Chapter 29: The Monetary

System
Objectives
• 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?
Why money?
• https://www.youtube.com/watch?v=WCr5UVf-vKM
 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 MONETARY SYSTEM 4

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 MONETARY SYSTEM 5

 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 MONETARY SYSTEM 6
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

THE MONETARY SYSTEM 7

 Measures of the U.S. Money Supply
• M1: currency, demand deposits,
traveler’s checks, and other checkable deposits.
M1 = $1.4 trillion (June 2008)
• M2: everything in M1 plus savings deposits,
small time deposits, money market mutual funds, and a
few minor categories.
M2 = $7.7 trillion (June 2008)

The distinction between M1 and M2

will usually not matter when we talk about
“the money supply” in this course.

THE MONETARY SYSTEM 8

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.

THE MONETARY SYSTEM 9

 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

THE MONETARY SYSTEM 10

 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%.
THE MONETARY SYSTEM 11
 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

THE MONETARY SYSTEM 12

 Banks and the Money Supply: An Example
CASE 1: No banking system
Public holds the $100 as currency.
Money supply = $100.

THE MONETARY SYSTEM 13

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

FNB holds
100% of FIRST NATIONAL BANK
deposit Assets Liabilities
as reserves:
Reserves $100 Deposits $100
Loans $ 0
Money supply
= currency + deposits = $0 + $100 = $100
In a 100% reserve banking system,
banks do not affect size of money supply.
THE MONETARY SYSTEM 14
 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

Money supply = $190 (!!!)

Depositors have $100 in deposits,
Borrowers have $90 in currency.
THE MONETARY SYSTEM 15
 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)

A fractional reserve banking system

creates money, but not wealth.

THE MONETARY SYSTEM 16

 Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
Suppose borrower deposits the $90 at Second
National Bank (SNB).

Initially, SNB’s SECOND NATIONAL BANK

T-account Assets Liabilities
looks like this: Reserves $ 90
9 Deposits $ 90
Loans $ 81
0

If R = 10% for SNB, it will loan all but 10% of the

deposit.

THE MONETARY SYSTEM 17

 Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
The borrower deposits the $81 at Third National
Bank (TNB).

Initially, TNB’s THIRD NATIONAL BANK

T-account Assets Liabilities
looks 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.

THE MONETARY SYSTEM 18

 Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
The process continues, and money is created with
each new loan.

Original deposit = $ 100.00

FNB lending = $
$
SNB lending = 𝑎
$ . 2 3
𝑎 + 𝑎𝑟 + 𝑎𝑟 + 𝑎𝑟 + ⋯ =
TNB lending = . 1−𝑟
.. 𝑤ℎ𝑒𝑛 𝑟 < 1
. .
Total money supply = $

THE MONETARY SYSTEM 19

 Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
The process continues, and money is created with
each new loan.

Original deposit = $ 100.00 In this

FNB lending = $ 90.00 example,
SNB lending = $ 81.00 $100 of
reserves
TNB lending = $ 72.90
.. .. generates
. . $1000 of
Total money supply = $1000.00 money.

THE MONETARY SYSTEM 20

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

THE MONETARY SYSTEM 21

ACTIVE LEARNING 1
Banks and the money supply
While cleaning your apartment, you look under the
sofa cushion find a $50 bill. R=20% =>MS=1/20%=5
=>account.
You deposit the bill in your checking max MS =250 which increase 200$

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?

22
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.
23
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.
24
 The Fed’s 3 Tools of Monetary Control
1. Open-Market Operations (OMOs): the purchase and
sale of U.S. government bonds by the Fed.

 To increase money supply, Fed buys govt bonds,

paying with new dollars:

THE MONETARY SYSTEM 25

 The Fed’s 3 Tools of Monetary Control
1. Open-Market Operations (OMOs): the purchase and
sale of U.S. government bonds by the Fed.

 To increase money supply, Fed buys govt bonds,

paying with new dollars.
…which are deposited in banks, increasing reserves
…which banks use to make loans, causing the
money supply to expand.
 To reduce money supply, Fed sells govt bonds,
taking dollars out of circulation, and the process
works in reverse.

THE MONETARY SYSTEM 26

 The Fed’s 3 Tools of Monetary Control
1. Open-Market Operations (OMOs): the purchase and
sale of U.S. government bonds by the Fed.

 OMOs are easy to conduct, and are the Fed’s

monetary policy tool of choice.

THE MONETARY SYSTEM 27

 The Fed’s 3 Tools of Monetary Control
2. Reserve Requirements (RR):
affect how much money banks can create by making
loans.
 To increase money supply?

 To reduce money supply?

THE MONETARY SYSTEM 28

 The Fed’s 3 Tools of Monetary Control
2. Reserve Requirements (RR):
affect how much money banks can create by making
loans.
 To increase money supply, Fed reduces RR.
Banks make more loans from each dollar of reserves,
which increases money multiplier and money supply.
 To reduce money supply, Fed raises RR,
and the process works in reverse.
 Fed rarely uses reserve requirements to control
money supply: Frequent changes would disrupt
banking.
THE MONETARY SYSTEM 29
The Fed’s 3 Tools of Monetary Control
• 2. Also related to Reserve Requirements: Paying interest on reserves
• Since October 2008
• The higher the interest rate on reserves
• The more reserves banks will choose to hold
• An increase in the interest rate on reserves
• Increase the reserve ratio
• Lower the money multiplier
• Lower the money supply
 The Fed’s 3 Tools of Monetary Control
3. The Discount Rate:
the interest rate on loans the Fed makes to banks

 When banks are running low on reserves,

they may borrow reserves from the Fed.
 To increase money supply, what can the Fed do?

 To reduce money supply, what can the Fed do?

THE MONETARY SYSTEM 31

 The Fed’s 3 Tools of Monetary Control
3. The Discount Rate:
the interest rate on loans the Fed makes to banks

 When banks are running low on reserves,

they may borrow reserves from the Fed.
 To increase money supply,
Fed can lower discount rate, which encourages
banks to borrow more reserves from Fed.
 Banks can then make more loans, which increases
the money supply.
 To reduce money supply, Fed can raise discount rate.

THE MONETARY SYSTEM 32

 The Fed’s 3 Tools of Monetary Control
3. The Discount Rate:
the interest rate on loans the Fed makes to banks

 The Fed uses discount lending to provide extra

liquidity when financial institutions are in trouble,
e.g. after the Oct. 1987 stock market crash.
 If no crisis, Fed rarely uses discount lending –
Fed is a “lender of last resort.”

THE MONETARY SYSTEM 33

 The Fed’s 3 Tools of Monetary Control
Problems with the Fed’s control of the money supply

• The Fed does not control:

• The amount of money that households choose to hold as
deposits in banks
• The amount that bankers choose to lend

Not precise

THE MONETARY SYSTEM 34

 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.
• Many interest rates are highly correlated,
so changes in the fed funds rate cause changes in other
rates and have a big impact in the economy.

THE MONETARY SYSTEM 35

The Fed Funds Rate and Other Rates, 1970-2008

20 Fed funds
prime
15 3-month Tbill
mortgage
(%)

10

0
1970 1975 1980 1985 1990 1995 2000 2005
 The Federal Funds Rate
• The Fed targets the federal funds rate through
open-market operations
• The Fed buys bonds
• Decrease in the federal funds rate
• Increase in money supply
• The Fed sells bonds
• Increase in the federal funds rate
• Decrease in money supply

THE MONETARY SYSTEM 37

 Monetary Policy and the Fed Funds Rate
To raise fed funds The Federal
rate, Fed sells rf Funds market
Federal
govt bonds (OMO). funds S2 S1
This removes rate
reserves from the 3.75%
banking system,
reduces supply of 3.50%
federal funds,
causes rf to rise.
D1
F
F2 F1
Quantity of
THE MONETARY SYSTEM 38 federal funds
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.
THE MONETARY SYSTEM 39
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 MONETARY SYSTEM 40

Bank Capital and Leverage
• Bank capital
• Resources a bank’s owners have put into the institution
• Used to generate profit
Bank Capital and Leverage
• Leverage
• Use of borrowed money to supplement existing funds for
purposes of investment
• Leverage ratio
• Ratio of assets to bank capital
• Capital requirement
• Government regulation specifying a minimum amount of
bank capital
Bank Capital and Leverage
leverage ratio
= $1,000/$50 =
20

A leverage ratio of 20 => for every

dollar of capital that the bank
owners have contributed, the bank
has $20 of assets.
 Bank Capital and Leverage
• If bank’s assets rise in value by 5%
• Because some of the securities the bank was holding rose in price
• $1,000 of assets would now be worth $1,050
• Bank capital rises from $50 to $100

So, for a leverage rate of

20:
A 5% increase in the value
of assets increases the
owners’ equity by 100%
Bank Capital and Leverage
• If bank’s assets are reduced in value by 5%
• Because some people who borrowed from the bank default on
their loans
• $1,000 of assets would be worth $950
• Value of the owners’ equity falls to zero

So, for a leverage ratio of

20:
A 5% fall in the value of the
bank assets leads to a 100%
fall in bank capital
Bank Capital and Leverage
• If bank’s assets are reduced in value by more than 5%
• Because some people who borrowed from the bank
default on their loans
For a leverage ratio of 20:
The bank’s assets would fall
below its liabilities

The bank would be

insolvent: unable to pay
off its debt holders and
depositors in full
Bank Capital and Leverage
• Capital requirement: Bank regulators require banks to hold a certain
amount of capital.
• => ensure that banks will be able to pay off their depositors (without
having to resort to government-provided deposit insurance funds).