The Monetary System:

What It Is and How It

Works
Chapter 4, Macroeconomics,
by N. Gregory Mankiw, 8th
Edition
ECO62, Udayan Roy
 Three Main Questions
1. What is money?
2. What is the role of a nations
banking system in determining the
quantity of money in the economy?
3. How does a nations central bank
influence the banking system and
the quantity of money?
WHAT IS MONEY?
 What is money?
Money is anything that can be readily
used to pay for purchases
Therefore, money is a medium of
exchange
and a store of value
Moreover, money also functions as a
unit of account
 Two Types of Money
Fiat money
People accept fiat money either because
a government decree (or, fiat) requires
them to do so or simply because others
would also accept it as payment
Commodity money
This money is valuable in itself (e.g.,
gold coins) or can by law be converted
into something valuable (as in a gold
standard system)
 The Quantity of Money
The quantity of money, amount of
money, and supply of money all refer
to the same thing:
The total value of all assets in the
economy that can be used as money
It is denoted M
Money: Definition

Money is the stock

of assets that can be
readily used to make
transactions.

Two common measures of the

quantity of money in an
economy are M1 and M2
 What Counts as Money?
The dollar value of the currency we
carry, C, should clearly be counted as
money
Moreover, when we do our shopping,
we use checks and debit cards
exactly the way we use currency.
Therefore, the dollars that we can
spend this way should also be
counted as money. Credit cards are ignored.
Why?
 The Quantity of Money
There are several prominent
measures of the quantity of money
(M)
Table 4.1 The Measures of
Money

Simplified version: Money Supply (M) = Currency (C) +

Demand Deposits (D)
 Data Sources
M1: http://
research.stlouisfed.org/fred2/series/M1SL?cid=25
M1 and its components: http://
research.stlouisfed.org/fred2/categories/25
Currency (C): http://
research.stlouisfed.org/fred2/series/CURRSL?cid=25
Demand Deposits: http://
research.stlouisfed.org/fred2/series/DEMDEPSL?cid=25
Travelers Checks: http://
research.stlouisfed.org/fred2/series/TVCKSSL?cid=25
Other Checkable Deposits: http://
research.stlouisfed.org/fred2/series/OCDSL?cid=25
 Data Sources
M2: http://
research.stlouisfed.org/fred2/series/M2SL?cid=29
M2 and its components: http://
research.stlouisfed.org/fred2/categories/29
Retail money market mutual fund balances: http://
research.stlouisfed.org/fred2/series/RMFNS?cid=29
Saving deposits: http://
research.stlouisfed.org/fred2/series/SAVINGSL?cid=29
Small time deposits: http://
research.stlouisfed.org/fred2/series/STDSL?cid=29
ROLE OF BANKS IN THE
MONETARY SYSTEM
Banks Liabilities: how do banks get
money?
Banks take deposits (D) from
depositors
Banks also borrow money (by selling
bonds). This is called their debt
The owners of a bank must also
invest their own money in their bank.
This is called the banks capital (or,
equity)
Total bank liabilities = deposits +
debt
 Banks Assets: what do banks do
with their money?
Some of the banks funds are kept in
the banks vaults as reserves (R)
Banks funds are also used to make
loans
The interest charged is a source of
income
and also to make securities
purchases
This too is a source of income
Total bank assets = reserves + loans
 The Role of Banks in the Monetary
System: Banks Balance Sheet
The banks fundsits liabilities plus
capitalare used to buy assets
Assets = liabilities + capital

Liabilities and
Assets
Owners Equity
Reserves $200 Deposits $750
Loans 500 Debt 200
Capital
Securities 300 (owners 50
equity)
The Role of Banks in the Monetary
System: Leverage
Leverage is the use of borrowed money
(deposits + debt) to supplement owners
funds for purposes of investment
Leverage ratio = assets/capital
= $(200 + 500 + 300)/$50 = 20
Liabilities and
Assets
Owners Equity
Reserves $200 Deposits $750
Loans 500 Debt 200
Capital
Securities 300 (owners 50
equity)
 The Role of Banks in the Monetary
System: Leverage
Being highly leveraged makes banks vulnerable.
Example: Suppose the value of our banks
assets falls by 5%, to $950.
Then, capital = assets liabilities = 950 950 =
0
Liabilities and
Assets
Owners Equity
Reserves $200 Deposits $750
Loans 500 Debt 200
Capital
Securities 300 (owners 50
equity)
 Capital Requirements
To reduce the risk of a bank going bust
as in the previous slides examplebank
regulators impose capital requirements
on banks
The goal is to ensure that a banks capital
would exceed its liabilities, so that the
banks owners could return the money of
its depositors and repay its debts
Banks with riskier assets face higher
capital requirements
 Capital Requirements
In the 2008-2009 financial crisis,
losses on mortgages shrank bank
capital, slowed lending, exacerbated
the recession
The government injected capital into
banks to ease the crisis and
encourage more lending
CENTRAL BANKS
INFLUENCE
 The Central Banks
Influence
We will now build an algebraic model
of the central banks influence on the
monetary system of a country
 The Central Banks
Influence
Our first equation is one we have
seen already: M = C + D
All three variablesmoney supply,
currency held by the public, and
demand depositswill be considered
endogenous
 Monetary Base
The monetary base (B) is the total
number of dollars held
by the public as currency (C) or
by banks as reserves (R)
So, our second equation is B = C + R
A countrys monetary base is directly
determined by its central bank
B is exogenous; C and R are
endogenous
 The Money Multiplier
cd = C/D is the currency-deposit
ratio, and
rd = R/D is the reserve-deposit ratio
Note that 0 < rd < 1
Although C and R are endogenous,
cd and rd will be considered
exogenous
This is a huge simplification of reality
 Demand Deposits

Therefore,
We have expressed an endogenous
variable, D, entirely in terms of our
exogenous variables (cd, rd, and B)
Currency held by the public

Again, we have expressed an
endogenous variable, C, entirely in
terms of our exogenous variables
(cd, rd, and B)
 Reserves held by banks

Again, we have expressed an
endogenous variable, R, entirely in
terms of our exogenous variables
(cd, rd, and B)
 Money Supply
We know that M = C + D. Therefore,

Again, we have expressed an

endogenous variable, M, entirely in
terms of our exogenous variables
(cd, rd, and B)
 The Money Multiplier

The factor of proportionality is called the
money multiplier:

Therefore,
Note that, as 0 < rd < 1, it must be that m > 1
That is, for every dollar of monetary base
created by the central bank, the money
supply increases by more than a dollar
 The Model Is Solved!

 Numerical Example
Q: Suppose the monetary base is B =
$800 billion, the reserve-deposit ratio
is rd = 0.1, and the currency-deposit
ratio is cd = 0.8. Calculate C, R, M, D,
and m.
A: R = $88.89 billion; C = $711.11
billion; D = $888.89 billion; M =
$1,600 billion, and m = 2.
 The Central Bank

When the central bank increases the
monetary base, the money supply
increases
When the reserve-deposit ratio decreases,
the money supply increases
When the currency-deposit ratio
decreases, the money supply increases
(Why?)
 The Central Bank

A countrys central bank
directly controls the monetary base, B,
and
indirectly controls the reserve-deposit
ratio, rd.
Therefore, the central bank can
change a countrys monetary supply
 How does the Fed change the
monetary base?
Open-market operations:
The Fed could print dollars and use them to
buy securities (usually short-term Treasury
bonds) from banks or from the public
This reduces securities and increases
reserves (R) in the assets column of the
banks balance sheets, and
Increases cash held by the public (C)
Therefore, the monetary base increases (B
= C + R)
 How does the Fed change the
monetary base?
Making loans to banks and thereby
increasing banks reserves (R)
This typically happens when banks have
lost the trust of private lenders and are
unable to borrow from them
The Fed is the lender of last resort
The Feds lending can take two forms:
Discount Window
Term Auction Facility
 How does the Fed change the
monetary base? Discount Window
The Fed lends to banks directly and
charges them an interest rate called
the discount rate
When the Fed reduces the discount rate,
banks borrow more, their reserves rise
by a bigger amount, and so the
monetary base rises by a bigger amount
 How does the Fed change the
monetary base? Term Auction Facility
The TAF was a response to the
financial crisis of 2008-9
The Fed decides how much it wants
to lend to banks. Eligible banks then
bid to borrow those funds, with the
loans going to the banks that offer to
pay the highest interest
In this way, both banks reserves and
the monetary base increase
 How does the Fed indirectly control
the reserve-deposit ratio?
We have seen that a decrease in the
reserve-deposit ratio (rd) causes
the money multiplier and the money
supply to increase
The Fed drives the rd in two ways:
reserve requirements for banks, and
interest on banks reserves
 How does the Fed indirectly control
rd? Reserve Requirements
Reserve requirements are Fed regulations
that impose a minimum reserve-deposit ratio
on banks
This is to ensure that there will always be enough
money in banks for depositors who may need to
withdraw cash
The required minimum rd is only a minimum
Still, when reserve requirements decrease, rd
tends to fall.
This causes m, M and B to increase
 How does the Fed indirectly control
rd? Interest on Reserves
This was a response to the financial
crisis of 2008-9
US banks keep their reserves with
the Fed
The Fed now pays banks interest on
the reserves they keep at the Fed
A reduction in this interest, induces
banks to keep fewer reserves
This reduces rd, and increases m, M,
and B
 Case Study: Quantitative
Easing
Prior to the financial crisis of 2008,
the US monetary base rose gradually
Between 2007 and 2011, it tripled,
mainly through open-market
operations
The Fed printed money and used it to
buy riskier securities than the Treasury
bonds it buys during normal times
 Case Study: Quantitative
Easing
Although
the monetary base tripled during
2007-11, the money supply rose a lot less:
M1 increased 40% and M2 increased 25%
Why?
Recall that and
Banks had suffered huge losses on their
loans. As a result, they stopped lending.
The reserve-deposit ratio rose, thereby
reducing m
This is why M did not rise as fast as B
 Case Study: Quantitative
Easing
But what if the rd returns to the pre-
crisis level?
Then the huge increase in B would
translate into an equally huge
increase in M
This, as we shall see in Chapter 5,
could cause massive inflation
Should we be worried?
 Case Study: Quantitative
Easing
No, theres nothing to worry, says the Fed
They could simply sell the securities that
they had earlier bought, thereby reducing
the monetary base to pre-crisis levels
Moreover, if there are signs that banks
are beginning to lend the reserves they
have accumulated, the Fed could raise
the interest it pays on reserves, thereby
reversing any decline in rd
Figure 4.1 The Monetary
Base
 The Feds Monetary Control is
Imperfect
Recall
that and
The Fed can control the required
minimum rd but not the actual rd.
Banks may decide to keep reserves
in excess of what is required.
The currency-deposit ratio is not
under the Feds control. For example,
when people are scared of keeping
money in banks, cd increases.
 Case Study: The 1930s
During
the Great Depression of the
1930s, the monetary base increased
but the money supply didnt
Why?
Recall that and
Both cd and rd increased, which
reduced m, making M grow slower
than B
 Case Study: The 1930s
Businesses were losing money and
defaulting on their loans
This caused lots of bank failures
Ordinary depositors lost faith in
banks and chose to keep their
savings in cash
As a result, the cash-deposit ratio
increased
There was no FDIC
This reduced the money multiplier
then!

So, M rose slower than B

Table 4.2 The Money Supply and
Its Determinants: 1929 and 1933
 Whats Next?
In this chapter, we have studied what
determines M
In the next chapter, we will see how
M affects the economy in the long
run