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3 Tutorials that teach Central banks
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Central banks

Central banks

Author: Kate Eskra
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This lesson covers the Central banks
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Tutorial

CENTRAL BANKS

Source: Image of private bank note, public domain, http://en.wikipedia.org/wiki/File:Bank_of_De_Soto_Dollar.JPG, Image of bank run, public domain, http://en.wikipedia.org/wiki/File:Bank_Run_c1933.jpg

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Hi. Welcome to macroeconomics. This is Kate. This tutorial is on central banks. As always, my key terms are in red, and examples are in green. In this tutorial, we'll talk about the need for and then the development of a central banking system in our country. You'll see that the main role in the beginning was really to standardize our currency, and then other tools developed over time. And we'll talk about also how central banks make national and international transactions easier.

So in our country, we kind of went back and forth between times when there was a centralizing banking system and times when there wasn't. And there was a free banking era. There were a lot of problems when states were given the right to regulate their own banks. And some of those issues were, first of all, banks lent out way too much money. They were not required to hold any reserves, necessarily. I'll define that for you on the next slide.

Different banks were issuing different kinds of currency, so it made traveling between states really difficult. Bankers were printing more money, and that was causing inflation. There were bank runs and panics, which we'll also talk about later in the tutorial. There were Wildcat banks, which were these banks located on the edges of settled areas, and their failure rate was really high. Banks were cheating customers.

And one example here was during the Civil War. So the official currency issued was called the greenback, but the Confederacy decided to issue their own currency, which they were backing by cotton, which then eventually became worthless as they were losing the war.

So the first thing here that really recognized the need for a central bank was the need for a common currency. Every bank was printing and issuing its own currency, so it was really difficult to know the value of any given banks notes that they were printing. This is just one example of a note that I found on the internet that looked interesting. It looks nothing like $1 today, it looked nothing like other dollars being printed at the time, so it was really difficult to know the value of one bank's notes versus another's.

So again, since every bank's notes are different, it was really difficult for people to buy anything when they're traveling any kind of distance. So people realized a central bank would really solve this problem. They could issue a common currency for everyone to use.

So a central bank is defined as a central banking authority that's typically charged with the regulation of a money supply and interest rates. Now that there was a standard currency being issued, as Americans, we started relying less and less on actual physical gold as money. Banks were printing paper money, which at first, during the gold standard, represented a designated amount of gold. Initially, it was 1/20 of an ounce of gold for each dollar.

Now with a central banking authority that was standardizing the dollar, people started to just trust that the dollar was an accepted form of payment. And that is what we know as a Fiat currency. So it's no longer a representative type of currency backed by gold. We didn't need to back it by gold anymore. It became just an accepted form of payment in and of itself.

So how is it that banks make money? We know that if they just stored it for us, they wouldn't profit. So we're aware that banks earn interest. Well, they earn interest by-- they pay interest to individuals who deposit money into an account, which is known as a deposit or checking account, but then make revenue by charging a higher interest rate to loan out money to others.

Well, they realize that they can make more loans, and then more money, by only holding onto a fraction of people's deposits in reserves. So reserves are what is held onto. For every dollar, then, that was held in their actual physical reserves, in theory, there could be multiple dollars and multiple checking accounts on which customers can write checks and demand the money.

When banks do this, when they only hold a fraction of their deposits, either in actual gold during the gold standard or after the gold standard in money, that's known as a fractional reserve system. It sounds a little weird, doesn't it? It sounds like it wouldn't work out. But really, it's OK. What are the chances that everyone will show up at your bank or those ATMs today and demand all of their money? As long as the demand for cash on any given day is less than the cash held in reserve, the system works just fine. It allows banks to make more loans to us and then earn more interest for them.

This is how banks actually create money in our economy. But the problem is, if banks do lend out too much money, if they're too risky or lend out a whole lot more money than they should, or if, for some reason, a lot of people show up demanding the cash in their accounts, then the bank finds itself in a situation where they cannot meet their demands. And the bank ends up failing, or going bankrupt.

This used to happen a lot. I always think of the scene from It's a Wonderful Life where everybody rushes to the bank and demands all of their money, and he has to explain to everybody, look, your money isn't all here. It's out in his house, and the improvements being made to their home, and everything like that. So bank runs occur when bank customers show up demanding all of their money at one time.

And when this happens on a large scale, like it did at the beginning of the Great Depression when the stock market plummeted, when there are a lot of bank runs, we call that situation a panic. People are panicking as a result of something that they heard about in the economy, they all run to the banks to get all of their money. The first people who get there might get their money, but then the rest of the people don't. Because again, the banks are only holding on to a fraction of their reserves, or in reserves.

So what these bank runs and panics do is take a bad situation and they make a much, much worse. These are not good for an economy. When banks fail, it creates a lot less confidence and a lot more worry from consumers. And the key to a healthy economy is confident consumers, people willing to go out and spend their money. It's very difficult to get the economy back on track in the case where people are not confident at all in the banking system.

So a panic or a run is a financial separation of an individual from a depository institution as a result of perceived risk in the institution's solvency-- their ability to make loans.

So our central banking system has evolved over time. It's come up with several tools to keep these runs and panics from happening, because we realized how bad it was for the economy. Reserves, again, the definition is a portion of deposits required to be held by a bank. These reserves are usually kept to maintain reserve requirements as set by our central bank today, the Fed. So this is the first tool that was really developed to try to cut down on these panics and runs.

So some of the tools that have developed over time, like I said, the first one deals with these reserves. So requiring a reserve requirement of all banks. Today we do have a reserve requirement required by the Fed, and every bank that is a member bank has to report daily that they have met their reserve requirement.

Another thing that the Fed, or central banking system, has done is to act as a lender of last resort. If banks don't have enough reserves for some reason-- maybe a lot of people came that day to withdraw money-- if they don't meet their reserve requirement, they can borrow from one another, or they can borrow from the Fed if it's necessary. So again, our central bank acts as a lender of last resort.

They also conduct, today, bank examinations, to make sure that banks are not being too risky with our money. All of these things are meant to give consumers, depositors, confidence in the banking system, to prevent runs and to prevent panics and make it a more stable banking system.

So not only did a central bank help Americans in different states buy from one another, because we had a standard currency now, central banks are also really important in international exchanges. And we know that over time, international exchanges have become more and more and more important. In part, it's become more important and become more prevalent because central banks have made it possible to be that way. Think about it, would a foreigner really want to sell anything to an American if they weren't sure of our dollar stability? That would be really difficult.

So as a final note here, we do have a bank for international settlements. And this is an international organization of central banks, and their goal really is to help facilitate international trade and to make it run smoothly.

So in this tutorial, we talked about the need for and how a central banking system developed over time in our country. We looked at how the main role really, in the beginning, was to standardize currency, and that certainly helped. But some other tools developed over time to cut down on the bank runs and panics. And finally, we noted that central banks make not only national transactions, but international transactions, much easier.

Thanks so much for listening. Have a great day.

Notes on "Central Banks"

Terms to Know

Central Bank

A central banking authority that is typically charged with the regulation of money supply and interest rates.

Reserves

A portion of deposits required to be held by a bank; reserves usually are kept to maintain reserve requirements, as set by the Fed.

Panic/Run

The financial separation of an individual from a depository institution as a result of perceived risk in the institution’s solvency.