Economics Terms A-Z - The most important terms in economics.

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Economics Terms A-Z


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By , reviewed by Kladiola Gjini

Banks are most commonly associated with storing people's money. But banks are financial institutions with multiple functions that are crucial in a modern economy. As such, though they are usually private businesses, banks face unique federal government-mandated regulations and protections that other industries do not (to the point that they may receive bailouts in times of dire recession). The importance of banks in economics goes beyond the traditional consumer-facing roles that we typically think about first.

A very brief history of banking

Banking can be traced all the way back to institutions in ancient Mesopotamia (circa 2000 BCE), including Babylonia and Sumer. In these ancient societies, religious temples sometimes offered space for civilians to store wealth. For example, farmers were able to store grain, coins and other valuables. Sometimes, civilians were charged small fees when depositing resources. The temples then lent out some of their stores to help others – representing a form of early loan.

Contracts for these services eventually developed, such that the Code of Hammurabi contained a series of laws regarding loan repayments and the liabilities of debtors and lenders. Other ancient societies developed banking practices as well; there are records of early banking and lending practices in Mughal India and in the Qing Dynasty in China.

In Italy in the 14th and 15th centuries CE, the Medici family invented a double-entry record-keeping system, which is still being used today in modern accounting. This paved the way for more complex financial instruments and transactions to be created.

And of course, central banks eventually evolved out of the concept of a standard bank. The earliest two were the Sveriges Riksbank (originally the Riksens Ständers Bank), founded in 1668, and the Central Bank of England, founded in 1694. In both cases, the banks were founded as lenders for the government, though the Central Bank of England was private and thus became a model for other central banks to follow.

In 1913, the United States introduced the Federal Reserve system of decentralized central bank branches organized by region, a system that is considered both public and private. And, after World War II, the Bretton Woods agreement in 1944 led to the creation of the IMF and the World Bank, institutions that are meant to serve as financial lenders for the community of nations around the world.

In the modern age, the role of banks in the economy still includes acting as safe places to store wealth, and as moneylenders for agents in the economy. Innovations like wire transfers and fractional reserve banking have allowed traditional banks (and newer investment banks) to form the now-global and interconnected network of finance. Increasingly, banking services can be done virtually, to the point where some new banks don’t have physical branches at all. But the important roles they play in the economy remain the same.

The many roles of banks in the economy

Storing one’s wealth in a safe place has been important for the development of the economy throughout human history. Having a way to store up excess wealth could help any economic actor, from businesses and governments to families and farmers survive difficult seasons and save money to invest in the future. These are critical functions; in many macroeconomic models of the economy (such as the Investment-Saving/Liquidity preference-Money supply model (IS-LM)), savings fuel investment, which fuels economic growth.

Despite the negative stigma associated with holding debt, loans and debt are crucial to the economy’s functioning. Taking out a loan allows individuals and businesses to afford goods and invest in the future in ways that would be impossible without debt.

This, too, fuels economic growth; it’s far easier to build a factory that can quickly begin churning out economy-enhancing machine parts, for instance, if a company can take out a loan and repay that loan with interest over the course of several years. If loans aren’t available, the company would be forced to save money until it could cover the entire cost of the factory, which could delay production of the machine parts, and consequent value to the company and the economy, for years.

These two major services – storing money and lending it – work in tandem in a mutually beneficial way. Banks are able to naturally function as a third-party broker that can easily match savers (who function as lenders) and borrowers.This reduces transaction costs and increases the amount of trade in the economy.

This “broker” role enables the banking system to perform two more important functions. First, banks act as natural stewards of the economy’s wealth, since their profit-seeking motive ensures they lend only to promising projects – an elegant example of Adam Smith’s invisible hand (though it is worth noting that moral hazard may lead them to act against the economy’s best interest, impeding this role). Second, banks form the backbone of our modern electronic payment infrastructure, issuing payment methods like credit cards. These allow individuals to easily access their assets like checking accounts and savings accounts on the go, increasing the velocity of money by making transactions easier.

To see this, first recall that savings fuel investment by allowing borrowers to use other people’s savings to fund their investments, then return more money than they lent. Imagine a family wishes to save $5,000. Without banks, the family would have to either store that money under a mattress – which is liable to loss, theft, or natural deterioration – or find an individual or business that wanted to borrow $5,000 and make a contract with them. The latter takes time, effort, and legal expertise that many families (and businesses) in the country probably don’t have.

But by saving in a bank, any family is able to save with a level of risk acceptable to them, and the bank is then able to match their funds to worthy borrowers, growing wealth for everyone.

Further Reading

Banks operate using a system of reserves where not all of their obligations to their customers are held at once. That is, if customers deposit $100 into a bank, it may only keep $20 of that money on hand because only a small portion of that deposit is likely to be retrieved at any given time. This system is known as fractional reserve banking.

But, because the bank is only keeping a fraction of its obligations on hand at any given time, it can become vulnerable to bank runs – situations where many depositors suddenly demand their money at once, potentially leading to the collapse of the institution as it fails to fulfill its obligations.

Banks are often governed by both government regulations and the central bank, which sets several of the rules that the institutions must adhere to. These include the reserve requirement and the federal funds rate.


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