Commercial banks and other deposit-taking institutions have a central role in the U.S. economy. Banks allow us to safely store our savings and facilitate transactions without the need for cash.  Banks also act as financial intermediaries, lending money and channeling funds from savers to borrowers.  The more interesting role for banks, however, is that they can create money.  We will examine the money creation process later in this chapter.

We will also discuss interest rates, which are the costs to borrowers for the use of a lender’s capital.  The concepts in this chapter will provide the reader with a grounding for the next chapter, in which we examine the history and role of the U.S. Federal Reserve System.



In this and subsequent chapters, we refer to banks as those financial institutions which accept customer deposits and make loans.  The deposit-taking function of banks distinguishes them from other types of financial institutions, such as investment banks and insurance firms.

2.1.  Sources of a Bank’s Funds

For banks, customer deposits are liabilities (amounts owed) in that they represent borrowings from customers.  Deposits are thus one source of a bank’s borrowed funds.  Banks also borrow funds from other institutions in the “wholesale lending market”.  Borrowed funds represent the majority of a bank’s funding, but banks must also hold a certain level of equity capital (the bank’s assets minus the bank’s liabilities).  This equity capital acts as a cushion against losses in the bank’s loan portfolio.  A bank’s equity capital comes in the form of issued stock and retained earnings (profits not paid out as dividends).  When a bank’s equity capital falls below mandated levels, regulators will require the bank to raise more equity capital by issuing more stock shares.[1]

Banks have two general categories of deposits: time deposits and demand deposits.  Time deposits are customer accounts which are either subject to a fixed term or only allow the customer to withdraw with notice.  In contrast, demand deposits are those deposits which allow customers to make withdrawals or write checks “on demand”, i.e., without prior notice.

All deposit-taking institutions are required by law to hold a certain portion of demand deposits as reserves.  Reserves may be in the form of deposits held at the Federal Reserve or cash held in the bank’s vaults.



3.1.  How Commercial Banks Create Money

Let’s assume that in a small town, Cash Only, USA, there are no banks or other financial institutions.  All transactions in this town occur in cash – merchants accept only cash, wages are paid in cash, etc.  The total amount of cash in this small town is $10 million.

Eventually, a bank (Bank A) comes into Cash Only, and the residents decide that keeping their money under mattresses and in safes is not a good idea.  The residents rush to put their money in the bank, knowing that it will be secure.  Thus, the bank has initial deposits of $10 million all of which is held as reserves.  The bank is required to hold 10% of its deposits as reserves, allowing it to lend out $9 million.  The bank’s assets are $10 million, but now $1 million is reserves and $9 million is in outstanding loans.  The bank still has $10 million in deposit liabilities.

Now, suppose that the total $9 million in loans are made to households and firms who hold accounts at Bank B.  Bank B now has $9 million more in deposits, of which $900 thousand must be kept as reserves, and $8.1 million can be lent out.  Bank B’s $8.1 million in loans end up in accounts at Bank C, which keeps $810 thousand as reserves and lends out $7.29 million.  This process continues until there is no more money left to lend out.

This process of taking in new deposits, keeping a portion as reserves, and lending out the remainder, is referred to as the money creation process.  In the above example, this process will eventually lead to $90 million in loans being made against the original $10 million in deposits added to the banking system (recall that the residents of Cash Only did not previously have their money in the banking system).  When the reserve requirement was 10%, the commercial banks created $9 for every $1 in new deposits.

The total amount of money which can be added to the banking system for every $1 of additional deposits can be calculated using a formula known as the money multiplier: new deposits ÷ required reserve ratio.  The smaller the reserve requirement, the greater the quantity of money created for each new deposit.  We should note, however, that this is the maximum amount of money which can be added to the banking system.  The actual amount may, and likely will be, less because banks may choose to hold excess reserves, i.e., reserves greater than what is legally required.


3.2.  Fractional Reserves

The money creation process is possible because of fractional reserve banking, where money is lent out on the assumption that depositors will not take their money out of the bank all at once.

But what happens if depositors demand their money all at once?  This is known as a bank run, and it was a common feature of the U.S. financial system before and during the Great Depression.  Bank runs often occurred from something as innocent as an unsubstantiated rumor regarding the health of the bank.  Banks would often fail because they were forced to liquidate their assets to accommodate the demands of frightened depositors.  By one account, more than 2000 banks failed annually during the depression years of 1930-1933.[2]

The modern banking system has two features which greatly prevent bank runs.  The first is deposit insurance, a creation of depression-era bank legislation.  Commercial bank deposits in the U.S. are insured up to a specified amount (currently $250,000).  The entity which provides this insurance is the Federal Deposits Insurance Corporation (FDIC), an independent government agency which is fully backed by the U.S. Treasury.  The FDIC is also a bank regulator and is responsible for the orderly liquidation of failed banks.

The second mechanism for preventing bank runs comes from the Federal Reserve in its “lender of last resort” capacity.  The Federal Reserve can lend to member banks through the discount window.  By providing short-term lending against acceptable collateral, the Federal Reserve can ensure that banks have the cash to meet depositor withdrawals.



Most of us are borrowers in one form or another.  We may have mortgages, student loans, auto loans, or credit cards.  Likewise, firms often borrow to expand their operations.

4.1.  Interest Rates of Prices

We may think of an interest rate as the contractually agreed-upon cost of borrowing funds.  But in aggregate, interest rates are also prices and thus subject to the same forces of supply and demand as any other good or service.  In other words, interest rates are the prices at which the demand for loanable funds equals the supply of loanable funds.  Interest rates rise when the aggregate demand for loanable funds exceeds the aggregate supply of loanable funds.  Conversely, interest rates fall when the supply of loanable funds exceeds the demand for loanable funds.

The supply of loanable funds comes from the savings from households, firms, and governments.  Saving is the act of deferring current consumption, and savers are incentivized to defer consumption by the rate of interest which they earn on their savings.  Saving reflects the saver’s “time preference”, and the rate of interest is the mechanism by which savers are indifferent between current and future funds.

Interest rates also represent the riskiness of the borrower.  Riskier borrowers (who pose a higher risk of defaulting on a loan), will pay a higher interest rate than less-risky borrowers.  The least risky borrower is the U.S. Treasury, as the government’s taxing authority gives it a claim on all the income produced by firms and households.  In finance, we say that short-term loans to the U.S. Treasury (Treasury bills), are risk-free and the rate on U.S. Treasury bills is the risk-free rate of interest.

The risk-free rate is an important concept in asset pricing.  If someone can earn the rate on Treasury bills without taking default risk, then all other instruments must be priced to yield some rate above this risk-free rate.  The difference between an interest rate and the risk-free rate is known as the asset’s risk-premium.  Generally, risk-premiums have remained within a relatively narrow range (except for during periods of financial distress).


4.2.  Real and Nominal Rates

The inflation rate is the annualized percentage rate of decline in money’s purchasing power.  In the next chapter, we will examine inflation in more depth.  For now, we will examine how expectations about inflation affect interest rates.

The stated interest rate on a loan is referred to as the nominal rate, in that it does not account for expected inflation.  In contrast, subtracting the expected rate of inflation from the nominal rate yields the real interest rate.  The real interest rate thus reflects the true inflation-adjusted cost of borrowing.  To think of this another way, lenders (and those purchasing credit instruments in the secondary market) factor in an expected inflation rate into interest rates.


4.3.  The Term Structure of Interest Rates

A credit instrument’s term-to-maturity is the period before the credit instrument (loan, bond, etc.) is fully repaid.  Credit instruments with otherwise identical characteristics will have different interest rates depending on their respective maturities.  Generally, a credit instrument’s yield curve, a graph showing the relationship between interest rates and maturities, will be upward sloping.  In other words, all else being equal, short-term credit instruments will (generally) have a lower interest rate than longer-term credit instruments.  At times, however, a yield curve can be flat or inverted.  When a yield curve is inverted, long-term interest rates are less than short-term interest rates.  The most widely reported yield curve is the Treasury yield curve, which plots the interest rates and maturities for different Treasury securities.

There are several theories that attempt to explain the shape of the yield curve.  One such theory, the expectations theory, assumes that long-term bond rates represent an average of short-term rates which are expected to occur over the term of the bond.  According to this theory, investors are indifferent to bonds of different maturities, and thus long-term bonds rates will exceed short-term bond rates when short-term bond rates are expected to rise in the future.  Under the expectations theory, a flat yield curve implies that, on average, short-term rates are expected to remain unchanged.  An inverted yield curve implies that, on average, short-term rates are expected to fall.

Another theory for the shape of the yield curve is the segmented markets theory.  This theory assumes that markets for bonds of different maturities are distinct, and thus subject to their own supply and demand forces.  In other words, long-term bond yields are independent of expectations of future short-term rates.

One theory which combines the expectations theory and the segmented markets theory is the liquidity premium theory.  This theory states that long-term bond rates reflect both expectations of future short-term rates and supply and demand characteristics unique to each maturity market.  The liquidity premium theory recognizes that short-term credit instruments are more liquid (more easily converted into cash).  In other words, the market for short-term credit instruments is both deeper (more buyers and sellers) and subject to less interest rate risk (the risk of price declines from rising interest rates).  Under this theory, long-term rates equal the average of expected short-term rates over the bond’s life plus a liquidity premium.  The liquidity risk premium (and similar theories) best explains the term structure of interest rates.[3]

Finally, I should mention that the Treasury yield curve is widely watched by investors and economists for what it suggests about the business cycle.  Specifically, a flat or inverted yield curve implies that future short-term rates are expected to fall.  Since falling short-term rates are associated with economic weakness, the yield curve is seen as a predictor of the business cycle.[4]



Mishkin, Frederic S.  The Economics of Money, Banking, and Financial Markets, 2nd ed. Boston:  Addison-Wesley, 2010.

Taylor, Timothy.  Principles of Economics, 2nd ed.  U.S.: Textbook Media, 2011.


[1] Issuing additional shares will dilute the proportional ownership of existing shareholders, so it is best for existing shareholders if banks can avoid having to raise additional equity capital.

[2] Mishkin, The Economics of Money, Banking, and Financial Markets, 250.

[3] Ibid, 131.

[4] Ibid, 141.