During the 2008-2009 credit crisis, we witnessed the near collapse of the global financial system. Several years later, it’s easy to reflect on how our fractional reserve banking system contributed to the crisis. In this writing, we’ll discuss precisely what it is, how it works, and the benefits and risks it presents.
Stable Prices: The Fed’s Balancing Act
One of the most important duties of the Federal Reserve Board is to maintain an environment of stable prices, which today is an inflation target of 2.0%. To achieve this, the Federal Reserve Board must maintain adequate control of the U.S. money supply.
If the production of money fails to keep pace with the output of goods and services then,
1) prices will fall
2) the labor force, factories and other production facilities will not be fully employed/utilized
3) some combination of the two will occur.
If the money supply expands too rapidly, the reverse would be true. Hence, the inverse relationship between the money supply and prices is an important concept to grasp. Now let’s examine the metrics used to measure the U.S. money supply.
The Money Supply
There are several ways to measure the money supply. These include the monetary base, M1, and M2. The Federal Reserve discontinued publishing the M3 monetary aggregate in March 2006. The monetary base is the sum of the currency in circulation plus the amount of reserve balances held by depository institutions at the Federal Reserve.
M1 is defined as the sum of currency held by the public and transaction deposits at depository institutions (which are financial institutions such as commercial banks, savings and loan associations, savings banks, and credit unions). M2 is defined as M1 plus savings deposits, small-denomination time deposits (less than $100,000), and retail money market mutual fund shares.
It should be noted that actual currency (i.e., coins and bills) comprise a relatively small part of the overall money supply.
What Makes Our Currency Valuable?
What gives our currency its value? For example, why is a $20 dollar bill worth $20 or a dime worth 10 cents? There is absolutely no intrinsic value in paper money and very little in coins. The value of our currency is based solely on the promise that it can be redeemed for an equal amount of goods and services or other financial assets. In essence, its value is based strictly on confidence and yet is still affected by supply and demand.
Centuries ago, people would leave their extra gold and coins on deposit with the local goldsmith until it was needed. Years later, deposit receipts were used since they were easier to carry. However, because the majority of bank deposits would sit idle until needed, and to avoid charging a fee to depositors for safeguarding their money, banks began to use deposits to make loans. Outstanding loans, however, are much greater than total deposits. This is the genesis of our fractional reserve banking system.