Question

Essay question Lots of institutions accept deposits and reissue them on demand - building societies, Christmas savings clubs and theatre cloakrooms. What is the key feature of banks that distinguishes them from other institutions? Why does this matter?

Short answer

Banks create credit, influencing money supply and economic activity.

Step-by-step solution

Identify the Common Function

All institutions mentioned, such as building societies, Christmas savings clubs, and theatre cloakrooms, perform the common function of accepting deposits and potentially paying them back on demand. This is a basic similarity in how they handle deposits.

Identify the Key Feature of Banks

The key feature that distinguishes banks from these other institutions is their ability to create credit. Banks can lend out more money than they physically hold in deposits through a process called fractional-reserve banking, whereas other deposit-holding institutions typically do not create credit in this manner.

Explain Why the Key Feature Matters

The ability to create credit is significant because it allows banks to influence the money supply and economic activity. This function supports economic growth by enabling investments and consumption beyond the immediate funds available, significantly impacting the overall economy.

Key concepts

Credit Creation

Credit creation is the process where banks generate new lending capacities from their deposits. When customers deposit money, banks do not simply store it.
Instead, they can lend out a large portion of these deposits to other customers, creating new loans. This means that banks can effectively lend more money than they currently have in their vaults.
This ability is crucial because it amplifies the funds available for various economic endeavors, such as starting a business or investing in infrastructure.

Why Credit Creation is Important

The importance of credit creation lies in its capacity to enhance economic growth.

• Enables businesses and individuals to finance purchases they could not otherwise afford.
• Increases consumer spending, which drives economic activity.
• Facilitates investment, which can lead to job creation and technological advancements.

Fractional-Reserve Banking

Fractional-reserve banking is the practice where banks hold a fraction of their depositors' money in reserve and lend out the rest. This is a legal and regulated standard that banks follow to optimize their resources while maintaining enough cash to meet the withdrawal needs of their customers.
Essentially, it allows banks to operate efficiently by using depositor's funds to make loans.

How Fractional-Reserve Banking Works

Banks are required by regulation to keep a certain percentage of deposits as reserves. This reserve percentage ensures that if customers want their money back, banks can pay them.

• The reserve requirement might be 10%, which means if a bank has $1,000, it keeps $100 and can loan $900.
• This loaned $900 gets deposited again in the banking system, creating more opportunity for lending.

This process allows the money supply to expand and support further economic activities.

Money Supply

Money supply refers to the total amount of money available in an economy at a particular time. Banks play a central role in influencing this through their lending activities. As they create credit through fractional-reserve banking, they increase the overall money supply.
An increased money supply can stimulate economic growth by making more funds available for investments and consumer spending.

Impact of Money Supply on the Economy

Changes in the money supply can affect several economic factors:

• Lower interest rates: More money in circulation often leads to reduced borrowing costs.
• Inflation: While more money can fuel economic growth, it can also lead to higher prices if not matched by output increases.
• Economic stability: A well-regulated money supply contributes to a stable economic environment.

Economic Activity

Economic activity encompasses all actions that involve the production, distribution, and consumption of goods and services within an economy. Banks, through their credit creation and impact on money supply, are pivotal to fostering economic activity.
Credit available from banks allows businesses to start or expand, consumers to buy products and services, and governments to fund various projects.

Importance of Economic Activity

Vibrant economic activity is essential for a healthy and growing economy. Here's why:

• Job Creation: Increased production and business activities lead to more employment opportunities.
• Technological Advancements: Investment in new technologies is often fueled by available credit, pushing innovation.
• Improved Living Standards: A dynamic economy tends to improve overall living standards, with more goods and services available.