Money & Banking

How does money move throughout the economy and what is its function as a supply? In the U.S. there is free flowing money and money that is generally being utilized by the public. This free-flowing money is the heart of the economy and its economic activity. Without free-flowing money that is constantly exchanging hands and being exchanged for good and services, the heart of the economy would not beat. Not only would it not beat but there would be a tremendous amount of friction as well. Friction causes the economy to become stale and when the economy is stagnant and there is a lack of free-flowing money, the prices of assets tend to drop and businesses tend to fail. Free flowing money is what makes our economy tick, without it, the economy would simple cease to function smoothly.

M1 Money Supply

The M1 is the total money that is available throughout the economy and the M2 is the total money that is freely moving and not locked away in deposits. M2 is important because it is essentially how much money is flowing throughout the economy. M2 is the lifeblood of economic activity. It allows for us to purchase goods and services with ease and it’s a better scale of how much money is actually moving freely.

M2 Money Supply

The M2 Money supply is how much free flowing money moves throughout the economy. This is the total of all liquid money currently in use and not locked up. The M2 tends to provide a more accurate measure of what is actually happening within the economy. If M2 is moving freely that means that economy has a lot of economic activity and it likely point towards economic growth. Anytime money is flowing and changing hands it means good and services are also flowing which is typically a signifier that the economy is also growing.

Deposits

Deposits are what banks use to help secure their loans and other financial activities. Banks are allowed to lend out money against these deposits and they only need to keep a reserve in the account. That reserve is a small fraction of what has actually been deposited into the bank. Due to this fact, without established trust and FDIC insurance, the banking system would not be able to make everyone whole

Bank Runs

It is illegal to incite a run on a bank and for good reason! This offense is a severely punishable offense under Federal law. This is extremely dangerous and could cause a tremendous amount of chaos to society in general. Under banking guidelines this will put you in jail and that’s why it’s also important to be careful when posting to social media. Social media has become an echo chamber nowadays and it could cause a great deal of harm to innocent bystanders looking to withdraw their money from a bank. Much panic and chaos would ensue.

Loans

Banks give out loans from customer deposits. What they end up doing is using those deposits to lend out money to other customers that are looking to borrow money. This is the main mechanism for how banks earn money. The deposits they receive into their bank, are utilized in order to generate some type of interest or yield. So, when you deposit money into a bank your money is actually being used to generate profit. The bank is holding it for you, but they are also lending it out to other consumers who request loans or are trying to find some type of way to generate a return on the deposit.

Reserves

Reserves are the required amount a bank has to hold onto to make customers whole on deposits, in case a customer wants to withdraw all of their available money. For this exact reason, you need to call in advance to withdraw a large amount of money at banks and notify your bank when you would like to make the cash withdrawal. Otherwise, you are fine to make electronic withdrawals at any time you like.

Example of reserves: If a bank gets $100 deposited into its banking institution, the bank may only be required to keep 9% of the money in reserves. The other $91, they are free to do as they like with.

Investments

Banks also make investments as a part of their business. Banks will typically have a wide portfolio of different investments and allocated assets. Their job is to keep a diversified portfolio. Investments can come in all different types of forms as banks keep many different classes of assets on their books for both themselves and their clients.

Federal Reserve

The Federal Reserve’s dual mandate is to maximize employment while also maintaining price stability. This FED is usually highly effective at maintaining this dual mandate but that isn't always the case. There have been many bouts of high inflationary periods in The U.S., however nothing on par with the hyperinflation witnessed in the Weimar Republic during 1930s Germany or other countries. The U.S. was undergoing one recently post COVID and all the stimulus that was given out to people during that time period. The M2 money supply increased during COVID to astronomical levels like never before seen. This a main reason we saw periods of high inflation. It stemmed from the rapid expansion of the money supply which inevitably led to serious inflationary pressures Worldwide.

Post COVID Inflation

Post COVID, the high inflationary pressures we witnessed on everything from lumber to eggs were detrimental to the American economy and the stock market. The Federal Reserve only had one option to combat the high inflationary pressures, they had to raise interest rates. It took years but finally inflation has subsided somewhat from the massive levels seen around 2021, 2022, etc.

It took many years of interest rate hikes to slow it down but it has come back down to earth.

Inflation in the 1970s under Jimmy Carter - The last bout of extreme inflationary pressures the U.S. witnessed was during the 1970s, most notably during Jimmy Carter’s presidency. Inflation was bad and there were numerous supply shocks hitting the economy. Consumers would sometimes have to wait for hours to fill up gas in some scenarios.

Federal Reserve

The FED Chair at the time was Volcker. Volcker set many precedents and Fed Chair Powell has since followed his lead. Volcker established the precedent of the “Volcker Rule”, essentially stating that in order to get a better handle on high inflationary pressures you have to artificially crash the economy.

Volcker’s Rule

Volcker attempted to do this once and it started working but he initially underestimated inflation and lowered interest rates too quickly. So, he ended up having to do the job twice in order to finish inflation once and for all and the second battle against inflation was much more difficult than the first. This was a lesson well learned and one that all future FED chairs will be mindful of, if they are dealing with similar issues.

After Volcker’s 2nd bout of against inflation within the economy, inflation finally started to come down and stayed down. Volcker’s bout with inflation will be remembered as it set a precedent on how to deal with high inflationary pressures and helped established Volcker's rule as it's known today.

Why Does It Matter?

Understanding how money and banking work, helps us understand why things work as they do. If we can better understand why things work as they do we can better understand our money in the system and figure out how best to utilize it. This can be a tremendous advantage to have and one we shouldn't take lightly.