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asset
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an individual or business firm is an item of value that the individual or firm owns.
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balance sheet
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an accounting statement listing the values of all assets on the left side and the values of all liabilities and net worth on the right side.
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It is more efficient to exchange goods and services by using money as a medium of exchange than by bartering them directly.
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In addition to being the medium of exchange, whatever serves as money is likely to become the standard unit of account and a popular store of value.
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Throughout history, all sorts of items have served as money. Commodity money gave way to full-bodied paper money (certificates backed 100 percent by some commodity, such as gold), which in turn gave way to partially backed paper money. Nowadays, our paper money has no commodity backing whatsoever; it is pure fiat money.
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One popular definition of the U.S. money supply is M1, which includes coins, paper money, and several types of checking deposits. Most economists prefer the M2 definition, which adds to M1 other types of checkable accounts and most savings deposits. Much of M2 is held outside of banks by investment houses, credit unions, and other financial institutions.
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Under our modern system of fractional reserve banking, banks keep cash reserves equal to only a fraction of their total deposit liabilities. This practice is the key to their profitability, because the remaining funds can be loaned out at interest. It also leaves banks potentially vulnerable to runs.
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Because of this vulnerability, bank managers are generally conservative in their investment strategies. They also keep a prudent level of reserves. Even so, the government keeps a watchful eye over banking practices.
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Before 1933, bank failures were common in the United States. They declined sharply when deposit insurance was instituted.
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Some large banks and other financial institutions pose systemic risk, meaning that their failure would threaten the entire financial system. For that reason, such systemically important institutions are often considered "too big to fail."
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Because it holds only fractional reserves, the banking system as a whole can create several dollars of deposits for each dollar of reserves it receives. Under certain assumptions, the ratio of new bank deposits to new reserves will be $1/m, where m is the required reserve ratio.
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The same process works in reverse, as a system of money destruction, when cash is withdrawn from the banking system.
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Because banks and individuals may want to hold more cash when the economy is shaky, the money supply would probably contract under such circumstances if the government did not intervene. Similarly, the money supply would probably expand rapidly in boom times if it were unregulated.
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Excess reserves have proven to be a huge problem in the United States ever since the financial panic of September 2008. When excess reserves increase, the money multiplier is reduced, so the money supply (however measured) grows less rapidly than bank reserves do.
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Suppose banks keep no excess reserves and no individuals or firms hold on to cash. If someone suddenly discovers $12 million in buried treasure and deposits it in a bank, explain what will happen to the money supply if the required reserve ratio is 10 percent.
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Under those conditions, the money multiplier is 1/.10, or 10, so an infusion of $ 12 million into reserves will support an increase in money of $ 120 million.
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