191 Banks, Loan Finance, and the Payments System
What you’ll learn to do: explain the structure, functions, and responsibilities of the Federal Reserve System
In a modern, market economy, the availability of credit is critical to the functioning of the economy. Too little credit can hamstring an economy, while too much can cause inflation. The Federal Reserve (or Fed) plays a key role in the macro economy by regulating the supply of credit. In addition, it promotes stability in the financial system, and provides banking services to government and to commercial banks.
Learning Objectives
- Explain the key role of banks in bringing lenders and borrowers together, and in facilitating the payments system
- Explain how the nature of banks makes them susceptible to bank runs
This module follows directly from the previous one on money and the banking system. Let’s think again about the banking system and how it works. Banks are businesses, which accept deposits and make loans. The deposits come mostly from households, but every business also has one or more bank accounts. Businesses use bank accounts in the same way that individuals do—as a safe, liquid place to store savings. Individuals and businesses also use banks as a facility for making payments, through the use of demand deposits (or checks) or electronic payments (e.g. debit cards). A payment (whether check or debit) has to come from somewhere in the financial system, and banks are one way to fulfill that role.
Loan Finance
Banks earn income by making loans. They also make other safe investments, like purchases of Treasury securities, but primarily they are in the loan business. Businesses borrow from banks to finance investment expenditures and also for shorter term needs like payrolls. Households borrow from banks to finance home purchases (i.e. mortgages). Individuals borrow money to purchase cars and other vehicles. They also borrow money to pay for higher education. It is no overstatement to say that money and credit are the grease in a modern economic system, without which the economic system would operate at a much lower level.
In short, banks are one part of the larger financial system, which links savers and borrowers. Savers supply the funds for borrowing and borrowers provide the demand. A key element between lenders and borrowers is the interest rate, which is the price one pays to borrow money and the reward one receives for lending. We have seen earlier in this course that interest rates play a key role in promoting or inhibiting business investment and purchases of consumer durable goods (e.g. autos) and new homes.
Banks also play a key role in the payments system, by which individuals and businesses pay for their purchases. Think about how often you pay for your purchases using cash versus using checks, or electronic means (e.g. debit cards, credit cards or electronic transfers from your bank account). If you’re like most Americans, fewer and fewer of your transactions are done w