Macroeconomics · StudentHub Lesson
Money & Banking
What money is, its functions, and how banks and central banks influence the money supply.
What you will learn
- Identify the three functions of money
- Explain how commercial banks create money through lending
- Understand the role of the central bank in monetary policy
- Describe the money multiplier concept
- Distinguish M1 and M2 measures of the money supply
Watch the lesson
Money and Finance: Crash Course Economics #11 · CrashCourse
Watch on YouTubeTopic notes
Main Idea
Money is anything widely accepted as payment that serves three key functions, and the banking system expands the money supply through lending.
Key Concepts
- Three functions of money: medium of exchange, store of value, unit of account
- Commercial banks accept deposits and make loans, effectively creating new money in the process
- Fractional reserve banking: banks keep only a fraction of deposits as reserves and lend out the rest
- Money multiplier: shows how an initial deposit can expand the total money supply (1/reserve requirement)
- Central banks (like the Federal Reserve) manage the money supply and interest rates through monetary policy
- M1: most liquid money (cash, checking deposits); M2: M1 plus savings accounts and other near-money
Diagram (described)
Imagine a flow chart: a $100 deposit at Bank A, which keeps $10 in reserve (10% reserve requirement) and lends out $90; that $90 gets deposited at Bank B, which lends $81, and so on — each round adds to the total money supply.
Formula
Money multiplier = 1 / reserve requirement (as a decimal)
Example
If the reserve requirement is 10%, the money multiplier = 1/0.10 = 10, meaning a $100 initial deposit could expand into $1,000 in the money supply.
Common Mistakes
- Thinking money must be physical cash — bank deposits count as money too
- Confusing the money multiplier with a fixed guarantee (real-world effects are often smaller)
- Mixing up M1 (very liquid) and M2 (broader, less liquid) definitions
Key concepts
Important terms
- Medium of exchange
- A function of money allowing it to be used to buy and sell goods and services.
- Fractional reserve banking
- A banking system where banks hold only a fraction of deposits as reserves and lend the rest.
- Money multiplier
- The factor by which an initial deposit can expand the total money supply, equal to 1 divided by the reserve requirement.
- Central bank
- The institution responsible for managing a country's money supply and monetary policy.
Worked examples
Problem
If the reserve requirement is 20%, what is the maximum money multiplier, and how much can a $500 deposit theoretically expand the money supply?
- 1. Money multiplier = 1/reserve requirement
- 2. = 1/0.20 = 5
- 3. Total possible expansion = deposit x multiplier = 500 x 5
Answer: Multiplier = 5; total possible money supply = $2,500
Quick revision
- Money functions: medium of exchange, store of value, unit of account
- Banks create money by lending out a portion of deposits
- Money multiplier = 1 / reserve requirement
- Central banks control money supply and interest rates
- M1 is more liquid than M2
- Fractional reserve banking allows money supply to expand beyond physical cash
Check your understanding
Question 1 · Multiple choice
Which of the following is NOT one of the three functions of money?
Question 2 · Multiple choice
If the reserve requirement is 25%, the money multiplier is:
Question 3 · True or false
M1 includes savings accounts while M2 does not.
Question 4 · Short answer
Explain briefly how a bank 'creates' money when it makes a loan.
Question 5 · Multiple choice
The institution responsible for setting monetary policy and managing the money supply is the:
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