key term - Commercial banks

Definition

Commercial banks are financial institutions that accept deposits, provide loans, and offer various financial services to individuals and businesses. They play a crucial role in the banking system by facilitating the creation of money through lending activities, which directly impacts the overall money supply in the economy.

5 Must Know Facts For Your Next Test

1. Commercial banks primarily earn revenue through interest on loans and fees for services, which allows them to sustain operations and provide returns to their shareholders.
2. They are essential for the economy as they provide liquidity to businesses and consumers by extending credit, which in turn fuels spending and investment.
3. The banking system relies on fractional reserve banking, where commercial banks only keep a fraction of deposits as reserves and lend out the rest, effectively increasing the money supply.
4. Regulatory bodies oversee commercial banks to ensure they operate safely and soundly, protecting depositors and maintaining confidence in the financial system.
5. Commercial banks can create money indirectly by making loans, which leads to an increase in deposits as borrowers spend the funds, thus expanding the overall money supply.

Review Questions

• How do commercial banks contribute to the expansion of the money supply in an economy?
  • Commercial banks contribute to the expansion of the money supply through a process called fractional reserve banking. By only keeping a small percentage of deposits as reserves, they can lend out a significant portion of their deposits. This lending activity creates new money in the economy as loans are deposited into other accounts, allowing for further lending. As this cycle continues, it amplifies the total amount of money available in circulation.
• Discuss the relationship between interest rates set by commercial banks and their impact on economic activity.
  • Interest rates set by commercial banks directly influence borrowing costs for consumers and businesses. When interest rates are low, borrowing becomes cheaper, encouraging spending and investment, which stimulates economic growth. Conversely, higher interest rates can deter borrowing, leading to reduced consumer spending and slower economic growth. Thus, changes in interest rates have a profound impact on overall economic activity.
• Evaluate the role of regulatory frameworks in ensuring the stability of commercial banks and their impact on monetary policy.
  • Regulatory frameworks play a critical role in ensuring that commercial banks operate safely and soundly by setting capital requirements, reserve ratios, and conducting regular audits. These regulations help maintain public confidence in the banking system and protect depositors. Furthermore, regulatory oversight influences how commercial banks respond to monetary policy changes from central banks, as tighter regulations may limit their ability to expand credit during periods of economic stimulus or contraction.

Related terms

Reserve Requirement:

The minimum amount of reserves that commercial banks must hold against deposits, set by the central bank.

Money Multiplier:

The ratio of the change in the money supply to the change in reserves, demonstrating how banks can expand the money supply through lending.

Interest Rates: The cost of borrowing money, which is influenced by central bank policies and affects the demand for loans from commercial banks.