Key Concepts Last Week: Macroeconomic Equilibrium

In the short run, real GDP and the price level are
determined by the intersection of the aggregate demand
(AD) curve and short-run aggregate supply (SRAS) curve.

In the long run, we

expect the economy
to produce at the
level of potential Long-Run
GDP—i.e., the Short-Run Macroeconomic
Macroeconomic Equilibrium
LRAS level.
Equilibrium

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What would we learn from the course?
GDP Inflation Unemployment
(Production/ Income)
 Measuring Unemployment and Inflation
 GDP: Measuring Total Production and Income
 Economic Growth, the Financial System, and Business Cycles
 Long-Run Economic Growth: Sources and Policies

Short-Run Fluctuations/
Business Cycle Key Markets for Analysis
 Aggregate Expenditure and Output - Demand
in the Short Run - Supply
 Aggregate Demand and Aggregate - Equilibrium: Price & Quantity
Supply Analysis - Dynamics

Macroeconomic Policy
to Reduce Short-Run
Fluctuations International Economy
❑ Money, Banks, and the Federal Reserve System
❑ Monetary Policy ❑ Macroeconomics in an Open Economy
❑ Fiscal Policy ❑ The International Financial System
❑ Inflation, Unemployment, and Federal Reserve Policy
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Lecture
CHAPTER

6 Money, Banks, and the Federal

Reserve System
Outline
1 What Is Money, and Why do we Need it?
2 How is Money Measured?
3 How Do Banks Create Money?
4 The Federal Reserve System (U.S. Central Bank)
5 The Quantity Theory of Money
6 Practice Exercises

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Money

Money is considered to be any asset that people are

generally willing to accept in exchange for goods and
services, or for payment of debts, where asset is anything
of value owned by a person or a firm.

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Why do we need Money?
Before the invention of money.
• If you wanted to trade, you would have to barter, trading
goods and services directly for other goods and services.
• Trades would require a double coincidence of wants.
Eventually, societies started using commodity money—
goods used as money that also have value independent of
their use as money—like animal skins or precious metals.
The existence of money makes trading much easier and
allows specialization, an important step for developing an
economy.

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Money Facilitates Trading
Barter

No double coincidence of wants!

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The Functions of Money

Money fulfills four primary functions:

• Medium of exchange
• Unit of account
• Store of value
• Standard of deferred payment

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Medium of exchange

A medium of exchange is an
asset that can be traded for
goods and services.

Money is acceptable to a wide

variety of parties as a form of
payment for goods and
services.

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Unit of account

A unit of account is a
universal yardstick that is
used to express relative
prices of goods and
services.

Money allows a way of

measuring value in a
standard manner.

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Store of value

A store of value is
an asset that
enables people to
transfer purchasing
power into the
future.

Money allows people to defer consumption till a later date by

storing value. Other assets can do this too, but money does it
particularly well because it is liquid, easily exchanged for goods.

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Standard of deferred payment

A standard of deferred payment is the accepted way to

settle a debt (in the future).
Money facilitates exchanges across time when we anticipate
that its value in the future will be predictable.

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What Can Serve as Money?
In order to serve as an acceptable medium of exchange (and hence a
potential “money”), a good should have the following characteristics:
1. The good must be acceptable to most people.
2. It should be of standardized quality so any two units are alike.
3. It should be durable so that value is not lost by storage.
4. It should be valuable relative to its weight, so that it can easily be
transported even in large quantities.
5. It should be divisible because different goods are valued
differently.

Commodity money has a value independent of its use as money,

such as gold or silver, and cigarettes in prisons.

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Fiat Money
Fiat money refers to any money, such as paper currency, that is
authorized by a central bank or governmental body, and that does not
have to be exchanged by the central bank for gold or some other
commodity money.
Fiat money makes central banks more flexible in creating money.

However it also creates a potential problem: fiat money is only

acceptable as long as households and firms have confidence that if
they accept paper dollars in exchange for goods and services, the
dollars will not lose much value during the time they hold them.

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2. How is Money Measured?

USA, for the week ending October 20, 2014.

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U.S. Money Supply, July 2013 – M1
How much money is there
in America? This is harder
to answer than it first
appears, because you
have to decide what to
count as “money”.
M1 is the narrowest
definition of the money
supply: the sum of
currency in circulation,
checking account deposits
Measuring the money in banks, and holdings of
Figure 14.1
supply, July 2013 traveler’s checks.
There is a relatively large amount of U.S. currency, because people in
other countries sometimes hold and use U.S. dollars instead of their
own currency.

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U.S. Money Supply, July 2013 – M2
Measuring the money
supply, July 2013

Figure 14.1

M2 is a broader definition of the money supply: it includes M1, plus

savings account balances, small-denomination time deposits,
balances in money market deposit accounts, and non-institutional
money market fund shares.

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Example
The Definitions of M1 and M2
Suppose you decide to withdraw $2,000 from your checking account and use the money
to buy a bank certificate of deposit (CD).
Briefly explain how this will affect M1 and M2.

Solving the Problem

Step 1: Review the chapter material.

Step 2: Use the definitions of M1 and M2 to answer the problem.

Funds in checking accounts are included in both M1 and M2.
Funds in CDs are included only in M2.
It is tempting to answer this problem by saying that shifting $2,000 from a checking account
to a CD reduces M1 by $2,000 and increases M2 by $2,000,
but the $2,000 in your checking account was already counted in M2.
So, the correct answer is that your action reduces M1 by $2,000 but leaves M2 unchanged.

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What about Credit and Debit Cards?
Debit cards directly access checking accounts, but the card is not
money, the checking account balance is.
Credit cards are a convenient way to obtain a short-term loan from
the bank issuing the card. But transactions are not really complete
until you pay the loan off—transferring money to pay off the credit
card loan. So credit cards do not represent money.

In our discussion of money, we are mostly interested in money’s role

as the medium of exchange, so this suggests using M1
Treat both currency and checking account balances as “money”, but
nothing else. (Traveler’s checks are insignificant.)
Realize that banks play an important role in the money supply, since
they control what happens to money when it is in a checking account.

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3. How Do Banks Create Money?

Banks play a critical role in the money supply. In general:

1. When banks gain reserves, they make new loans, and the
money supply expands
2. When banks lose reserves, they reduce their loans, and the
money supply contracts
The bank must keep some cash available for its depositors; it
does this through a combination of vault cash and deposits with
the Federal Reserve. The deposits that a bank keeps as cash in
its vault or on deposit with the Federal Reserve are Reserves.

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Bank Balance Sheets

Figure 14.2 Balance sheet of a typical large bank

On a balance sheet, a firm’s assets are listed on the left, and its
liabilities (and stockholders’ equity, or net worth) are listed on the
right. The left and right sides must add to the same amount.
Banks use money deposited to make loans and buy securities.
The deposit accounts are their liabilities: money owed to depositors.

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Reserves on Bank Balance Sheets

Figure 14.2 Balance sheet of a typical large bank

Reserves are deposits that a bank keeps as cash in its vault or on

deposit with the Federal Reserve.
• Notice that the bank does not keep enough deposits on hand to
cover all of its deposits. This is how the bank makes a profit:
lending out or investing money deposited with it.

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Required and Excess Reserves
In the U.S., the bank must keep some cash available for its
depositors; it does this through a combination of vault cash and
deposits with the Federal Reserve.
Banks are required to hold required reserves: reserves that a
bank is legally required to hold, based on its checking account
deposits.
The minimum fraction of deposits banks are required by law to
keep as reserves is known as the required reserve ratio (RR).
Banks might choose to hold excess reserves: reserves over
the legal requirement.

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Flow of Money through Banks
Reserves are not loaned
out or invested.

Banks make consumer

loans to households and
commercial loans to
businesses.
Loans are banks’ assets
because the borrowers
promise to make certain
payments to the banks.

Deposits are banks’

liabilities because they are
owed to the households or
firms that have deposited
the funds and have to be
paid back later.

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Money Creation Shown in T-Account
A T-account is a stripped-down version of a balance sheet that
shows only how a transaction changes a bank’s balance sheet.

When you deposit $1,000 in currency at Bank of America, its reserves

increase by $1,000 and so do its deposits in its T-account:
M1= Currency in Circulation
+ Checking Account Deposits
+ Traveler’s checks
Before depositing:
M1=$1,000 + $0 +$0 =$1,000
After depositing:
M1=$0 + $1,000 +$0 =$1,000

The currency in circulation decreases by $1,000; but the checking

deposits increases by $1,000. There is no change in the money
supply yet.

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Example: Money Creation at Bank of America
Suppose the required reserve ratio is 10%. Bank of America needs
to make a profit; so it keeps 10% of the deposit as required reserves,
and lends out the rest $900, which is usually done by increasing a
borrower’s checking account in the T-account.
M1= Currency in Circulation
+ Checking Account Deposits
+ Traveler’s checks
Before depositing:
M1=$0 + $1,000 +$0=$1,000
After depositing:
M1=$0 + $1,900 +$0 =$1,900

By making this $900 loan, Bank of America has increased the

money supply by $900.
The initial $1,000 in currency you deposited into your checking
account has been turned into $1,900 in checking account
deposits—a net increase in the money supply of $900.

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T-Accounts of BoA and PNC
Suppose the borrower of the $900 loan from BoA write a check to
purchase a MacBook Air. Apple deposit the check received in PNC
Bank. Then Bank of America will transfer $900 in currency to PNC
bank at which the $900 check is deposited.

M1= Currency in Circulation + Checking Account Deposits + Traveler’s checks

Before purchasing MacBook Air: M1=$0 + $1,900 +$0=$1,900
After purchasing MacBook Air: M1=$0 + $1,900 +$0 =$1,900

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PNC Continues to Loan Out
PNC has an incentive to keep $90 as reserves and to loan out its
excess reserves of $810. If PNC does this, we can show the change
in its balance sheet by using another T-account:
M1= Currency in Circulation
+ Checking Account Deposits
+ Traveler’s checks
Before PNC loan out:
M1=$0 + $1,900 +$0=$1,900
After PNC loan out:
M1=$0 + $2,710 +$0 =$2,710

The initial deposit of $1,000 in currency into Bank of America has

now resulted in the creation of $1,000 + $900 + $810 = $2,710 in
checking account deposits.
The money supply has increased by $2,710 − $1,000 = $1,710.
Each “round”, the additional checking account deposits get smaller
and smaller. Every round, 10% of the deposits are kept as reserves.

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M1 includes all checking account deposits

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When Will it End?
Every round, 10% of the deposits are kept as reserves. This
allows us to tell by how much the checking deposits will
eventually increase: the $1,000 in currency will become the
10% required reserves for all of the checking deposits, so a
total of $10,000 in checking deposits can be created.
Bank Increase In Checking Account Deposits
Bank of America $1,000
PNC + 900 (= 0.9 × $1,000)
Third Bank + 810 (= 0.9 × $900)
Fourth Bank + 729 (= 0.9 × $810)
• +•
• +•
• +•
Total change in checking account deposits = $10,000

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Simple Deposit Multiplier
In order to find out how much money the original $1,000 in currency
will create, we add up all of the checking account deposits.

$1,000 + [0.9 × $1,000] + [(0.9 × 0.9) × $1,000] + [(0.9 × 0.9 × 0.9) × $1,000] + …
= $1,000 + [0.9 × $1,000] + [0.92 × $1,000] + [0.93 × $1,000] + …
= $1,000 (1 + 0.9 + 0.92 + 0.93 + …)

The expression in the parentheses can be rewritten as:

1 1
= = 10
1 − 0. 9 0.10
So the total increase in deposits is $1,000(10) = $10,000.
The “10” here is the simple deposit multiplier: the ratio of the
amount of deposits created by banks to the amount of new reserves.

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General Form for the Simple Deposit Multiplier
In general, we can write the simple deposit multiplier as:
1
Simple deposit multiplier =
RR
So with a 10% required reserve ratio (RR), the simple deposit multiplier
is 10.
• With a 20% required reserve ratio, the simple deposit multiplier is 5.
Then:
1
Change in checking account deposits = Change in bank reserves 
RR
For example, $1,000 in new deposit, with a 10% required reserve
ratio, results in:
1
Change in checking account deposits = $1,000 
0.10
= $1,000  10 = $10,000

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Example
Showing How Banks Create Money
Suppose you deposit $5,000 in currency into your checking account at a branch of PNC
Bank, which we will assume has no excess reserves at the time you make your deposit.
Also assume that the required reserve ratio is 0.10.

a. Use a T-account to show the initial effect of this transaction on PNC’s balance sheet.

b. Suppose that PNC makes the maximum loan it can from the funds you deposited.
Use a T-account to show the initial effect on PNC’s balance sheet from granting the loan.
Also include in this T-account the transaction from question a.

c. Now suppose that whoever took out the loan in question b. writes a check for this amount
to someone who deposits it in Bank of America.
Show the effect of these transactions on the balance sheets of PNC Bank and Bank of
America after the check has cleared.
On the T-account for PNC Bank, include the transactions from questions a. and b.

d. What is the maximum increase in checking account deposits and the money supply that
can result from your $5,000 deposit? Explain.

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Example
Showing How Banks Create Money
Solving the Problem
Step 1: Review the chapter material.
Step 2: Answer part a. by using a T-account to show the effect of the deposit.
Keeping in mind that T-accounts show only the changes in a balance sheet that result from
the relevant transaction and that assets are on the left side of the account and liabilities are
on the right side, we have:

Because the bank now has your $5,000 in currency in its vault, its reserves (and, therefore,
its assets) have risen by $5,000.
But this transaction also increases your checking account balance by $5,000.
Because the bank owes you this money, its liabilities have also risen by $5,000.

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Example
Showing How Banks Create Money
Step 3: Answer part b. by using a T-account to show the effect of the loan.
The problem tells you to assume that PNC Bank currently has no excess reserves and that
the required reserve ratio is 10 percent.
This requirement means that if the bank’s checking account deposits go up by $5,000,
it must keep $500 as reserves and can loan out the remaining $4,500.
Remembering that new loans usually take the form of setting up, or increasing, a checking
account for the borrower, we have:

The first line of the T-account shows the transaction from question a.
The second line shows that PNC has loaned out $4,500 by increasing the checking account
of the borrower by $4,500.
The loan is an asset to PNC because it represents a promise by the borrower to make
certain payments spelled out in the loan agreement.

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Example
Showing How Banks Create Money
Step 4: Answer part c. by using T-accounts for PNC and Bank of America to show the
effect of the check clearing.
We now show the effect of the borrower having spent the $4,500 he received as a loan from
PNC on someone who deposits it in her account at Bank of America.
We need two T-accounts to show this activity:

Once Bank of America sends the check written by the borrower to PNC, PNC loses $4,500 in
reserves, Bank of America gains $4,500 in reserves, and $4,500 is deducted from the
borrower’s account.
The $5,000 deposit in currency PNC received from you wasn’t earning any interest when it
was sitting in the bank vault, but the $4,500 of it that was loaned out does earn interest now,
which allows PNC to cover its costs and earn a profit required to stay in business.
Bank of America now has an increase in deposits and reserves of $4,500 resulting from the
check being deposited, and is in the same situation as PNC was in question a:
It has excess reserves as a result of this transaction and a strong incentive to lend them out.

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Example
Showing How Banks Create Money
Step 5: Answer part d. by using the simple deposit multiplier formula to calculate the
maximum increase in checking account deposits and the maximum increase in the
money supply.

The simple deposit multiplier expression is (remember that RR is the required reserve ratio)
1
Change in checking account deposits = Change in bank reserves 
RR
In this case, bank reserves rose by $5,000 as a result of your initial deposit, and the required
reserve ratio is 0.10, so:
1
Change in checking account deposits = $5,000  = $5,000  10 = $50,000
0.10
Because checking account deposits are part of the money supply, it is tempting to say that
the money supply has also increased by $50,000.
Remember, though, that your $5,000 in currency was counted as part of the money supply
while you had it, but it is not included when it is sitting in a bank vault. Therefore:
Increase in checking account deposits − Decline in currency in
circulation = Change in the money supply
or $50,000 − $5,000 = $45,000

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4. The Federal Reserve System (Fed)

Figure 14.3 The Federal Reserve system

There are 12 Federal Reserve districts, but the real power lies in the Board
of Governors in Washington, D.C. The Fed manages the money supply.
The Federal Open Market Committee (FOMC) conducts America’s
monetary policy: the actions the Federal Reserve takes to manage the
money supply and interest rates to pursue macroeconomic objectives.

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How the Fed Manages the Money Supply
The Fed has three monetary policy tools at its disposal:
Open market operations (most common) refers to the buying and
selling of Treasury securities by the Federal Reserve to control the
money supply. The Fed buys U.S. Treasury securities to increase the
money supply, and sells its securities to decrease the money supply.
Discount policy
The discount rate is the interest rate paid on money banks borrow from the
Fed. The Fed makes loans to banks called discount loans, charging a rate
of interest called the discount rate. By lowering the discount rate, the Fed
encourages banks to borrow (and hence lend out) more money, increasing
the money supply. Raising the discount rate has the opposite effect.
Reserve requirements
The Fed can alter the required reserve ratio. A decrease would result in
more loans being made, increasing the money supply. An increase would
result in fewer loans being made.

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Increase Money Supply with Open Market Operations
Suppose the Fed engages in an open market purchase of $10 million.
• The banking system’s T-account reflects an increase in reserves,
and a corresponding decrease in assets due to its debt to the Fed.

• The banking system’s reserves are liabilities for the Fed, but it
gains assets equal to the debt owed to it by the banking system.

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5. The Quantity Theory of Money
In the early 20th century, Irving Fisher formalized the relationship
between money and prices as the quantity equation:
𝑀 ×𝑉 =𝑃 ×𝑌
Money supply real output
velocity of money price level
Velocity of money: the average number of times each dollar in the
money supply is used to purchase goods and services included in
GDP. Rewriting this equation by dividing through by M, we obtain:
𝑃×𝑌
𝑉=
𝑀
The quantity theory of money asserts that, subject to measurement
error, we will always get the same answer in the calculation of V.
Quantity theory of money: A theory about the connection between
money and prices assuming that the velocity of money is constant.

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The Quantity Theory Explanation of Inflation
When variables are multiplied together, we can form the same
equation with their growth rates added together. So the equation:
𝑀 ×𝑉 =𝑃 ×𝑌
generates:
Growth rate of the money supply + Growth rate of velocity
= Growth rate of the price level or the inflation rate
+ Growth rate of real output
Rearranging this to make the inflation rate the subject, and assuming
that the velocity of money is constant, we obtain:
Inflation rate = Growth rate of the money supply − Growth rate of real output
The equation predicted that: if the money supply grows faster
(slower) than real GDP, there will be inflation (deflation).

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The Inflation Rate According to the Quantity Theory
Inflation rate = Growth rate of the money supply − Growth rate of real output
This equation provides the following predictions:
1. If the money supply grows faster than real GDP, there will be
inflation.
2. If the money supply grows slower than real GDP, there will be
deflation (a decline in the price level).
3. If the money supply grows at the same rate as real GDP, there
will be neither inflation nor deflation: the price level will be stable.

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Hyperinflation
Very high rates of inflation—in excess of 100 percent per year—are
known as hyperinflation. Hyperinflation results when central banks
increase the money supply at a rate far in excess of the growth rate of
real GDP. This might happen when governments want to spend much
more than they raise through taxes, so they force their central bank to
“buy” government bonds.

Example: Recently,
hyperinflation has occurred
in Zimbabwe; during the
2000s, prices increased by
(on average) 7500% per
year. At that rate, a can of
soda costing $1 this year
would cost $75 next year,
and over $5600 the year
after that.

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6. Practice Exercises
6.1: Suppose that the Fed makes a $100 million
discount loan to Bank of America. Assume that the
required reserve ratio is 20% and BoA has no excess
reserves before receiving the discount loan.
#1: Use a T-account to show the effect of this
transaction.
#2: What is the maximum amount of the $100 million
that BoA can lend out?
#3: What is the maximum total increase in the money
supply that can result from the Fed’s $100
million discount loan?

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6.2: Suppose you withdraw $500 from your checking account
deposit and bury it in a jar in your back yard. If the required
reserve ratio is 10 percent, checking account deposits in the
banking system as a whole could drop up to a maximum of
A) $0.
B) $50.
C) $500.
D) $5,000.

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