A Store of Value

The Money Supply

and the Federal 25 store of value An asset that can be used to transport purchasing power from
one time period to another.
Reserve System
CHAPTER OUTLINE liquidity property of money The property of money that makes it a good
An Overview of Money medium of exchange as well as a store of value: It is portable and readily
What Is Money?
Commodity and Fiat Monies accepted and thus easily exchanged for goods.
Measuring the Supply of Money in the United States
The Private Banking System
The main disadvantage of money as a store of value is that the value of money
How Banks Create Money
falls when the prices of goods and services rise.
A Historical Perspective: Goldsmiths
The Modern Banking System
The Creation of Money
The Money Multiplier
The Federal Reserve System A Unit of Account
Functions of the Federal Reserve
Expanded Fed Activities Beginning in 2008 unit of account A standard unit that provides a consistent way of quoting
The Federal Reserve Balance Sheet
prices.
How the Federal Reserve Controls the Money Supply
The Required Reserve Ratio
The Discount Rate
Open Market Operations
Excess Reserves and the Supply Curve for Money
Looking Ahead
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An Overview of Money Commodity and Fiat Monies

What Is Money? commodity monies Items used as money that also have intrinsic value in
some other use.
Money is a means of payment, a store of value, and a unit of account.
fiat, or token, money Items designated as money that are intrinsically
A Means of Payment, or Medium of Exchange worthless.

barter The direct exchange of goods and services for other goods and legal tender Money that a government has required to be accepted in
services. settlement of debts.

A barter system requires a double coincidence of wants for trade to take place.
That is, to effect a trade, you have to find someone who has what you want and Aside from declaring its currency legal tender, the government usually does
that person must also want what you have. one other thing to ensure that paper money will be accepted: It promises the
public that it will not print paper money so fast that it loses its value.

medium of exchange, or means of payment What sellers generally accept currency debasement The decrease in the value of money that occurs when
and buyers generally use to pay for goods and services. its supply is increased rapidly.

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Measuring the Supply of Money in the United States The Private Banking System

M1: Transactions Money financial intermediaries Banks and other institutions that act as a link
between those who have money to lend and those who want to borrow money.

M1, or transactions money Money that can be directly used for transactions.

The main types of financial intermediaries are commercial banks, followed by

savings and loan associations, life insurance companies, and pension funds.
M1
other checkable deposits

Commercial banks make money by providing loans and earning interest

income from those loans. They collect the savings of households and loan it out
M1 is a stock measure it is measured at a point in time. M1 at the end of
to investors, entrepreneurs and to the ones who want to buy a new car or
December 2012 was $2,440.1 billion.
house. Banks charges an interest rate of lets say 12% to its borrowers and
pays 10% of interest rate to its depositors. The difference is (2% in this case) is
the profit of the bank.

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M2: Broad Money The Private Banking System

near monies Close substitutes for transactions money, such as savings

accounts and money market accounts.
10% interest rate
12% interest rate

M2, or broad money M1 plus savings accounts, money market accounts, and
other near monies. Earning:
2% interest rate

M2 M1 + savings accounts + money market accounts + other near monies Lenders BANKS Borrowers
M2 at the end of December 2012 was $10,402.4 billion. (Savings of Excess
(Investors
the reserves
M2 is sometimes more stable than M1. Entrepreneurs
households) etc.)
Beyond M2
One of the very broad definitions of money includes the amount of available
credit on credit cards (your charge limit minus what you have charged but not
paid) as part of the money supply. CBRT
There are no rules for deciding what is and is not money. This poses problems Required Reserves
for economists and those in charge of economic policy. However, for our
. Excess reserves required reserves

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How Banks Create Money The Modern Banking System
A Brief Review of Accounting
A Historical Perspective: Goldsmiths
Assets Liabilities Net Worth
The origins of the modern banking system date back to the fifteenth and or
sixteenth centuries, when gold was used as money but was also inconvenient Assets Liabilities + Net Worth
to carry around. People began to place their gold with goldsmiths for
safekeeping. The receipts issued to the depositor became a form of paper Assets are things a firm owns that are worth something. For a bank, these
money. The receipts were backed 100 percent by gold. assets include the bank building, its furniture, its holdings of government

The goldsmiths found that people did not come often to withdraw gold. People for our purposes at least, are the loans it has made.

Other bank assets include cash on hand (sometimes called vault cash) and
sitting around that they could lend out, effectively changing from depositories to
deposits with the U.S. central bank.
banklike institutions that had the power to create money. Without adding any
more gold to the system, the goldsmiths increased the amount of money in
circulation. Federal Reserve Bank (the Fed) The central bank of the United States.

liabilities are its debts

are its deposits. Deposits are debts owed to the depositors because when you
deposit money in your account, you are in essence making a loan to the bank.

Net worth represents the value of the firm to its stockholders or owners.

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The Money Multiplier

Goldsmiths-turned-bankers did face certain problems. Once they started
making loans, their receipts outstanding (claims on gold) were greater than the An increase in bank reserves leads to a greater than one-for-one increase in
amount of gold they had in their vaults at any given moment. the money supply.
In normal times, goldsmiths were safe, but once people started to doubt the
Economists call the relationship between the final change in deposits and the
safety of the goldsmith, they would be foolish not to demand their gold back
change in reserves that caused this change the money multiplier.
from the vault.

run on a bank Occurs when many of those who have claims on a bank money multiplier The multiple by which deposits can increase for every dollar
(deposits) present them at the same time. increase in reserves; equal to 1 divided by the required reserve ratio.

Goldsmiths had no legal reserve requirements, although the amount they

loaned out was subject to the restriction imposed on them by their fear of
In the United States, the required reserve ratio varies depending on the size of
running out of gold.
the bank and the type of deposit. For large banks and for checking deposits,
the ratio is currently 10 percent, which makes the potential money multiplier
1/.10 = 10. This means that an increase in reserves of $1 could cause an
increase in deposits of $10 if there were no leakage out of the system.

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The Money Multiplier The Central Bank of Republic of Turkey (CBRT)
The CBRT was established as a joint stock company on 11 June 1930. The primary
objective of the Bank is to achieve price stability. The CBRT is also responsible for taking
Person A Person B Person C Person D measures to sustain the stability of the financial system in Turkey. Particularly, the Bank
strives to contain the macro financial risks stemming from global imbalances.
10000 TL 9000 TL 8100 TL 7290 TL Accordingly, maintaining financial stability is defined as the supporting objective of the
Bank.

Bank 1 Bank 2 Bank 3 Bank 4 The privilege of printing banknotes in Turkey was initially vested with the Grand National
10000 TL 9000 TL 8100 TL 7290 TL Assembly of Turkey. The Assembly has transferred the privilege of printing and issuing
banknotes exclusively and indefinitely to the CBRT.

One of the main responsibilities of the CBRT is to determine the exchange rate regime
Required Required Required Required jointly with the government. The CBRT is responsible for and authorized to design and
Reserve Reserve Reserve Reserve implement the exchange rate policy in line with the agreed exchange rate regime. Since
1000 TL 900 TL 810 TL 729 TL 2001, the floating exchange rate regime has been implemented in Turkey.

Monetary Policy Committee

Suppose the required reserve ratio is 10%. In 2001, the Monetary Policy Committee was established by an amendment made to the
Person A + Person B + Person C + Person D = 34390 TL CBRT Law. Since then, monetary policy decisions have been made by the MPC. The
Committee is chaired by the Governor, and is composed of Deputy Governors, a member
If this goes on and all the money stays in the banking system in the end total to be elected by and from among the members of the Board and a member to be
money will be 100,000 TL (money multiplier is 10 in this example since req. appointed by a joint decree on the recommendation of the Governor.
reserve ratio is 0.1)
So 10,000 TL becomes 100,000 TL which is actually 10.000 TL
This is called money creation process of banking system. 17 of 46 21 of 46

Functions of the Federal Reserve How the Federal Reserve Controls the Money Supply
The Fed is the central bank of the United States. Central banks are sometimes
The money supply is equal to the sum of deposits inside banks and the
currency in circulation outside banks.
money supply. If the Fed wants to increase the supply of money, it creates more reserves,
thereby freeing banks to create additional deposits by making more loans. If it
The Fed also performs several important functions for banks, such as clearing wants to decrease the money supply, it reduces reserves.
interbank payments, regulating the banking system, and assisting banks in a
difficult financial position. Three tools are available to the Fed for changing the money supply:

(1) Changing the required reserve ratio.

foreign exchange reserves.
(2) Changing the discount rate.
It is often involved in intercountry negotiations on international economic
issues. (3) Engaging in open market operations.

Besides facilitating the transfer of funds among banks, the Fed is responsible
for many of the regulations governing banking practices and standards.

lender of last resort One of the functions of the Fed: It provides funds to
troubled banks that cannot find any other sources of funds.
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The Required Reserve Ratio Open Market Operations

Securities:
Decreases in the required reserve ratio allow banks to have more deposits with Government bonds: Assets with a maturity of more than one year
the existing volume of reserves. Treasury bills (T-bills): Assets with a maturity of less than one year
Issue date: 01.01.2020
As banks create more deposits by making loans, the supply of money (currency If the price of this bond (PB) is 1000 TL,
+ deposits) increases.
then the interest rate (i) is 10% because
The reverse is also true: If the Central Bank of Republic of Turkey (CBRT)
wants to restrict the supply of money, it can raise the required reserve ratio, in
the nominal value of the bond is 1100 TL.
If (PB) = 1048 TL, then r is 5%.
1100 TL
which case banks will find that they have insufficient reserves and must Due date: 01.01.2021
So as PB
and as PB
The result is a decrease in the money supply.
On the mid of the year (15.06.2020) the fair price of this bond is roughly 1050
Ms TL. If you have this bond and CBRT offers more than 1050 TL, you sell your
bond to CBRT. The reverse is also true. If CBRT sells this bond of a price less
as required reserve ratio Ms than 1048 you prefer to buy it if the interest rate in the financial market is 10%.
Because in both cases you earn more than 10%.

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The Discount Rate

discount rate The interest rate that banks pay to the Fed to borrow from it. Open Market Operations
When banks increase their borrowing, the money supply increases.
open market operations The purchase and sale by the Fed of government
securities in the open market; a tool used to expand or contract the amount of
reserves in the system and thus the money supply.

When the Fed purchases a security, it pays for it by writing a check that, when
cleared, expands the quantity of reserves in the system, increasing the money
supply. When the Fed sells a bond, private citizens or institutions pay for it with
their bank deposits, which reduces the quantity of reserves in the system.

Two Branches of Government Deal in Government Securities

The Treasury Department is responsible for collecting taxes and paying the
G - T) is the amount the
Treasury must borrow each year. This means that the Treasury cannot print
money to finance the deficit.

The Fed is not the Treasury. It is a quasi-independent agency authorized by

Congress to buy and sell outstanding (preexisting) U.S. government securities
on the open market.
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 Open Market Operations The Mechanics of Open Market Operations

Purchasing Securities
We can sum up the effect of these open market operations this way:

CBRT An open market purchase of securities by the Fed results in an increase in

reserves and an increase in the supply of money by an amount equal to the
money multiplier times the change in reserves.

securities money An open market sale of securities by the Fed results in a decrease in
reserves and a decrease in the supply of money by an amount equal to the
money multiplier times the change in reserves.

Financial
System money supply for several reasons. They can be used with some precision; are
extremely flexible; and, have a fairly predictable effect on the money supply.

Reserves of the banks and so that money supply increases Ms

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Open Market Operations Excess Reserves and the Supply Curve for Money
Selling Securities

CBRT
securities money

Financial
System FIGURE 25.5 The Supply of Money
If the Fed s money supply behavior is not influenced by the interest rate, the money
supply curve is a vertical line.
Through its three tools, the Fed is assumed to have the money supply be whatever
Reserves of the banks and so that money supply decreases Ms
value it wants.
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Looking Ahead

This chapter has discussed only the supply side of the money market.

In the next chapter, we turn to the demand side of the money market.

We will examine the demand for money and see how the supply of and
demand for money determine the equilibrium interest rate.

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