In this chapter, look for the answers to these
questions:
• What assets are considered “money”? What are
the functions of money? The types of money?
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• 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?
© 2007 Thomson South-Western
© 2007 Thomson South-Western
The Functions of Money
THE MEANING OF MONEY
Money is the set of assets in an economy that people
regularly use to buy goods and services from other
people.
•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.
• Money has three functions in the economy:
• Medium of exchange
• Unit of account
• Store of value
© 2007 Thomson South-Western
© 2007 Thomson South-Western
The Functions of Money
The Functions of Money
• Medium of Exchange
• Liquidity is the ease with which an asset can be
converted into the economy’s medium of
exchange.
• A medium of exchange is an item that buyers give to sellers
when they want to purchase goods and services.
• A medium of exchange is anything that is readily acceptable
as payment.
• Unit of Account
• A unit of account is the yardstick people use to post prices
and record debts.
• Store of Value
• A store of value is an item that people can use to transfer
purchasing power from the present to the future.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
1
The Kinds of Money
Money in the U.S. Economy
• Commodity money takes the form of a
commodity with intrinsic value.
• Currency is the paper bills and coins in the
hands of the public.
• Demand deposits are balances in bank accounts
that depositors can access on demand by
writing a check.
• Examples: Gold, silver, cigarettes.
• Fiat money is used as money because of
government decree.
• It does not have intrinsic value.
• Examples: Coins, currency, check deposits.
© 2007 Thomson South-Western
Figure 1 Two Measures of the Money Stock for the U.S.
Economy
Billions
of Dollars
M2
$6,398
• Savings deposits
• Small time deposits
• Money market
mutual funds
• A few minor categories
($5,035 billion)
$1,363
0
M1
• Demand deposits
• Traveler’s checks
• Other checkable deposits
($664 billion)
• Currency
($699 billion)
© 2007 Thomson South-Western
CASE STUDY: Where Is All The Currency?
• In 2004 there was $699 billion of U.S. currency
outstanding.
• That is $3,134 in currency per adult.
• Who is holding all this currency?
• Currency held abroad
• Currency held by illegal entities
• Everything in M1
($1,363 billion)
© 2007 Thomson South-Western
© 2007 Thomson South-Western
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.
© 2007 Thomson South-Western
THE FEDERAL RESERVE SYSTEM
• The Federal Reserve (Fed) serves as the
nation’s central bank.
– It is designed to oversee the banking system.
– It regulates the quantity of money in the economy.
• The Fed was created in 1913 after a series of
bank failures convinced Congress that the
United States needed a central bank to ensure
the health of the nation’s banking system.
© 2007 Thomson South-Western
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The Fed’s Organization
THE FEDERAL RESERVE SYSTEM
• The primary elements in the Federal Reserve
System are:
– The Board of Governors
– The Regional Federal Reserve Banks
– The Federal Open Market Committee
• The Fed is run by a Board of Governors, which has
seven members appointed by the president and
confirmed by the Senate.
• Among the seven members, the most important is
the chairman.
• The chairman directs the Fed staff, presides over
board meetings, and testifies about Fed policy in
front of Congressional Committees.
• The Board of Governors
• Serve staggered 14-year terms so that one comes
vacant every two years.
• President appoints a member as chairman to serve a
four-year term.
© 2007 Thomson South-Western
The Fed’s Organization
© 2007 Thomson South-Western
The Federal Reserve System
• The Federal Reserve System is made up of the Federal
Reserve Board in Washington, D.C., and twelve regional
Federal Reserve Banks.
• The Federal Reserve Banks
• Twelve district banks
• Nine directors
• Three appointed by the Board of Governors.
• Six are elected by the commercial banks in the district.
• The directors appoint the district president, which is
approved by the Board of Governors.
• The New York Fed implements some of the Fed’s most
important policy decisions.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
The Federal Open Market Committee
(FOMC)
The Fed’s Organization
• Three Primary Functions of the Fed
• Regulates banks to ensure they follow federal laws
intended to promote safe and sound banking
practices.
• Acts as a banker’s bank, making loans to banks and
as a lender of last resort.
• Conducts monetary policy by controlling the money
supply.
© 2007 Thomson South-Western
• Serves as the main policy-making organ of the Federal
Reserve System.
• Meets approximately every six weeks to review the
economy.
• The Federal Open Market Committee (FOMC) is made up of
the following voting members:
• The chairman and the other six members of the Board of
Governors.
• The president of the Federal Reserve Bank of New York.
• The presidents of the other regional Federal Reserve
banks (four vote on a yearly rotating basis).
© 2007 Thomson South-Western
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The Federal Open Market Committee
(FOMC)
• Monetary policy is conducted by the Federal
Open Market Committee.
• The money supply refers to the quantity of money
available in the economy.
• Monetary policy is the setting of the money supply
by policymakers in the central bank.
The Federal Open Market Committee
• Open-Market Operations
• The money supply is the quantity of money
available in the economy.
• The primary way in which the Fed changes the
money supply is through open-market operations.
• The Fed purchases and sells U.S. government bonds.
• To increase the money supply, the Fed buys
government bonds from the public.
• To decrease the money supply, the Fed sells
government bonds to the public.
© 2007 Thomson South-Western
BANKS AND THE MONEY SUPPLY
• Banks can influence the quantity of demand deposits in the
economy and the money supply.
• Reserves are deposits that banks have received but have not
loaned out.
• In a fractional-reserve banking system, banks hold a fraction
of the money deposited as reserves and lend out the rest.
• 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 is the fraction of deposits that banks hold as
reserves.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
Money Creation with Fractional-Reserve
Banking
• When a bank makes a loan from its reserves,
the money supply increases.
• The money supply is affected by the amount
deposited in banks and the amount that banks
loan.
• Deposits into a bank are recorded as both assets and
liabilities.
• The fraction of total deposits that a bank has to keep
as reserves is called the reserve ratio.
• Loans become an asset to the bank.
© 2007 Thomson South-Western
Banking Money Creation with FractionalReserve
Money Creation with Fractional-Reserve
Banking
• T-account: a simplified
accounting statement
that shows a bank’s assets
& liabilities.
• Banks’ liabilities include
deposits, assets include
loans & reserves.
• This T-Account shows a
bank that…
• accepts deposits,
keeps a portion as
reserves,
• and lends out the rest.
• It assumes a reserve ratio
of 10%.
• When one bank loans money, that money is
generally deposited into another bank.
• This creates more deposits and more reserves to
be lent out.
• When a bank makes a loan from its reserves,
the money supply increases.
First National Bank
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
$90.00
Total Assets
$100.00
Total Liabilities
$100.00
© 2007 Thomson South-Western
© 2007 Thomson South-Western
4
The Money Multiplier
The Money Multiplier
Increase in the Money Supply = $190.00!
• How much money is eventually created by the
new deposit in this economy?
• The money multiplier is the amount of money
the banking system generates with each dollar
of reserves.
First National Bank
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
Second National Bank
Assets
Reserves
$9.00
Liabilities
Deposits
$90.00
Loans
$90.00
$81.00
Total Assets
Total Liabilities Total Assets
$100.00
$100.00
$90.00
© 2007 Thomson South-Western
Total Liabilities
$90.00
© 2007 Thomson South-Western
The Money Multiplier
The Money Multiplier
Original deposit = $100.00
• 1st Natl. Lending = 90.00 (=.9 x $100.00)
• 2nd Natl. Lending = 81.00 (=.9 x $ 90.00)
• 3rd Natl. Lending = 72.90 (=.9 x $ 81.00)
• … and on until there are just pennies left to
lend!
• Total money created by this $100.00 deposit is
$1000.00. (= 1/.1 x $100.00)
• The money multiplier is the reciprocal of the
reserve ratio:
M = 1/R
• Example:
• With a reserve requirement, R = 20% or .2:
• The money multiplier is 1/.2 = 5.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
Exercise
Exercise
While cleaning your apartment, you look under
the sofa cushion find a $50 bill (and a half-eaten
taco). You deposit the bill in your checking
account.
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?
•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.
•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 remains unchanged.
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© 2007 Thomson South-Western
© 2007 Thomson South-Western
5
The Fed’s Tools of Monetary Control
The Fed’s Tools of Monetary Control
• The Fed has three tools in its monetary toolbox:
• Open-Market Operations
• The Fed conducts open-market operations when it buys
government bonds from or sells government bonds to the
public:
• Open-market operations
• Changing the reserve requirement
• Changing the discount rate
• When the Fed sells government bonds, the money supply decreases.
Fed sells govt bonds, taking dollars out of circulation
… which are withdrawn from banks, reducing reserves
… banks have to ask borrowers to repay their loans, and as the
volume of loans decreases, money supply decreases.
• When the Fed buys government bonds, the money supply increases.
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.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
The Fed’s Tools of Monetary Control
The Fed’s Tools of Monetary Control
• Reserve Requirements
• The Fed also influences the money supply with reserve requirements.
• Reserve requirements are regulations on the minimum amount of
reserves that banks must hold against deposits.
• Changing the Reserve Requirement
• The reserve requirement is the amount (%) of a bank’s total reserves
that may not be loaned out.
• Increasing the reserve requirement decreases the money supply. Fed
raises RR, Banks make fewer loans from each dollar of reserves, which
decreases money multiplier and money supply.
• Decreasing the reserve requirement increases the money supply. To
increase money supply, Fed reduces RR. Banks make more loans from
each dollar of reserves, which increases money multiplier and money
supply.
• Changing the Discount Rate
• Fed rarely uses reserve requirements to control money supply:
Frequent changes would disrupt banking.
• The discount rate is the interest rate the Fed charges banks
for loans.
• Increasing the discount rate decreases the money supply.
• Decreasing the discount rate increases the money supply.
• 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.
© 2007 Thomson South-Western
Problems in Controlling the Money Supply
• The Fed’s control of the money supply is not
precise.
• The Fed must wrestle with two problems that
arise due to fractional-reserve banking.
• The Fed does not control the amount of money that
households choose to hold as deposits in banks.
• The Fed does not control the amount of money that
bankers choose to lend.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
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 & hold more reserves to
satisfy depositors.
• These events increase R, reverse the process of money creation,
cause money supply to fall.
• 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.
• Bank runs not a problem today due to federal deposit insurance.
© 2007 Thomson South-Western
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