Definition
Bank Money refers to the funds that commercial banks generate by extending loans based on the deposits they hold under a fractional reserve banking system. This type of money is often not backed by physical reserves at a 1:1 ratio; instead, banks keep only a fraction of the deposited amount as reserves and lend out the remaining portion, thereby creating new money in the form of bank credits.
Examples
- Personal Loans: When individuals take out a loan from a commercial bank, the bank credits the borrower’s account with the loan amount, thus creating new bank money.
- Business Loans: A company may receive a loan to expand operations. The loan amount is credited to the company’s account, increasing the money supply.
- Mortgage Loans: When a bank issues a mortgage, it credits the borrower’s account with the loan amount, which can then be used for property purchase.
Frequently Asked Questions (FAQs)
1. How does fractional reserve banking create money?
Fractional reserve banking creates money by allowing banks to keep only a portion of deposit funds as reserves. The rest is used to issue loans, increasing the overall money supply.
2. Is bank money the same as fiat money?
No, fiat money is government-issued currency that is not backed by a physical commodity. Bank money, on the other hand, is created through the lending activities of commercial banks.
3. How does bank money affect the economy?
Bank money influences the economy by expanding the money supply, which can stimulate economic activity by providing more funds for consumption and investment. However, it can also lead to inflation if not managed properly.
4. Can bank money lead to financial instability?
Yes, if banks issue too much money through loans and the borrowers default, it can lead to financial instability, as seen in banking crises.
5. How is the creation of bank money regulated?
The creation of bank money is regulated by central banks through monetary policy tools such as reserve requirements, interest rates, and open market operations.
- Fractional Reserve Banking: A banking system where only a fraction of bank deposits are kept as reserves, allowing the remainder to be loaned out.
- M1 Money Supply: A measure of the money supply that includes cash and checking deposits, which are highly liquid forms of money.
- Monetary Policy: The process by which a central bank controls the money supply in the economy, often targeting inflation or interest rates.
- Central Bank: The national institution that oversees the monetary system of a country, controlling monetary policy and regulating commercial banks.
Online References
Suggested Books for Further Studies
- “Money, Banking, and Financial Markets” by Frederic S. Mishkin
- “The Economics of Money, Banking, and Financial Markets” by Frederic S. Mishkin
- “Modern Money Mechanics” by Federal Reserve Bank of Chicago
Fundamentals of Bank Money: Banking Basics Quiz
### Which system allows banks to create bank money?
- [ ] Full reserve banking
- [x] Fractional reserve banking
- [ ] Barter system
- [ ] Direct deposit system
> **Explanation:** Bank money is created under a fractional reserve banking system where banks are required to hold only a fraction of their depositors' money in reserve while loaning out the rest.
### What is an example of bank money creation?
- [x] A commercial bank issuing a personal loan
- [ ] Government printing new banknotes
- [ ] A consumer purchasing items with cash
- [ ] A business accepting credit card payments
> **Explanation:** When a commercial bank issues a personal loan, it credits the borrower's account with the loan amount, increasing the overall money supply, thus creating bank money.
### Can bank money lead to inflation?
- [x] Yes, if issued excessively without backing
- [ ] No, bank money has no impact on inflation
- [ ] Only in a non-regulated economy
- [ ] Only during fiscal deficits
> **Explanation:** Excessive issuance of bank money can increase the money supply too rapidly, leading to inflation if it outpaces economic growth.
### What is typically kept on reserve by banks under fractional reserve banking?
- [x] A fraction of their total deposits
- [ ] 100% of their total deposits
- [ ] None of their deposits
- [ ] Only the deposits of large accounts
> **Explanation:** Under fractional reserve banking, banks are required to keep only a portion (or a fraction) of their total deposits as reserves.
### What organization typically regulates the creation of bank money?
- [ ] The Federal Deposit Insurance Corporation (FDIC)
- [x] The central bank (e.g., The Federal Reserve)
- [ ] Individual commercial banks
- [ ] The International Monetary Fund (IMF)
> **Explanation:** The central bank regulates the creation of bank money by setting policies such as reserve requirements and through other monetary policy tools.
### What happens if a borrower defaults on a loan?
- [ ] No impact on the bank's finances
- [ ] Bank money increases
- [x] It can lead to financial instability for the bank
- [ ] Reserve requirements are reduced
> **Explanation:** If borrowers default on loans, it can lead to losses for the bank and potential financial instability, especially if the defaults are widespread.
### What does 'M1 Money Supply' include?
- [x] Cash and checking deposits
- [ ] Only physical cash
- [ ] Long-term savings accounts
- [ ] Stock market investments
> **Explanation:** M1 Money Supply includes highly liquid forms of money such as cash and checking deposits.
### How does central bank influence the creation of bank money?
- [x] Through monetary policy tools like reserve requirements and interest rates
- [ ] By directly lending money to the public
- [ ] By managing stock exchange operations
- [ ] By collecting taxes
> **Explanation:** The central bank uses monetary policy tools such as adjusting reserve requirements and interest rates to influence the creation of bank money.
### What is fractional reserve banking primarily aimed at?
- [ ] Holding all deposits in reserve
- [x] Allowing banks to lend out a portion of deposits
- [ ] Eliminating the need for loans
- [ ] Encouraging cash-only transactions
> **Explanation:** Fractional reserve banking allows banks to lend out a portion of their deposits while keeping a fraction in reserve, thus facilitating more efficient money use and lending.
### Which term describes the national institution that oversees monetary policy and regulates commercial banks?
- [x] Central Bank
- [ ] Federal Deposit Insurance Corporation
- [ ] Investment Bank
- [ ] Financial Conduct Authority
> **Explanation:** The central bank is the national institution that controls the monetary system of a country, including regulatory functions and monetary policy directives.
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