Banking and investments seem impossibly mysterious to many people who have trouble just getting their checkbook to balance.
Let’s begin by looking at what’s called the “money supply.” The money supply is the total amount of money available to the economy at any particular moment. What is money? It’s more than just the metal slugs and slips of green paper in your pocket. Money is simply anything that can be used to settle a debt.
How is the money supply measured? There are four ways of measuring it, referred to as the M0, M1, M2 and M3. M0 money is physical currency: the coins and green paper you carry around–that is, the money in actual circulation–and the cash assets held in a central bank.
M1 money includes the stuff of M0 with the addition of money in “demand accounts”–that is, checking accounts. M1 is the measure that economists use to quantify the amount of money that is in actual circulation.
M2 is made up of everything in M1, with the addition of time deposits (those things like Certificates of Deposit that you can’t access for a specific period of time), savings deposits, and non-institutional money-market funds. Economists use M2 when they are trying to predict inflation.
M3 is made up of everything in M2 and includes large time deposits, institutional money-market funds, short-term repurchase agreements, and other larger liquid assets. It is used by economists when they want to measure the entire supply of money within an economy.
These different sorts of money that exist in the money supply statistics arise from the practice known as fractional-reserve banking.
When a bank gives out a loan, money is actually created by the bank. If you deposit a hundred dollars into the bank, they lend it out ten times with a fractional-reserve rate of twenty percent. This means that of the initial one hundred dollars, twenty percent of it, or twenty bucks, is set aside and kept in the vault, while the remaining eighty percent, or eighty bucks, is loaned out. The recipient of the eighty dollars then spends that money. The receiver of that eighty dollars then deposits it into a bank. The bank then sets aside twenty percent of that eighty dollars, or sixteen dollars, as reserves and lends out the remaining sixty-four dollars. As the process continues, more commercial bank money is created, since the bank only is keeping as a reserve twenty percent of any of the money given to it. The rest it loans out. That’s how the bank makes money on the money you put into it. Otherwise, the bank would have to charge you for holding on to your money. This creation of money by this means inflates the money supply. If the economy grows to match the increase in this money supply, then wages and prices remain stable. If things get out of balance, then you get “inflation.”
The banks lend the money at an interest rate based on how much it costs them to get the money they are lending out, and based on the amount of risk they are taking in making the loan: if banks and other lenders are careful, then they will receive back more money than they lent out, thus making a profit and allowing them to continue lending money. If they are not careful, then they can wind up in a situation where they do not have enough funds to lend any more money, or worse, cannot repay those who have deposited money into the bank.
If you recall the movie A Wonderful Life, when the depression hits and people panic, creating a “run” on the bank, George Baily calms the situation by pointing out that the money the people in his town have put in his Savings and Loan is not in the vault–it’s been lent out to their friends and neighbors: “it’s in Joe’s house.”
This fractional-reserve banking works because over any typical period of time, demands by people to take the money out of the bank–redemption demands– are for the most part offset by new deposits or issues of notes. The bank thus needs only to satisfy the excess amount of redemptions. Second, only a minority of people will actually choose to withdraw their demand deposits or present their notes for payment at any given time. Third, most people keep their funds in the bank for a prolonged period of time. And finally, banks usually keep enough cash reserves in the bank to handle all the demands for cash.
If the demands for cash are unusually large, however, the bank will run low on reserves and will be forced to raise new funds from additional borrowings (that is, by borrowing from the money market or by using lines of credit held with other banks), and/or sell assets, to avoid running out of reserves and defaulting on its obligations. If creditors are afraid that the bank is running out of cash, they have an incentive to redeem their deposits as soon as possible, triggering a bank run.
Bank runs are very unusual today, largely because of the systems set in place following the Great Depression, such as deposit insurance and the current requirements now of how much of a reserve banks must keep. The interest rates that we pay or get for our deposits are determined to a large extent by how much banks charge other banks for the money they lend to each other. The government sets the interest rate that banks charge one another. The decision on what rate to charge is based on how well the economy as a whole is doing. If it isn’t doing well, or if there is a fear that it won’t, the rate will be lowered: that will put more money into circulation. If there is a fear that inflation may be in the works, the interest rate will be raised, thus lessoning the money supply.
How does the stock market work into all of this? It is simply a public market for the buying and selling of securities–that is a percentage shares–in businesses. It is a way for businesses to raise money that they can then use to expand; if the business is successful, they will make a profit, which will allow them to pay back all the people who purchased a percentage of the company, or if people keep the stock, then those share holders will receive a percentage of the profit as a dividend payment. People may buy and sell shares of the company at any time, however, and the price of a company’s shares will rise or fall based on how well the company is doing, or how well people imagine it is doing.