Banks and the Circular Flow
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Money and Banks

The Graph of the Circular Flow

Federal Reserve System

Banks and the circular flow perform two essential functions for the macro economy which are banks transfer money from savers to spenders by lending funds (reserves) held on deposit and banking system creates additional money by making loan in excess of total reserves. The three major constraint on the deposit creation of the banking system are deposits, constraint is the willingness of consumer and business to continue using and accepting checks rather than cash in the marketplace, the second borrowers constraint on deposit creation is the willingness of consumers, business, and governments to borrow the money that banks make available and the third is regulation that has constraint on deposit creation is the Federal Reserve System. The power of banks to create money originates in the fractional reserve system. As we have observed, a bank holds reserves that are small fraction of its liabilities, implying that no bank could pay off its customers if they all sought to withdraw their deposits at one time.

Types of Banks:

There are three different types of banks we will discuss:
  1. Savings Banks
  2. Credit Unions
  3. Commercial Banks

     Savings Banks are financial institutions that gather savings and pay interest or dividends to savers.  The earliest savings banks developed out of Italy somewhere around the year of 1769.  However, the first U.S. savings bank was not established until 1810.  Savings banks have not made quite the influence on any country, as the commercial bank has.  A quick comparison between the two is pretty simple, as in the year 1990, there were about 600 savings banks compared to about 15,000 commercial banks at the same time.  Savings banks credit any excess money to the depositors as divideneds, however a savings bank also makes loans, which in turn can take away from money and dividends.

     Credit Unions are a credit cooperative formed by an organized group of people with a common bond who save their money and make low cost loans amongst each other.  Most loands are usually short term, but there are some exceptions.  Numbers wise, around the year 1984, there were about 20,000 credit unions in the United States, with only about 3,600 in Canada.  This ends up giving North America a large number but shows how much more the United States prefers the credit union over canada.  The United States' close to 20,000 is the most credit unions in any country in the world over that time, and also today in the year 2005, it still holds the highest number of credit unions in the world.

     Commercial Banks not only have the power to make loans (as do savings banks and credit unions), but they are also at the center of most money markets today.  A commercial bank is required to hold a fraction of its deposits as reserves, which in turn, allows the bank to use some of the money on deposit to extend some loans.  The assets of a commercial bank carry less importance and risk than that of both the other financial institutions listed above.  This is definitely one of the main reasons as to why consumers today prefer the commercial bank over both the savings bank and the credit union.   

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