A group of economics students gathered to study for a test on the money and banking system in the U.S. During a fast and furious brainstorm session, Jill scribbled down several key phrases she will use to study tomorrow. Unfortunately, in her haste, all the statements in her notes are incorrect:
- Two forms of money include cash and credit cards because both are accepted as payment.
- All savings accounts are considered transaction accounts because they represent money.
- Consumers who make loan payments create transaction accounts.
- If I open a savings account at a bank with cash received as a birthday gift, I'll increase the money supply in the economy.
- By creating transaction accounts, even a single bank has unlimited power to affect the money supply.
- If a bank has $10 million in reserves and an additional $3 million in excess reserves, it can make loans up to $13 million.
What advise would you offer Jill about statement E above?
the amount of loan a bank can make is limited tothe amount equal to its excess reserve.
I would advise Jill that statement E is incorrect. While banks do have the ability to create transaction accounts, even a single bank does not have unlimited power to affect the money supply. The money supply is ultimately determined by factors such as central bank policies, government regulations, and the overall demand for money in the economy.
To explain why statement E is incorrect and how to understand the relationship between banks and the money supply, let's break it down:
1. Banks can create transaction accounts: This part of the statement is true. Banks create transaction accounts when they accept deposits from customers. These accounts, such as checking accounts, allow individuals and businesses to make transactions and payments.
2. Even a single bank has unlimited power to affect the money supply: This part of the statement is incorrect. While banks can create transaction accounts, the overall money supply in an economy is not solely determined by a single bank or even a few banks. The money supply is influenced by various factors, including the actions of central banks, government regulations, and the overall demand for money.
Central banks, such as the Federal Reserve in the U.S., have the ultimate authority to control the money supply. They do so through various mechanisms, including open market operations, setting reserve requirements, and adjusting interest rates. These actions affect the ability of banks to create loans and expand the money supply.
Additionally, government regulations and policies also play a role in influencing the money supply. For example, regulations on banks' capital requirements and lending practices can limit their ability to create loans and affect the money supply.
Overall, while banks do have the power to create transaction accounts, they are not the sole determinants of the money supply. The money supply is influenced by a combination of central bank actions, government regulations, and the overall demand for money in the economy.