The Importance of Bank Deposits in the Money Supply

Historically

Historically, economists had trouble deciding how bank deposits fit into the money supply. After all, different banking systems chose different ways to represent deposits either through actual assets, such as silver and gold or through only records. These systems changed over time with the creation with more accurate methods of accounting. This led to some differences in economic theory on how to treat bank deposits, especially in the beginning. By the 1900s, however, most economists agreed that deposits and bank notes alike had to be considered part of the money supply.

Savings and Investment Methods

Deposits are not only a part of the money supply, they also affect it in important ways. Governments create and spread money throughout the economy in response to key movers like investment. Investment is largely possible because people can move large sums of money by saving, transferring and withdrawing funds from bank accounts. Bank deposits are a primary tool for investment, and without them businesses would not be able to access funds from individuals at all.

Money Creation Through Demand Deposits

Businesses and individuals can also receive funds through the bank itself. Banks can affect the money supply through demand deposits, or loans that the bank funds through cash deposits it receives. By using interest rates to create their own profit, banks are also creating money to increasing the money supply in the economy. Banks cannot use all their reserves for loans, however -- the government requires them to keep a certain amount to satisfy withdrawals.

Federal Funds Rate

The government also controls the money supply to influence inflation and other parts of the economy through the federal funds rate. This is the rate at which banks lend to each other, usually for overnight loans that allow banks to meet very short-term obligations or raise investment money for a brief period of time. Because these loans are often millions or billions of dollars, changing the federal funds rate is an easy way to alter the money supply as a whole. If it is easy for banks to borrow money using Federal Reserve funds, it is unnecessary to keep large supplies of funds at hand. If rates rise, however, banks will respond by raising their supply of reserves, contracting the money supply in the open market. Changing the rate also changes expectations regarding Treasury bonds, which are another tool the government uses to change the money supply.