CHAPTER
15
Money, the Banking
System, and
the Federal Reserve
Prepared by: Jamal Husein
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
What Is Money?


Money is anything that is regularly
used in economic transactions or
exchanges.
People are willing to accept money as
a medium of exchange because of its
recognizable value. We trust that the
money we receive will also be accepted
by others in lieu of payment.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
2
What Is Money?


In addition to currency, we also accept
checks because checks can also be used
to make payments.
Throughout history, many different
items have played the role of money.

Precious metals, stones, gold bars, and
even cigarettes have played the role of
money.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
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What Is Money?


In addition to recognizable value,
other desirable properties of money
include durability and divisibility.
Money serves several functions, all
related to making economic exchanges
easier:
 Money
serves as a medium of exchange
 Money serves as a unit of account
 Money serves as a store of value
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Three Properties of Money
1. Money serves as a medium of exchange:
 Instead of using money, we could barter—or trade
goods directly for goods. But when compared to
barter, money is clearly more efficient.
 Barter requires a double coincidence of wants.
Barter requires you to find someone who has
precisely what you are looking for and wants to
buy precisely what you are willing to offer in
exchange.
 The probability of a double coincidence of wants
occurring is very, very tiny. Money solves that
problem.
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5
Three Properties of Money
2. Money serves as a unit of account:
 Money provides a convenient
measuring rod when prices for all
goods are quoted in money terms.
 Money serves as the unit of account, or
standard unit which can be used to
compare the relative value of goods,
making it easier to carry out economic
transactions.
© 2005 Prentice Hall Business Publishing
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6
Three Properties of Money
3. Money serves as a store of value:
 Money can be used to store value before it
is used to carry out transactions.
 From the time you receive a payment
until the time you make a payment, you
can use money to store value.
 However, money is an imperfect store of
value, particularly in an inflationary
economy, when the real value of a
nominal amount of money decreases.
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Measuring Money in the U.S. Economy

The most basic measure of money in the
United States is called M1.
Components of M1, January 2003
(billions $)
Currency held by the public
$630
Demand deposits
295
Other checkable deposits
279
Travelers’ checks
8
Total of M1
© 2005 Prentice Hall Business Publishing
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$1,212
O’Sullivan & Sheffrin
8
Measuring Money in the U.S. Economy


Since there are approximately 280 million
people in the United States, the $630 billion
of currency held by the public amounts to
$2,250 per person.
In fact, most people don’t hold such a large
amount of cash. Much of this currency is
held abroad by wealthy people who hold
part of their wealth in U.S. dollars; some
circulates in other countries along with the
official currency; and some is used in illegal
transactions.
© 2005 Prentice Hall Business Publishing
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9
Measuring Money in the U.S. Economy

A broader definition of money, known
as M2, includes assets that are
sometimes used in economic exchanges
or can be readily turned into M1, such
as deposits in money market mutual
funds and savings accounts.
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Banks As Financial Intermediaries


A typical commercial bank accepts funds
from savers in the form of deposits, and uses
the money to make loans to businesses.
A simplified balance sheet for a commercial
bank has two sides:

Liabilities are the sources of funds. The bank is
“liable” for returning funds to depositors.

Assets are the uses of funds. Assets generate
income for the bank. Loans are assets for the
bank because a borrower must pay interest to
the bank.
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Balance Sheet for a Commercial Bank
Assets
Reserves $ 200
Loans
2,000
Liabilities
Deposits
Net worth
$2,000
200
______________
______________
Total: $2,200
Total: $2,200
Net worth =
assets – liabilities
 Net
worth refers to the bank’s initial funds
contributed by its owners.
 Net
worth is entered on the liabilities side because
it is also a source of funds.
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Balance Sheet for a Commercial Bank
Reserves are assets that are not lent out.
 Banks are required by law to hold a
fraction of their deposits as reserves and
not make loans with it. This fraction is
called required reserves.
 The bank may choose to hold additional
reserves beyond what is required; these
are called excess reserves.

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The Process of Money Creation




Currency and checking deposits are included in the
money supply.
When a customer makes a $1,000 cash deposit to open
a checking account, currency held by the public
decreases and checking deposits increase. The money
supply remains unchanged, but the bank’s reserves
increase.
Assume that the bank holds no excess reserves and the
required reserve ratio equals 10% of deposits.
First Bank of Hollywood
The $1,000 deposit changes
the bank’s balance sheet as
Assets
Liabilities
follows:
Reserves $100 Deposits $1,000
Loans
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900
14
The Process of Money Creation

The First Bank of Hollywood makes a $900 loan which is
used to open a checking account in the Second Bank of
Burbank, with a balance of $900.

The balance sheet of the
Second Bank of Burbank
changes as follows:

The Second bank of
Burbank makes loans in the
amount of $810, which are
deposited in the Third
Bank of Venice, and the
process continues.
© 2005 Prentice Hall Business Publishing
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Second Bank of Burbank
Assets
Liabilities
Reserves $ 90
Loans
810
Deposits $900
Third Bank of Venice
Assets
Liabilities
Reserves $ 81
Loans
729
O’Sullivan & Sheffrin
Deposits $810
15
The Deposit Creation Formula

The original $1,000 cash deposit has
created checking account balances equal to:
$1,000 + $900 + $810 + $729 + $656.10 +.…= $10,000

The general formula for deposit creation is:
increase in checkingaccount balances=

1
x initial deposit
reserve ratio
The increase in the money supply, M1, resulting
from the increase in the $1,000 deposit equals
$10,000 - $1,000 = $9,000.
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The Money Multiplier

1
reserve ratio
This term in the deposit creation
formula is called the money
multiplier.

The money multiplier shows the total increase in
checking account deposits for any initial cash
deposit.

The initial cash deposit triggers additional
rounds of deposits and lending by banks, which
leads to a multiple expansion of deposits.
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17
The Money Multiplier

The money multiplier for the
United States is between 2 and 3.
It is much smaller than the value in
our example because, in reality,
people hold part of their loans as
cash. This cash is not available for
the banking system to lend.
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The Money Multiplier


The money multiplier also works in reverse.
Assuming a reserve ratio of 10%, a
withdrawal of $1,000 reduces reserves by
$100, and results in $900 less the bank will
have to lend out.
Finally, it is important to note that when one
individual writes a check to another, and the
other deposits the check in the bank, the
money supply will not change. Instead, the
expansion in one bank’s reserves will offset
the contraction in the reserves of the other.
© 2005 Prentice Hall Business Publishing
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19
Open Market Operations


The Federal Reserve, our central bank, has
the power to change the total amount of
reserves in the banking system.
The most important tool to change the total
amount of reserves in the banking system,
and therefore the money supply, is called
Open Market Operations — the purchase
and sale of government securities to the
private sector.
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Open Market Operations



Suppose the Fed purchases $1 million worth of
government bonds from the private sector.
The Fed writes a check for $1 million and
presents it to the party who sold the bonds.
The Fed now owns those bonds, and the party
who sold the bonds has a check for $1 million.
Checks written against the Fed count as
reserves for banks. If the reserve ratio is 10%,
the bank must keep $100,000 in new reserves,
but can make loans for $900,000. And so, the
process of money creation begins.
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Open Market Operations


Open market purchases increase the
money supply; and open market sales
decrease it.
The Fed has unlimited ability to create
money. It can write checks against
itself to purchase the government
bonds without having any explicit
“funds.” Banks accept it because these
checks count as reserves for the bank.
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Other Tools of Monetary Policy

Other tools the Fed has available to
change the money supply, although less
important and not used as often as
Open Market Operations are:


Changes in the reserve requirement: banks
are asked to hold a smaller or larger
fraction of their deposits as reserves.
Changes in the discount rate, or the rate at
which banks borrow from the Fed.
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Other Tools of Monetary Policy


The Fed does not increase the reserve
requirement often because it can be
disruptive to the banking system. Banks
would be forced to call in or cancel many of
its loans.
Before banks borrow from the Fed, they try
to borrow from each other through the
federal funds market, a market in which
banks lend or borrow reserves from each
other, overnight.
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Other Tools of Monetary Policy


In practice, the Fed keeps the discount rate
close to the federal funds rate to avoid large
swings in borrowed reserves by banks.
The Fed conducts monetary policy by
setting targets for the federal funds rate.
Once it has set those targets, it uses open
market operations to keep the actual
federal funds rate on target.
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The Structure of the Federal Reserve



The Federal Reserve System was created in
1913 following a series of financial panics
in the United States.
Congress created the Federal Reserve to be
a central bank, serving as a banker’s bank.
One of the Fed’s primary jobs was to serve
as a lender of last resort—lending funds to
banks that suffered from panic runs,
thereby reducing some of the adverse
consequences of the panics.
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The Structure of the Federal Reserve



The United States was divided into 12
Federal Reserve districts, each of which has
a Federal Reserve Bank.
The reason for creating 12 separate,
semiautonomous regional banks was to avoid
monopoly and concentration of power in a
single area or financial center.
District banks provide advice and take part
in monetary policy decisions, and provide a
liaison between the Fed and the banks in
their districts.
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Federal Reserve Banks
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The Structure of the Federal Reserve

The structure of the Federal
Reserve today consists of three
distinct subgroups:



Federal Reserve Banks
The Board of Governors, and
The Federal Open Market Committee
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The Structure of the Federal Reserve
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The Board of Governors



The Board of Governors of the Federal Reserve is
the true seat of power over the monetary system.
Headquartered in Washington, DC, the seven
members of the board are appointed for
staggered 14-year terms by the President and
must be confirmed by the Senate.
The chairperson serves a four-year term and is
the principal spokesperson for monetary policy in
the U.S. What he speaks is carefully observed, or
anticipated, by financial markets.
© 2005 Prentice Hall Business Publishing
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The Federal Open Market Committee
(FOMC)


The Federal Open Market Committee
(FOMC) is a 12-person board consisting of the
seven members of the Board of Governors, the
president of the New York Federal Reserve
Bank, plus the presidents of four other
regional Federal Reserve Banks. These four
presidents serve on a rotating basis.
The seven nonvoting bank presidents attend
the meetings and provide their views. The
chairperson of the Board of Governors also
serves as the chairperson of the FOMC.
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Central Bank Independence


The matter of central bank
independence from political authorities
is a lively debate among economists.
Monetary discipline is important for the
performance of the economy. Countries
with greater central independence tend
to have lower inflation rates.
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Central Bank Independence


In the United States, the Board of
Governors of the Federal Reserve operates
with considerable independence.
Presidents and members of Congress can
bring political pressures on the Board of
Governors, but the 14-year terms provide
some insulation from external pressures.
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Central Bank Independence


There are both supporters and opponents
of the current system which allows bank
presidents to play an important role in the
determination of monetary policy. These
presidents are neither appointed by elected
officials nor confirmed by the Senate.
The Fed is a subject of significant public
interest because the Fed exercises ultimate
control of the money supply, which gives it
substantial power over the economy.
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