CHAPTER 4: THE MONETARY SYSTEM: WHAT IT IS AND HOW IT WORKS

Two Arms of Macroeconomic Policy

- Fiscal Policy – government’s decisions about spending and taxation (made by elected
representatives)
- Monetary Policy – decisions about the nation’s system of coin, currency, and banking (made by
central banks, set up by elected representatives but are allowed to operate independently)
What is Money?
- Money – stock of assets that can be readily used to make transactions
o Dollars/pesos in the hands of the public make up the nation’s stock of money
The Functions of Money
- Store of value – way to transfer purchasing power from the present to the future
o Work -> earn $40 -> can spend tomorrow or in the future
- Unit of account – provides the terms in which prices are quoted and debts are recorded
o A car costs $20,000 and not 400 shirts
- Medium of exchange – what we use to buy goods and services.
o Liquidity – ease with which an asset can be converted into the medium of exchange and
used to buy other things; money is the most liquid asset
- Without money, the world will have a barter economy that needs double coincidence of wants –
unlikely happenstance of two people each having a good that the other wants at the right time
and place to make an exchange
The Types of Money
- Fiat Money – money that has no intrinsic value
- Commodity Money – commodity with some intrinsic value for money; gold can be used as a
jewelry, dental fillings, as well as for transactions
o Gold Standard – an economy where people use gold as money (or use paper money that
is redeemable for gold)
The Development of Fiat Money
- Using raw gold as money is costly because it takes time to verify the purity of the gold and to
measure the correct quantity.
- The use of money in exchange is a social convention: everyone values fiat money because they
expect everyone else to value it.
How the Quantity of Money Is Controlled
- Money Supply – quantity of money available in an economy
- Monetary Policy – government’s control over the money supply
- Central Bank – partially independent institution where monetary policy is delegated
- Open-Market Operations – purchase and sale of government bonds
o Increase money supply: buy government bonds from the public.
 Money from the Fed goes to the hands of the public
o Decrease money supply: sells some government bonds from its own portfolio
 Money goes to the Fed from the hands of the public
How the Quantity of Money Is Measured
- Currency – sum of outstanding paper money and coins
- Demand Deposits – funds people hold in their checking accounts
 o If most sellers accept personal checks or debit cards that access checking accounts
balances -> assets in a checking account is as convenient as currency
- Once we admit the logic of including demand deposits in the measured money stock, many
other assets become candidates for inclusion.
o Funds in savings account – sometimes allow investors to write checks
o Using debit cards are similar to writing a check (immediate access to deposits in their
bank accounts) but credit
cards are not included in
the measure of money
(postpone payment for
their purchases)
o However, the increased
popularity of credit cards
may reduce the amount
of money that people
choose to hold (affect the
demand for money)
- The most common measures for
studying the effects of money on
the economy are M1 and M2.
The Role of Banks in the Monetary System
- The earlier discussion of money supply is incomplete because it omits the role of the banking
system in this process.
- Money supply is not solely determined by Fed but also by the behavior of households (which
hold money) and banks (in which money is held)
- Money Supply – includes both currency in the hands of the public and deposits (such as checking
account balances) at banks that households can use on demand for transactions
- M =C + D
o Money Supply = Currency + Demand Deposits
100–Percent–Reserve Banking
- Reserves – deposits that banks have received but have not lent out
- 100–percent–reserve banking – all deposits are held as reserves: banks simply accept deposits,
place the money in reserve, and leave the money there until the depositor makes a withdrawal
or writes a check against the balance
- A dollar deposited in a bank reduces
currency by one dollar and raises deposits by
one dollar, so the money supply remains the same.
- If banks hold 100 percent of deposits in reserve, the banking system does not affect the supply
of money.
Fractional–Reserve Banking
- Bank decides to loan out deposits to charge interest and earn -> should keep reserves on hand
so that reserves are available whenever depositors want to make withdrawals
- As long as new deposits = withdrawals -> a bank need not keep all its deposits in reserve ->
incentive to make loans
 - Fractional-Reserve Banking – a system under which banks keep only a fraction of their deposits
in reserve
- Reserve–Deposit Ratio (rr) – the fraction of
deposits kept in reserve (20% in the ex.)
- Firstbank increases the supply of money by
$800 when it makes this loan. Before the loan is made, the money supply is $1,000, equaling the
deposits in Firstbank. After the loan is made, the money supply is $1,800: the depositor still has
a demand deposit of $1,000, but now the borrower holds $800 in currency.
- Thus, in a system of fractional–reserve banking, banks create money.

1
- Original Deposit: 1000; rr: 0.2(20%) -> x 1000=5000
0.2
- Primary difference between banks and other financial institutions: banking system’s ability to
create money
- Financial Intermediation – process of transferring funds from savers to borrowers
o Stock market, the bond market, and the banking system
o Yet only banks have the legal authority to create assets (such as checking accounts) that
are part of the money supply
 Banks are the only financial institutions that directly influence the money supply
- Fractional–reserve banking creates money (increase liquidity), but it does not create wealth
o Bank loans out some of its reserves -> borrowers the ability to make transactions ->
increases the supply of money -> borrowers have a debt obligation to the bank -> loan
does not make them wealthier
Bank Capital, Leverage, and Capital Requirements
- Opening a bank requires some capital (bank owners must start with some financial resources to
get the business going)
- Bank Capital – equity of the bank’s owners
o From owners who provide capital,
from deposits taken in, and from
issuance of debts
o Held as reserves, used to make bank loans, and used to buy financial securities
(government or corporate bonds)
- Leverage – use of borrowed money to supplement existing funds for purposes of investment
o Leverage Ratio – ratio of the bank’s total assets (the left side of the balance sheet) to
bank capital (right side; represents owner’s equity)
  1000/50 = 20 (For every dollar of capital that the bank owners have contributed,
the bank has $20 of assets and, thus, $19 of deposits and debts.)
 One implication of leverage is that, in bad times, a bank can lose much of its
capital very quickly. If the bank’s assets fall in value by a mere 5 percent, then
the $1,000 of assets is now worth only $950. Because the depositors and debt
holders have the legal right to be paid first, the value of the owners’ equity falls
to zero. That is, when the leverage ratio is 20, a 5 percent fall in the value of the
bank assets leads to a 100 percent fall in bank capital. The fear that bank capital
may be running out, and thus that depositors may not be fully repaid, is typically
what generates bank runs when there is no deposit insurance.
- Capital Requirement – to ensure that banks can pay off their depositors and other creditors
o Safe Assets – can hold less capital; government bonds
o Risky Assets – hold more capital; loans to borrowers whose credit is of dubious quality
How Central Banks Influence the Money Supply
- Influence is the essence of monetary policy
A Model of the Money Supply
- Fed adds a dollar to the economy -> dollar is held as currency -> increases money supply by 1
dollar; if that dollar is deposited in a bank -> fractional-reserve -> money supply increases by
more than 1 dollar
- To understand what determines the money supply under fractional–reserve banking, we need
to take account of the interactions among
1. Fed’s decision about how many dollars to create
2. Banks’ decisions about whether to hold deposits as reserves or to lend them out
3. Households’ decisions about whether to hold their money in the form of currency or
demand deposits
- 3 Exogenous Variables of the Model
o Monetary Base (B) – total number of dollars held by the public as currency C and by the
banks as reserves R; controlled by Fed
o Reserve–Deposit Ratio (rr) – fraction of deposits that banks hold in reserve. It is
determined by the business policies of banks and the laws regulating banks
o Currency–Deposit Ratio (cr) – amount of currency (C) people hold as a fraction of their
holdings of demand deposits (D). It reflects the preferences of households about the
form of money they wish to hold.
- See attachments (pp. 131-132)
cr +1
- Money Multiplier (m) – factor of proportionality;
cr +rr
- High-Powered Money – alternate term for monetary base since it has a multiplied effect on the
money supply
- We can now see how changes in the three exogenous variables—B, rr, and cr—cause the money
supply to change.
1. The money supply is proportional to the monetary base. Thus, an increase in the monetary
base increases the money supply by the same percentage (positive)
 2. The lower the reserve–deposit ratio, the more loans banks make, and the more money
banks create from every dollar of reserves. Thus, a decrease in the reserve–deposit ratio
raises the money multiplier and the money supply. (negative)
3. The lower the currency–deposit ratio, the fewer dollars of the monetary base the public
holds as currency, the more base dollars banks hold as reserves, and the more money banks
can create. Thus, a decrease in the currency–deposit ratio raises the money multiplier and
the money supply (negative)
The Instruments of Monetary Policy
- Fed controls the money supply indirectly using a variety of instruments.
- How the Fed Changes the Monetary Base
o Open-market operations
 Buys bonds to increase monetary base and money supply
 Sells bonds to decrease monetary base and money supply
o Lending reserves to banks
 Lender of Last Resort – when Fed lends to a bank that is having trouble
obtaining funds from elsewhere
 Discount Window: Discount Rate – interest rate that the Fed charges on these
loans.
 Lower discount rate, cheaper borrowed reserves, more banks borrow at
Fed’s discount window
 Decrease in discount rate raises monetary base & money supply
 Fed determines the price and banks determine the quantity
 Term Auction Facility: Fed set a quantity of funds it wants to lend to banks, and
eligible banks then bid to borrow those funds
 Loan goes to the highest bidder with the highest offered interest rate
 Fed sets the quantity of loans and banks determine the price by bidding
- How the Fed Changes the Reserve–Deposit Ratio
o Money multiplier is the link between monetary base and money supply
 Money multiplier depends on reserve-deposit ratio (influenced by Fed policy
instruments)
o Reserve Requirements – Fed regulations that impose a minimum reserve–deposit ratio
on banks
 Increase in reserve requirements tends to raise the reserve–deposit ratio and
thus lower the money multiplier and the money supply
 Least frequently used; less effective because many banks hold more reserves
than are required
 Excess Reserves – reserves above the minimum required
 Interest on Reserves – when a bank holds reserves on deposit at the Fed, the
Fed now pays the bank interest on those deposits.
 Increase in interest rate on reserves, the more reserves banks will
choose to hold -> increase the reserve–deposit ratio, lower the money
multiplier, and lower the money supply
Problems in Monetary Control
- Fed can influence money supply but it cannot control it perfectly
 o Bank discretion in conducting business can cause the money supply to change in ways
the Fed did not anticipate.
 Banks may choose to hold more excess reserves
 More excess reserves -> increase reserve-deposit ratio -> lowers money
supply
o Fed cannot precisely control the amount banks borrow from the discount window
 Less banks borrow -> smaller monetary base -> smaller money supply
Summary
1. Money is the stock of assets used for transactions. It serves as a store of value, a unit of account,
and a medium of exchange. Different sorts of assets are used as money: commodity money
systems use an asset with intrinsic value, whereas fiat money systems use an asset whose sole
function is to serve as money. In modern economies, a central bank such as the Federal Reserve
is responsible for controlling the supply of money
2. The system of fractional–reserve banking creates money because each dollar of reserves
generates many dollars of demand deposits.
3. To start a bank, the owners must contribute some of their own financial resources, which
become the bank’s capital. Because banks are highly leveraged, however, a small decline in the
value of their assets can potentially have a major impact on the value of bank capital. Bank
regulators require that banks hold sufficient capital to ensure that depositors can be repaid.
4. The supply of money depends on the monetary base, the reserve–deposit ratio, and the
currency–deposit ratio. An increase in the monetary base leads to a proportionate increase in
the money supply. A decrease in the reserve– deposit ratio or in the currency–deposit ratio
increases the money multiplier and thus the money supply.
5. The Federal Reserve influences the money supply either by changing the monetary base or by
changing the reserve ratio and thereby the money multiplier. It can change the monetary base
through open-market operations or by making loans to banks. It can influence the reserve ratio
by altering reserve requirements or by changing the interest rate it pays banks for reserves they
hold.