The money market is where the exchange of short-term investments happens. Many of the investments are high in liquidity, which means they can be converted into cash quickly. Short-term investments tend to take less time to mature. Examples include certificates of deposit and U.S. Treasury bills. Money market activity consists of both lending and borrowing. Lenders typically receive repayments plus interest within a year or less. Likewise, investors usually cash out the value of their initial investment plus interest within the same time frame.
The U.S. banking system operates under the policy of "fractional reserves." This means banks back up only a portion of their recorded deposits. Banks typically store backups as cash or funds at a central location. A bank's recorded deposits usually come from consumer checking and savings accounts. If the fractional reserve ratio set by the government is 20 percent, banks must back up 20 percent of the total balance of their deposit accounts. Let's say a bank has $1 million worth of deposit accounts. It must keep $200,000 in its reserves; the remaining $800,000 exists only on paper.
Due to the fractional reserve banking system, banks create money through loans. Banks are allowed to lend out money that is not backed by reserves. The bank that has $1 million000 worth of deposit accounts and $200,000 in reserves may extend $800,000 worth of loans. This $800,000 comes back to the bank when borrowers repay. Technically, the bank still has the original $800,000 worth of deposits on record plus another $800,000 in loans. Instead of $800,000 in assets, the bank now has $1.6 million.
A surplus in the money market occurs when banks save more than they lend. Excess reserves are additional backups that a bank may keep. Any amount that exceeds a bank's required reserves becomes part of its actual reserves. For example, suppose the bank with $1 million worth of deposit accounts and operating under a fractional reserve ratio of 20 percent actually has $400,000 in reserves. The bank is retaining reserves at a 40 percent rate rather than the required minimum. Individual banks only lend out amounts that are equal to their excess reserves. The amount of its excess reserves limits the amount of new money a bank creates.
A surplus also occurs when the demand for money is less than the supply of money. Interest rates, or the cost of borrowing, have a direct effect on the lending market. The government is able to manipulate the discount rate, which is the interest rate the Federal Reserve Bank charges member banks. Lower interest rates stimulate demand by encouraging consumers to spend and banks to lend. A lower interest rate can also discourage saving and investing. If interest rates and the reserve ratio are set too low for demand, the result will be a surplus in the money supply.
- National Bureau of Economic Research: Scope and Function of the Capital Market in the American Economy
- Economics: Principles, Problems, and Policies 17th Edition; Campbell McConnell, Ph.D. and Stanley Brue, Ph.D
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