick for prices, so that the costs of very different goods and services can be quoted in the same units and compared. A 45-dollar phone plan and a 60-dollar one are both priced in dollars, so you can compare them and find a gap of 15 dollars a month.
Some courses add a fourth job, a standard of deferred payment, meaning money is the unit future debts are written in. This course teaches three and names the fourth only here.
Pause and try this. A friend says a rare pair of sneakers is money, because it's worth a lot. Which job of money does the sneaker fail?
Picture handing those sneakers to a grocery cashier.
Here's the answer. It fails the medium-of-exchange job. Valuable things aren't money unless people generally accept them in payment, and no cashier takes sneakers for groceries.
2. Money is not wealth, and it is not income
Picture an illustrative retired couple. They own a house worth 300,000 dollars and keep 400 dollars in cash in a kitchen drawer. People would call them wealthy. But at the grocery store, the house does them no good. Only the 400 dollars, or what's in their checking account, can pay for the groceries.
Everyday speech blurs three words that economics keeps apart. Wealth is everything a person or household owns minus everything it owes, at a point in time; a house or a car is part of wealth but is not money, because it cannot be handed over in payment.
Income is the earnings a person or household receives over a period of time, such as wages per week or per year; it is a flow, while the money a person holds is a stock. This is where your Week 8 habit pays off. Ask one question: does this number need "per month" to make sense, or is it measured "right now"?
Try it on an illustrative nurse who earns 4,000 dollars a month, has 2,500 dollars in checking, and owns a car. The 4,000 dollars a month needs a time period, so it's income, a flow. The 2,500 dollars in checking is measured at one moment and can be spent, so it's money. The car counts toward wealth, but no store takes it as payment.
Pause and try this. Someone says, "She makes a lot of money." In this course's words, is that sentence about money, wealth, or income?
Ask whether the amount needs a time period.
Here's the answer. It's about income. "Makes" means earns over time, so it's a flow, and in this course money is the stock you hold at a moment.
3. Counting the money supply in layers
Imagine you could freeze the whole economy for one moment and count its money. You'd count the cash in wallets and the checking balances you spend with a card. But what about a savings certificate that takes a few days to cash in? Economists count in layers, from the most spendable outward.
Here's the term. The money supply is the total amount of money in an economy at a point in time, measured with aggregates such as M1 and M2 and written M. The capital letter M always means the money supply in this course. Imports get the two letters I M.
M1 is the narrow measure of the money supply: currency in the hands of the public plus the deposits people can spend most directly. M2 is the broad measure of the money supply: everything in M1 plus near-money such as small time deposits and retail money market funds, which can be turned into spending money with little delay.
There's one more layer, and it sits underneath both. Banks keep cash in their vaults and keep accounts of their own at the central bank. Bank reserves are the cash a bank holds in its vault plus the deposits it keeps at the central bank, money the bank has on hand rather than lent out. And the monetary base is currency plus bank reserves, the narrower total that the central bank controls directly and that the banking system builds the larger money supply on.
Here's an image to hold. The monetary base is a building's foundation, and M1 and M2 are the floors. The central bank pours the foundation, and banks, by lending, build the floors. In our illustrative banking system, the monetary base is 105 dollars.
Pause and try this. Is the 105 dollars the money supply, or the monetary base? And who controls it directly?
Think foundation, not floors.
Here's the answer. It's the monetary base, currency plus reserves, and the central bank controls it directly. The money supply built on top of it will be larger.
4. A bank's ledger: keep the required part, lend the excess
A café owner closes up after a busy evening and deposits 1,000 dollars of cash takings at the first bank. The bank doesn't lock all of it in the vault. It keeps a slice and lends out the rest.
Here's the term. Fractional-reserve banking is a banking system in which each bank keeps only a fraction of its deposits as reserves and lends out the rest, so the banking system as a whole can create money.
How big a slice? The required reserve ratio is the fraction of each deposit that rules require a bank to hold as reserves, written R R; in the course's illustrative banking system it is 0.10. Required reserves are the part of a deposit a bank must keep on hand, equal to the required reserve ratio times the deposit; the bank keeps these and does not lend them. Excess reserves are reserves a bank holds beyond what the rules require; in the classroom model a bank lends its excess reserves, and any excess it chooses to keep shrinks the chain of new deposits.
Let's do the first bank's ledger. Required reserves are 0.10 times 1,000, which is 100 dollars. The bank keeps those. Excess reserves are 1,000 minus 100, which is 900 dollars, and the bank lends them out. Now check that the ledger balances. The bank owes the café owner 1,000 dollars. It holds 100 dollars in reserves plus a 900-dollar loan, and 100 plus 900 is 1,000. Both sides match.
Pause and try this. A classmate says the first bank lends out its 100 dollars of required reserves. What's the right split?
Remember which part the rules make the bank keep.
Here's the answer. The bank keeps the 100 dollars of required reserves and lends the 900 dollars of excess reserves. Lending the required part gets the split backwards.
5. Following the loan, one round at a time
The 900-dollar loan doesn't sit still. Say a bike-repair shop borrowed it to buy tools. The shop pays a tool supplier, and the supplier deposits the 900 dollars at a second bank. Now the second bank has a new deposit, and it does exactly what the first bank did.
The second bank keeps 0.10 times 900, which is 90 dollars, and lends 900 minus 90, which is 810. That 810 is spent and lands at a third bank. The third bank keeps 81 dollars and lends 729. Notice the pattern. Each deposit is 0.90 of the one before, because each bank keeps 0.10 and lends 0.90.
After three banks, deposits add up to 1,000 plus 900 plus 810, which is 2,710 dollars. And the 729-dollar loan is about to become a fourth deposit, so the chain is still running.
Here's the part that surprises people. The café owner still has a 1,000-dollar balance, and the tool supplier now has a 900-dollar balance. Both can spend. The loan created a deposit that didn't exist before, and nobody's account went down to pay for it. Each loan comes back as someone else's deposit.
Pause and try this. At the third bank, why is the new deposit 810 dollars and not 900?
Think about what the second bank kept.
Here's the answer. The second bank kept 90 dollars as required reserves and lent only 900 minus 90, which is 810. Each round shrinks to 0.90 of the round before.
6. Adding up the chain: the money multiplier
Adding round after round by hand would take all evening. Fortunately, each deposit is the same fraction of the one before, so the chain adds up to a fixed total.
Here's the first term. A geometric series is a sum in which each term is the same fraction of the term before it. The deposits created in a chain of bank loans form one, and it adds up to the first term divided by one minus that fraction. Our fraction is 0.90. So the total is 1,000 divided by 1 minus 0.90. That's 1,000 divided by 0.10, which is 10,000 dollars of deposits.
Now the shortcut, the money multiplier. It's the number 1 ÷ RR, the most that one dollar of new reserves can become in deposits when every bank lends all of its excess reserves. It is an upper bound on money creation, not a forecast. Said aloud, that's 1 divided by the required reserve ratio. At 0.10, 1 divided by 0.10 is 10, and 1,000 times 10 is 10,000. That's the same ceiling the series gave us. Of that 10,000, the new money the loans created is 10,000 minus 1,000, or 9,000 dollars.
The same shortcut works on the whole system. The money supply is at most the multiplier times the monetary base. With a base of 105 and a multiplier of 10, the money supply is 1,050 dollars.
The reserve ratio sets the size. At a ratio of 0.05, the multiplier is 20, and the money supply could reach 2,100. At 0.20, it's 5, and the money supply is 525. At 0.25, it's 4, and the money supply is 420. The more each bank keeps, the shorter the chain.
Now, a warning about a lookalike. In Week 7, the spending multiplier was 1 divided by 1 minus the M P C, the marginal propensity to consume. It scales a burst of spending into output, and it's a fiscal idea. The money multiplier scales reserves into deposits, and it's a banking idea. Using Week 7's multiplier of 5 on the café owner's deposit gives 5,000 dollars, half the correct ceiling of 10,000.
Pause and try this. A banking question asks how far a new deposit can multiply. Which multiplier belongs there, and which one doesn't?
Ask what's being multiplied: spending, or reserves.
Here's the answer. The money multiplier, 1 divided by the required reserve ratio, belongs there, because reserves are turning into deposits. The spending multiplier belongs to fiscal policy and never answers a banking question.
7. A ceiling, not a forecast
Picture a kitchen sink filling from the faucet, with a slow leak in the drain. The faucet sets how high the water could rise, and the leak keeps it lower. The money multiplier is the "could rise" number.
The 10,000-dollar total holds only if two things happen at every step. Every bank lends every excess dollar. And every borrower's spending lands back in a bank as a new deposit. If people keep some cash in a wallet or a drawer, that money leaves the chain. And if banks choose to hold extra reserves as a cushion, the chain shrinks.
Let's see how much. Suppose banks keep an extra 0.10 of each deposit on top of the required 0.10. That's an illustrative assumption. Together they keep 0.20, so the multiplier falls to 1 divided by 0.20, which is 5. Now the 105-dollar base supports at most 525 dollars of money, which is 525 dollars less than the 1,050 ceiling. Half of it is gone.
Here's the honest note I promised. The 10 percent ratio and the 1 ÷ RR multiplier are a classroom model of how deposits multiply. In the United States, required reserve ratios have been zero since 2020. The Federal Reserve now runs an ample-reserves system. That's the way the Federal Reserve now runs monetary policy, with banks holding plenty of reserves and required reserve ratios set at zero, so the classroom money multiplier does not describe how much banks actually lend. Lending is limited by banks' own reserve choices, capital rules, and the demand for loans, and real-world multipliers are far smaller than our model's.
So why learn the model? Because its logic holds even when its number doesn't: banks create deposits when they lend, and holding more reserves shrinks the expansion.
Pause and try this. A headline says, "With a multiplier of 10, the money supply will be 10 times the base." What one phrase would you fix?
Think about the kitchen sink.
Here's the answer. Change "will be" to "can be at most." The multiplier is a ceiling, reached only if every bank lends every excess dollar and nobody holds cash.
Closing
Let's pull it together. Money does three jobs: it's a medium of exchange, a store of value, and a unit of account. Money isn't wealth, and it isn't income; income is a flow, and money is a stock you hold.
We counted the money supply in layers. M1 is the narrow measure and M2 the broad one, and the monetary base, currency plus reserves, is the foundation the central bank controls. A bank keeps its required reserves and lends its excess. Each loan comes back as someone else's deposit, so the banking system creates money round by round.
The money multiplier, 1 divided by the required reserve ratio, adds up the whole chain: 10 at a ratio of 0.10, turning a base of 105 into a money supply of at most 1,050. It's a banking idea, never the spending multiplier. And it's a ceiling, not a forecast.
Next in this module, read the Readings & Resources page, then work the lecture tutorial, the practice set, and the quiz. Next week, in The Federal Reserve & Monetary Policy, we'll meet the central bank's tools and see how it moves that foundation.
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