Role of Commercial Banks in Money Supply

The money supply of a nation is either controlled by a central bank or similar government entity. In the United States, the Federal Reserve is responsible for this process. Commercial banks are one piece of the process in controlling a nation’s money supply.

Commercial banks are financial institutions that hold customer deposits, make personal and business loans, or provide other financial services. Their role in money supply is to offer financing—based on a customer’s credit—that helps individuals make large purchases for which they do not have cash on hand.

The Federal Reserve can influence the money supply through commercial banks by changing money reserves or discount rates. Money reserves indicate how much money a commercial bank must retain rather than loan out. Discount rates work in a similar fashion. Low rates increase the money supply while high rates decrease the money supply.

Money supply is critical in an economy because it can directly affect inflation. Inflation is classically defined as too many dollars chasing too few goods. A loose fiscal policy that increases the money supply can raise inflation, reducing purchasing power. Tight money supply can limit the amount of business individuals and companies can conduct in the economic market.