The Monetary System

In this chapter,
look for the answers to these questions:
• What assets are considered “money”? What are the
functions of money? The types of money?
• What is the Federal Reserve?
• What role do banks play in the monetary system?
How do banks “create money”?
• How does the Federal Reserve control the money
supply?
What Money Is and Why It’s Important
• Without money, trade would require barter,
the exchange of one good or service for another.
• Every transaction would require a double coincidence
of wants—the unlikely occurrence that two people each
have a good the other wants.
• Most people would have to spend time searching for
others to trade with—a huge waste of resources.
• This searching is unnecessary with money,
the set of assets that people regularly use to buy g&s
from other people.
The 3 Functions of Money
• Medium of exchange: an item buyers give to sellers when they want
to purchase g&s
• Unit of account: the yardstick people use to post prices and record
debts
• Store of value: an item people can use to transfer purchasing power
from the present to the future
The 2 Kinds of Money
Commodity money:
takes the form of a commodity
with intrinsic value
Examples: gold coins, cigarettes
in POW camps

Fiat money:
money without intrinsic value,
used as money because of
govt decree
Example: the U.S. dollar
The Money Supply
• The money supply (or money stock):
the quantity of money available in the economy
• What assets should be considered part of the money supply? Two
candidates:
• Currency: the paper bills and coins in the hands of the (non-bank) public
• Demand deposits: balances in bank accounts that depositors can access on
demand by writing a check
Measures of the U.S. Money Supply
• M1: currency, demand deposits,
traveler’s checks, and other checkable deposits.

• M2: everything in M1 plus savings deposits,

small time deposits, money market mutual funds, and a
few minor categories.

The distinction between M1 and M2

will often not matter when we talk about
“the money supply” in this course.
Central Banks & Monetary Policy
• Central bank: an institution that oversees the banking system and
regulates the money supply
• Monetary policy: the setting of the money supply by policymakers in
the central bank
• Federal Reserve (Fed): the central bank of the U.S.
Bank Reserves
• In a fractional reserve banking system,
banks keep a fraction of deposits as reserves
and use the rest to make loans.
• The Fed establishes reserve requirements,
regulations on the minimum amount of reserves that
banks must hold against deposits.
• Banks may hold more than this minimum amount
if they choose.
• The reserve ratio, R
= fraction of deposits that banks hold as reserves
= total reserves as a percentage of total deposits
Bank T-Account
• T-account: a simplified accounting statement
that shows a bank’s assets & liabilities.
• Example:
FIRST NATIONAL BANK
Assets Liabilities
Reserves $ 10 Deposits $100
Loans $ 90

 Banks’ liabilities include deposits,

assets include loans & reserves.
 In this example, notice that R = $10/$100 = 10%.
 Banks and the Money Supply: An Example

Suppose $100 of currency is in circulation.

To determine banks’ impact on money supply,
we calculate the money supply in 3 different cases:
1. No banking system
2. 100% reserve banking system:
banks hold 100% of deposits as reserves,
make no loans
3. Fractional reserve banking system
 Banks and the Money Supply: An Example

CASE 1: No banking system

Public holds the $100 as currency.
Money supply = $100.
 Banks and the Money Supply: An Example
CASE 2: 100% reserve banking system
Public deposits the $100 at First National Bank (FNB).

FNB holds FIRST NATIONAL BANK

100% of Assets Liabilities
deposit
Reserves $100 Deposits $100
as reserves:
Loans $ 0
Money supply
= currency + deposits = $0 + $100 = $100
In a 100% reserve banking system,
banks do not affect size of money supply.
 Banks and the Money Supply: An Example

CASE 3: Fractional reserve banking system

Suppose R = 10%. FNB loans all but 10%
of the deposit: FIRST NATIONAL BANK
Assets Liabilities
Reserves $100
10 Deposits $100
Loans $ 90
0

Depositors have $100 in deposits,

borrowers have $90 in currency.
Money supply = C + D = $90 + $100 = $190 (!!!)
 Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
How did the money supply suddenly grow?
When banks make loans, they create money.
The borrower gets
• $90 in currency—an asset counted in the
money supply
• $90 in new debt—a liability that does not have an
offsetting effect on the money supply

A fractional reserve banking system

creates money, but not wealth.
 Banks and the Money Supply: An Example

CASE 3: Fractional reserve banking system

Borrower deposits the $90 at Second National Bank.
SECOND NATIONAL BANK
Initially, SNB’s
T-account looks Assets Liabilities
like this: Reserves $ 90 9 Deposits $ 90
Loans $ 81
0

If R = 10% for SNB, it will loan all but 10% of the deposit.
 Banks and the Money Supply: An Example

CASE 3: Fractional reserve banking system

SNB’s borrower deposits the $81 at Third National
Bank. THIRD NATIONAL BANK
Initially, TNB’s
T-account looks Assets Liabilities
like this: Reserves $ $8.10
81 Deposits $ 81
Loans $72.90
$ 0

If R = 10% for TNB, it will loan all but 10% of the deposit.
 Banks and the Money Supply: An Example

CASE 3: Fractional reserve banking system

The process continues, and money is created with each
new loan. In this
Original deposit = $ 100.00
example,
FNB lending = $ 90.00
$100 of
SNB lending = $ 81.00 reserves
TNB lending = $ 72.90 generates
.. ..
. . $1000 of
Total money supply = $1000.00 money.
The Money Multiplier
• Money multiplier: the amount of money the banking system
generates with each dollar of reserves
• The money multiplier equals 1/R.
• In our example,
R = 10%
money multiplier = 1/R = 10
$100 of reserves creates $1000 of money
ACTIVE LEARNING 1
Banks and the money supply
While cleaning your apartment, you look under the sofa
cushion and find a $50 bill (and a half-eaten taco). You
deposit the bill in your checking account.
The Fed’s reserve requirement is 20% of deposits.
A. What is the maximum amount that the
money supply could increase?
B. What is the minimum amount that the
money supply could increase?
ACTIVE LEARNING 1
Answers
You deposit $50 in your checking account.
A. What is the maximum amount that the
money supply could increase?
If banks hold no excess reserves, then
money multiplier = 1/R = 1/0.2 = 5
The maximum possible increase in deposits is
5 x $50 = $250
But money supply also includes currency,
which falls by $50.
Hence, max increase in money supply = $200.
ACTIVE LEARNING 1
Answers
You deposit $50 in your checking account.
A. What is the maximum amount that the
money supply could increase?
Answer: $200
B. What is the minimum amount that the money
supply could increase?
Answer: $0
If your bank makes no loans from your deposit, currency
falls by $50, deposits increase by $50, money supply does
not change.
A More Realistic Balance Sheet
• Assets: Besides reserves and loans, banks also hold
securities.
• Liabilities: Besides deposits, banks also obtain funds
from issuing debt and equity.
• Bank capital: the resources a bank obtains by issuing
equity to its owners
• Also: bank assets minus bank liabilities
• Leverage: the use of borrowed funds to supplement
existing funds for investment purposes
A More Realistic Balance Sheet

MORE REALISTIC NATIONAL BANK

Assets Liabilities
Reserves $ 200 Deposits $ 800
Loans $ 700 Debt $ 150
Securities $ 100 Capital $ 50

Leverage ratio: the ratio of assets to bank capital

In this example, the leverage ratio = $1000/$50 = 20
Interpretation: for every $20 in assets,
$ 1 is from the bank’s owners,
$19 is financed with borrowed money.
Leverage Amplifies Profits and Losses
• In our example, suppose bank assets appreciate by 5%,
from $1000 to $1050. This increases bank capital from
$50 to $100, doubling owners’ equity.
• Instead, if bank assets decrease by 5%,
bank capital falls from $50 to $0.
• If bank assets decrease more than 5%, bank capital is
negative and bank is insolvent.
• Capital requirement: a govt regulation that specifies a
minimum amount of capital, intended to ensure banks
will be able to pay off depositors and debts.
Leverage and the Financial Crisis

• In the financial crisis of 2008–2009, banks suffered losses on mortgage

loans and mortgage-backed securities due to widespread defaults.
• Many banks became insolvent:
In the U.S., 27 banks failed during 2000–2007,
166 during 2008–2009.
• Many other banks found themselves with too little capital, responded by
reducing lending, causing a credit crunch.
The Government’s Response
• To ease the credit crunch, the Federal Reserve and U.S. Treasury injected
hundreds of billions of dollars’ worth of capital into the banking system.
• This unusual policy temporarily made U.S. taxpayers part-owners of
many banks.
• The policy succeeded in recapitalizing the banking system and helped
restore lending to normal levels in 2009.
The Fed’s Tools of Monetary Control
• Earlier, we learned
money supply = money multiplier × bank reserves
• The Fed can change the money supply by changing bank reserves or
changing the money multiplier.
How the Fed Influences Reserves
• Open-Market Operations (OMOs):
the purchase and sale of U.S. government bonds by the Fed.
• If the Fed buys a government bond from a bank, it pays by depositing new
reserves in that bank’s reserve account.
With more reserves, the bank can make more loans, increasing the money
supply.
• To decrease bank reserves and the money supply, the Fed sells government
bonds.
How the Fed Influences Reserves
• The Fed makes loans to banks, increasing their reserves.
• Traditional method: adjusting the discount rate—the
interest rate on loans the Fed makes to banks—to
influence the amount of reserves banks borrow
• New method: Term Auction Facility—the Fed chooses
the quantity of reserves it will loan, then banks bid
against each other for these loans.
• The more banks borrow, the more reserves they have
for funding new loans and increasing the money supply.
 How the Fed Influences the Reserve Ratio
• Recall: reserve ratio = reserves/deposits,
which inversely affects the money multiplier.
• The Fed sets reserve requirements: regulations on the
minimum amount of reserves banks must hold against
deposits.
Reducing reserve requirements would lower the reserve
ratio and increase the money multiplier.
• Since 10/2008, the Fed has paid interest on reserves
banks keep in accounts at the Fed.
Raising this interest rate would increase the reserve ratio
and lower the money multiplier.
 Problems Controlling the Money Supply

• If households hold more of their money as currency, banks have

fewer reserves,
make fewer loans, and money supply falls.
• If banks hold more reserves than required,
they make fewer loans, and money supply falls.
• Yet, Fed can compensate for household
and bank behavior to retain fairly precise control over the money
supply.
Bank Runs and the Money Supply
• A run on banks:
When people suspect their banks are in trouble, they
may “run” to the bank to withdraw their funds, holding
more currency and less deposits.
• Under fractional-reserve banking, banks don’t have
enough reserves to pay off ALL depositors, hence banks
may have to close.
• Also, banks may make fewer loans and hold more
reserves to satisfy depositors.
• These events increase R, reverse the process of money
creation, cause money supply to fall.
Bank Runs and the Money Supply

• During 1929–1933, a wave of bank runs and bank closings caused

money supply to fall 28%.
• Many economists believe this contributed to the severity of the Great
Depression.
• Since then, federal deposit insurance has helped prevent bank runs in
the U.S.
• In the U.K., though, Northern Rock bank experienced a classic bank
run in 2007 and was eventually taken over by the British government.
The Federal Funds Rate

• On any given day, banks with insufficient reserves can borrow from
banks with excess reserves.
• The interest rate on these loans is the federal funds rate.
• The FOMC uses OMOs to target the fed funds rate.
• Changes in the fed funds rate cause changes in other rates and have a
big impact on the economy.
 Monetary Policy and the Fed Funds Rate
To raise fed funds The Federal
rate, Fed sells Federal rf Funds market
govt bonds (OMO).
funds rate S2 S1
This removes
reserves from the 3.75%
banking system,
reduces supply of 3.50%
federal funds,
causes rf to rise.
D1
F
F2 F1
Quantity of
federal funds
SUMMARY

• Money serves three functions: medium of exchange,

unit of account, and store of value.
• There are two types of money: commodity money
has intrinsic value; fiat money does not.
• The U.S. uses fiat money, which includes currency and
various types of bank deposits.
SUMMARY

• In a fractional reserve banking system, banks create

money when they make loans. Bank reserves have a
multiplier effect on the money supply.
• Because banks are highly leveraged, a small change in
the value of a bank’s assets causes a large change in
bank capital. To protect depositors from bank
insolvency, regulators impose minimum capital
requirements.
SUMMARY

• The Federal Reserve is the central bank of the U.S., is

responsible for regulating the monetary system.
• The Fed controls the money supply mainly through
open-market operations. Purchasing govt bonds
increases the money supply, selling govt bonds
decreases it.
• In recent years, the Fed has set monetary policy by
choosing a target for the federal funds rate.