It's a Not So Wonderful Life
This lesson printed from:
Posted May 23, 2007
Author: Scott Niederjohn
Posted: May 23, 2007
Updated: December 19, 2007
In this lesson students learn about banks and banking. The study the fractional reserve system, and the role the Fed plays in the money creation process.
- Learn how a fractional reserve banking system works.
- Understand the role banks play in the economy.
- Identify ways in which the Federal Reserve System influences interest rates and the supply of money and credit in the economy.
Many people remember a scene from the movie It's a Wonderful Life in which the worried townspeople of Bedford Falls race to the community's Building and Loan Bank. They congregate outside the bank's iron gates, which George Bailey's Uncle Billy has closed in a panic. When George arrives and opens the gates, the townspeople rush into the bank lobby, demanding to withdraw all of their funds. Uncle Billy says, "This is a pickle, George. This is a pickle." George tries to explain to the people that their money is tied up in their neighbors' homes, as an investment, and the bank has very little cash left to give out.
Bank failures of the sort depicted in this scene almost never occur today, but they were common in the United States in the nineteenth century and early in the twentieth century. What caused these bank failures, and why don't they occur today? This lesson addresses these questions. It introduces students to basic banking procudures, the money creation process in the economy, and ways in which the Fed uses monetary policy to influence the economy.
Teacher Resources from the Fed:
The Federal Reserve System provides many resources for instruction. These include conferences for teachers, the annual Fed Challenge competition for highschool students and a variety of print and electronic materials. The regional Federal Reserve Banks offer many of these same resources, andy often provide tours for teachers and high school students.
To learn about these resources, your first step might be to visit the Federal Reserve Education site. This website has several great features. It introduces teachers to the Fed Challenge. This is an academic competition that provides high school students (grades 9-12) with an insider's view of how the Fed makes monetary policy. Learn more by going to the High School Fed Challenge .
The Federal Reserve Education site also features resources on personal finance, including information about the following topics:
- Consumer banking
- Consumer protection
- Home ownership
- Interest rates
- Loans and credit
- And much more.
The Federal Reserve Education site also features a section called Fed 101. Here you can learn about the history and structure of the Fed as well and find information about monetary policy, banking supervision, and financial services. You will also find a short video on the money creation process.
Finally, the Federal Reserve Education site provides a wide range of other resources:
- Publications and videos
- Online learning
- Regional bank websites
- Resources and research
- Links to other economic education websites including several from the Council for Economic Education.
For a good example of the resources provided by the regional Fed banks, go to the site for the Federal Reserve Bank of San Francisco . Click on Educational Resources. Here you will find, for exmaple, a newsletter titled Econ Ed and the Fed. It offers a lesson on The Federal Reserve (the Fed), the Federal Open Market Committee (FOMC), and monetary policy. You also can click on Open & Operating to learn about a video describing the response of the Fed following the attacks of 9-11. And you can click on Dr. Econ which presents answers in response to questions you enter. Other resources here include the following:
- Fed Chairman Game
- Great Economists Treasure Hunt
- Crossword Puzzle
The famous movie scene summarized earlier in this lesson illustrates a fundamental point about banks and banking: banks do not have all of their customer's deposits on hand. Even today, if all the customers of your local bank demanded to withdraw all their deposits at once, the bank would not have enough cash on hand to satisfy their demands. Most of the money deposited by bank customers is not kept in the bank's vault; instead , most of it is lent out to other customers, to be used for productive purposes.
This role of a bank, often called financial intermediation, is vital to the efficient workings of a market economy. Banks bring people together: people with extra money (the lenders or savers) and people who need money (the borrowers or spenders). It is a very important service. It enables people to buy homes, to start new businesses, to go to college or (in the case of loans to the local school district) to build a new state-of-the-art school.
How might people do these things if there were no banks? Consider the prospects of a young teacher trying to buy a $150,000 home. Perhaps, by diligently saving her money, she is able to acquire the $30,000 needed for a 20 percent down payment. In that case, she still needs $120,000 to purchase the home. Since she can't go to a bank to borrow the money, she might seek loans from members of her family, friends and neighbors, maybe even co-workers. While she might possibly come up with all of the money she needs to buy the home in this way, each of these loans would almost certainly be negotiated with its own terms and conditions, and borrowing from friends and relatives might involve complicated personal issues. The costs of acquiring money in this manner are very high.
Today, as an alternative, we have banks that utilize something called a fractional reserve system. In a fractional reserve system, only a fraction of bank deposits is actually kept in the bank to satisfy withdrawals. The rest of the money is lent out to individuals, firms, municipalities, the federal government or other borrowers to be used for productive purposes. The money that banks keep on hand to satisfy withdrawals is called reserves. Reserves are held in the bank's vault or in an account at a Federal Reserve Bank. The Federal Reserve, also known as the Fed, mandates a required reserve ratio, typically around 10 percent of checking deposits, which banks must hold in reserve to provide liquidity and satisfy requests for withdrawals. The required reserve ratio has an effect on the country's supply of money.
Because banks utilize a fractional reserve system, it is often said that banks "create money." While this term may conjure up images of a banker running a printing press in the bank basement, that is not how banks create money. To understand how banks do create money, we first need to understand how an economists define money. Economists consider money to be anything that is generally accepted as payment for goods and services. That definition clearly includes cash and currency. However, it also includes checking accounts, since checks can be written on these accounts and used to pay for items that people purchase. So, how does a bank create money?
Consider the following scenario. Sally Saver goes to First National Bank and deposits $1,000 that she received as a gift from her grandparents. She now has a checking account with a balance of $1,000 from which she can write checks. What will First National Bank do with this newly deposited money? Well, if there is a 10 percent reserve requirement, the bankers will put $100 in their vault and lend out the rest to people who want loans. Say Mike Inventor walks into First National Bank looking to borrow $900 to develop his next great invention. If the bankers decide that his project is worthwhile, they might give him the $900 he requests. If Mike puts the $900 in his checking account, he then can write checks for this amount. There is now $1,900 of money available ($1,000 in Sally's checking account and $900 in Mike's) to be spent. In other words, $900 in new money has been "created." This process will continue over and over again as the bank lends out $810 of Mike's deposit while putting $90 in reserves and thus "creating" more money -- up to as much as $10,000. Our fractional reserve banking system leads to this multiplier effect on money.
The students can track the growth of money in the fractional reserve system by filling out this worksheet.
Banks play an important role in the economy. They bring together those people who have extra money and people who need money. Banks utilize a fractional reserve system. This system creates money through the lending process.
How does the Federal Reserve control the supply of money? Discuss the role of the Fed with your students, concentrating on monetary policy and the money supply process.
A 1978 amendment to the Federal Reserve Act gives the Fed responsibility for pursuing a number of goals for the nation's economy. Essentially, this Act states that the Fed should promote high employment, stable prices and sustainable economic growth. The Fed cannot guarantee that everyone will have a job or that inflation will remain under control; employment rates and inflation are affected by the decisions of millions of firms and households interacting in the economy. However, the Fed can help create an environment in which these goals are more likely to be achieved. How does the Fed do this? The answer is through monetary policy. Through monetary policy decisions, the Fed influences interest rates and the supply of money and credit, thus influencing the path of economic activity. The Fed does this primarily by using three tools:
Open Market Operations
The most important tool of monetary policy, and the one most frequently used, is open market operations. Eight times per year, the Federal Open Market Committee (FOMC) meets to set interest rate targets. These meetings receive significant attention from many people, including people in the media, with post-meeting reports typically stating that the Fed "lowered interest rates,""raised interest rates," or "didn't change interest rates." Open market operations are the tool the Fed uses to make these interest rate changes.
While media reports make it sound as if the Fed can simply change interest rates, as they desire, there is a bit more to it in practice. The Fed uses open market operations to control the federal funds rate �€“ i.e the interest rate that banks charge when one bank borrows from another bank's reserves. While this may sound complicated, it really isn't. As we mentioned previously, banks are subject to a reserve requirement mandated by the Fed. In the earlier example, we assumed that banks were required to keep 10 percent of their checking deposits in reserve. Sometimes banks are either short of their required reserves, and sometimes they have excess reserves at the end of the day. When this happens, banks with extra funds can lend money, through the Federal Funds Market to banks that are short. In the Federal Funds Market, the borrower pays the federal funds rate.
The Fed influences the federal funds rate by buying and selling existing government bonds. When the Fed wants to lower interest rates, and encourage firms and individuals to borrow, it buys government bonds from securities dealers. In return for these bonds, the Fed credits these dealers' bank accounts at the Fed. This puts more money into the banking system and places downward pressure on the federal funds rate (increases the supply of money). Other interest rates in the economy then follow (like interest rates on car loans or homes) and borrowing becomes cheaper. This is typically done when the Fed is worried about the economy slipping into recession. The hope is that lower interest rates will encourage borrowing and keep the economy strong. On the other hand, the Fed can raise the federal funds rate by selling government bonds. By doing so, the Fed takes money out of the banking system (lowers the supply of money) and consequently raises interest rates. This is typically done when the Fed fears inflation. Fed officials then hope to slow spending on goods and services by raising the costs of borrowing money.
As we have discussed, the Fed sets a percentage of checking deposits that banks must hold in reserves. In April of 1992, the Fed lowered this required reserve ratio from 12 percent to 10 percent. Tthis tool of monetary policy has not been used since then. When the reserve requirement is lowered, banks are required to keep less money in reserves, and more money is created in the lending process. In other words, less money sits in bank vaults and more is in the hands of the public to use to purchase goods and services. Conversely, if the reserve requirement were raised, banks would have to hold more reserves and less money would be created in the lending process. Reserve requirements are infrequently changed by the Fed, primarily because of the impact that changes in reserve requirements would have on banks and their costs of doing business.
The final tool of monetary policy that the Fed can wield is called discount policy. Discount policy means changing the discount rate: the rate banks must pay to borrow from the Fed. By lowering this discount rate, the Fed can encourage borrowing: or it can raise the discount rate and discourage borrowing. In either case, the money supply can be affected. While the discount rate is typically changed in conjunction with the federal funds rate, discount loans are rare. One reason for this is that the discount rate is kept higher than the federal funds rate, so that banks have no incentive to borrow in the discount market. Discount loans are most often used to bail out failing banks or to help banks that operate in agricultural markets where most of their lending takes place during one part of the year. Discount loans can also be used during times of great financial market uncertainty (such as after September 11, 2001).
Have the students look up the current reserve ratio, federal funds rate and discount rate on the Fed's web site page Monetary Policy .
Have the students record the definitions and any other important information on this worksheet.