How money works, where it comes from, and why banks matter more than you think.
What Is Money?
Money is anything widely accepted as payment for goods and services.
Functions of Money
| Function | Description | Example |
|---|
| Medium of exchange | Facilitates trade | Buy groceries with dollars |
| Store of value | Preserves purchasing power | Save for retirement |
| Unit of account | Common measure of value | Price everything in dollars |
| Standard of deferred payment | Settle debts later | Loans denominated in currency |
Types of Money
| Type | Description | Example |
|---|
| Commodity money | Has intrinsic value | Gold, silver, cigarettes in prison |
| Representative money | Backed by commodity | Gold certificates |
| Fiat money | Value by government decree | Modern currencies |
| Digital money | Electronic form | Bank deposits, crypto |
Properties of Good Money
| Property | Why It Matters |
|---|
| Durable | Survives use |
| Portable | Easy to carry |
| Divisible | Can make change |
| Uniform | Each unit identical |
| Scarce | Maintains value |
| Acceptable | Widely recognized |
The Money Supply
Measures of Money
| Measure | Components | Liquidity |
|---|
| M0 (Monetary Base) | Currency + bank reserves | Most liquid |
| M1 | M0 + checking deposits + traveler's checks | Very liquid |
| M2 | M1 + savings + small time deposits + money market | Less liquid |
| M3 | M2 + large time deposits + institutional funds | Least liquid |
US Money Supply (Approximate)
| Measure | Amount (2024) |
|---|
| Currency in circulation | $2.3 trillion |
| M1 | $18 trillion |
| M2 | $21 trillion |
Note: Most "money" isn't physical cash - it's digital bank balances.
How Banks Work
The Banking Business Model
| Activity | Bank's Perspective |
|---|
| Accept deposits | Liability (owe money to depositors) |
| Make loans | Asset (borrowers owe bank) |
| Earn interest spread | Profit = Loan interest - Deposit interest |
| Provide services | Fee income |
A Simple Bank Balance Sheet
| Assets | Liabilities + Equity |
|---|
| Reserves: $100 | Deposits: $900 |
| Loans: $800 | Equity: $100 |
| Securities: $100 | |
| Total: $1,000 | Total: $1,000 |
Key Banking Ratios
| Ratio | Formula | Purpose |
|---|
| Reserve ratio | Reserves / Deposits | Liquidity measure |
| Capital ratio | Equity / Assets | Solvency measure |
| Leverage ratio | Assets / Equity | Risk measure |
| Loan-to-deposit | Loans / Deposits | Lending aggressiveness |
Fractional Reserve Banking
Banks hold only a fraction of deposits as reserves, lending the rest.
How It Works
| Step | Deposits | Reserves (10%) | Loans |
|---|
| Initial deposit | $1,000 | $100 | $900 |
| Second round | $900 | $90 | $810 |
| Third round | $810 | $81 | $729 |
| Fourth round | $729 | $73 | $656 |
| ... | ... | ... | ... |
| Total (infinite) | $10,000 | $1,000 | $9,000 |
The Money Multiplier
Money Multiplier = 1 / Reserve Ratio
| Reserve Ratio | Money Multiplier | $1,000 Creates |
|---|
| 20% | 5 | $5,000 |
| 10% | 10 | $10,000 |
| 5% | 20 | $20,000 |
| 2% | 50 | $50,000 |
Key insight: Banks create money through lending. Most money in the economy was created by commercial banks, not the government.
Limits on Money Creation
| Limit | Explanation |
|---|
| Reserve requirements | Minimum reserves mandated |
| Capital requirements | Minimum equity buffer |
| Demand for loans | Someone must want to borrow |
| Creditworthy borrowers | Someone must qualify |
| Interest rates | Higher rates reduce borrowing |
Bank Runs and Failures
How Banks Fail
| Problem | Description |
|---|
| Liquidity crisis | Can't meet withdrawal demands |
| Insolvency | Assets < Liabilities (negative equity) |
| Contagion | Failure of one bank triggers others |
| Confidence collapse | Self-fulfilling panic |
Anatomy of a Bank Run
| Stage | What Happens |
|---|
| 1. Rumor/news | Depositors worry about solvency |
| 2. Early withdrawals | Prudent depositors withdraw |
| 3. Cascade | Others see lines, panic increases |
| 4. Illiquidity | Bank can't sell assets fast enough |
| 5. Failure | Bank closes doors |
Self-fulfilling prophecy: A bank that might have survived becomes insolvent because the run itself causes the failure.
Protections Against Bank Runs
| Protection | How It Works | Limitation |
|---|
| Deposit insurance | FDIC guarantees up to $250K | Moral hazard |
| Lender of last resort | Fed provides emergency liquidity | Limited to solvent banks |
| Capital requirements | Buffer for losses | Can still be inadequate |
| Stress testing | Simulate bad scenarios | Models may miss risks |
| Resolution procedures | Orderly wind-down | Disruptive anyway |
The Federal Reserve System
Structure of the Fed
| Component | Role |
|---|
| Board of Governors | 7 members, set policy direction |
| Chair | Leader, face of Fed policy |
| Regional Fed Banks | 12 districts, implement policy |
| FOMC | Sets monetary policy (12 members) |
| Member banks | Commercial banks in the system |
Fed Functions
| Function | Description |
|---|
| Monetary policy | Set interest rates, manage money supply |
| Bank supervision | Regulate and examine banks |
| Financial stability | Monitor systemic risk |
| Payment system | Operate check clearing, wire transfers |
| Lender of last resort | Emergency lending to banks |
| Government's bank | Process Treasury transactions |
Fed Balance Sheet (Simplified)
| Assets | Liabilities |
|---|
| Treasury securities | Currency in circulation |
| Mortgage-backed securities | Bank reserves |
| Loans to banks | Treasury deposits |
| Gold and foreign currency | |
Quantitative Easing: Fed buys assets, credits bank reserves (creates money).
Interest Rates
Types of Interest Rates
| Rate | What It Is | Who Sets It |
|---|
| Federal funds rate | Overnight bank-to-bank lending | Fed target |
| Prime rate | Base rate for best customers | Banks (Fed + 3%) |
| LIBOR/SOFR | Interbank reference rate | Market |
| Treasury rates | Government borrowing cost | Market |
| Mortgage rates | Home loan cost | Market (tied to Treasuries) |
| Credit card rates | Unsecured consumer lending | Banks (prime + risk) |
The Yield Curve
| Maturity | Typical Rate | Shape Meaning |
|---|
| 3-month | Lower | Normal: upward slope |
| 2-year | | Flat: uncertainty |
| 10-year | | Inverted: recession signal |
| 30-year | Higher | |
Why Long Rates Usually Exceed Short Rates
| Reason | Explanation |
|---|
| Inflation risk | More time for inflation |
| Default risk | More time for things to go wrong |
| Liquidity preference | People prefer accessible money |
| Opportunity cost | Tied up longer |
Credit and Lending
Types of Credit
| Type | Collateral | Rate | Example |
|---|
| Secured | Yes | Lower | Mortgage, auto loan |
| Unsecured | No | Higher | Credit card, personal loan |
| Revolving | Sometimes | Varies | Credit card, HELOC |
| Installment | Sometimes | Fixed | Auto loan, student loan |
What Determines Your Interest Rate
| Factor | Effect |
|---|
| Credit score | Lower score = higher rate |
| Loan-to-value | More borrowed = higher rate |
| Debt-to-income | More debt = higher rate |
| Loan term | Longer = higher rate |
| Collateral | Better collateral = lower rate |
| Economic conditions | Recession = tighter credit |
The Credit Score
| Score Range | Rating | Typical Impact |
|---|
| 800-850 | Excellent | Best rates, easy approval |
| 740-799 | Very Good | Great rates |
| 670-739 | Good | Average rates |
| 580-669 | Fair | Higher rates, harder approval |
| 300-579 | Poor | Subprime rates, often denied |
Factors in Credit Score
| Factor | Weight | How to Improve |
|---|
| Payment history | 35% | Pay on time, every time |
| Amounts owed | 30% | Keep utilization below 30% |
| Length of history | 15% | Keep old accounts open |
| Credit mix | 10% | Have different types |
| New credit | 10% | Limit hard inquiries |
Financial Crises
Anatomy of a Financial Crisis
| Phase | Characteristics |
|---|
| 1. Credit boom | Easy lending, rising asset prices |
| 2. Euphoria | "This time is different" |
| 3. Trigger | Some event reveals problems |
| 4. Panic | Everyone tries to sell/withdraw |
| 5. Contagion | Spreads across institutions |
| 6. Credit freeze | Lending stops |
| 7. Intervention | Government/central bank action |
| 8. Recovery | Gradual normalization |
Major Financial Crises
| Crisis | Year | Cause | Consequence |
|---|
| Great Depression | 1929-33 | Stock crash, bank runs | 25% unemployment, deflation |
| S&L Crisis | 1980s | Interest rate mismatch | 1,000+ bank failures |
| Asian Crisis | 1997 | Currency/debt crisis | Regional contagion |
| Dot-com | 2000 | Tech bubble burst | Mild recession |
| Global Financial | 2008 | Subprime mortgages, leverage | Severe recession |
| COVID | 2020 | Pandemic shock | Sharp drop, fast recovery |
2008 Crisis Explained
| Step | What Happened |
|---|
| 1. Easy credit | Low rates, lax lending standards |
| 2. Housing bubble | Prices rose unsustainably |
| 3. Subprime mortgages | Loans to unqualified borrowers |
| 4. Securitization | Mortgages bundled, sold globally |
| 5. Leverage | Banks borrowed heavily |
| 6. Housing crash | Prices fell, defaults rose |
| 7. Bank failures | Lehman Brothers collapsed |
| 8. Credit freeze | Banks stopped lending |
| 9. Bailouts | TARP, Fed emergency lending |
| 10. Slow recovery | Took years to normalize |
Cryptocurrency and Digital Money
Types of Digital Currency
| Type | Description | Example |
|---|
| Cryptocurrency | Decentralized, blockchain-based | Bitcoin, Ethereum |
| Stablecoins | Pegged to fiat currency | USDC, Tether |
| CBDC | Central bank digital currency | Digital yuan, proposed digital dollar |
Bitcoin vs. Traditional Money
| Feature | Bitcoin | US Dollar |
|---|
| Issuer | Algorithm | Federal Reserve |
| Supply | Fixed (21 million) | Unlimited |
| Backing | Nothing | Government decree |
| Volatility | Very high | Low (by design) |
| Acceptance | Limited | Universal |
| Privacy | Pseudonymous | Varies |
| Reversibility | None | Possible |
Cryptocurrency Challenges
| Challenge | Explanation |
|---|
| Volatility | Poor store of value |
| Scalability | Transaction limits |
| Energy use | Proof-of-work intensive |
| Regulation | Uncertain legal status |
| Criminal use | Money laundering, ransomware |
| Complexity | Hard for average user |
Key Takeaways
Money is trust - Currency has value because people believe others will accept it
Banks create money - Through fractional reserve lending, commercial banks multiply the money supply
The Fed controls money - Through interest rates and asset purchases, the Fed expands or contracts money
Interest rates reflect risk - Higher risk borrowers and longer terms mean higher rates
Bank runs are self-fulfilling - Even healthy banks can fail if enough depositors panic
Credit scores matter - Your three-digit number affects borrowing costs throughout life
Financial crises follow patterns - Credit boom, bubble, panic, intervention, recovery