The Banking System and
the Money Supply
Slides by: John & Pamela Hall
ECONOMICS: Principles and Applications 3e
HALL & LIEBERMAN
© 2005 Thomson Business and Professional Publishing
What Counts as Money
• Money has several useful functions
– Provides a unit of account
• Standardized way of measuring value of things that are traded
– Serves as store of value
• One of several ways in which households can hold their wealth
• Yet credit cards are not considered money, even though you
can use them to buy things
• Why is this?
– A more formal definition of money helps to answer questions like this
• Money is an asset that is widely accepted as a means of payment
– Only assets—things of value that people own—can be considered as money
» This is why credit limit on your credit card, or your ability to go into a
bank and borrow funds, is not considered money
– Only things that are widely acceptable as a means of payment are regarded
as money
» Other assets—such as stocks and bonds or even gold bars—cannot
generally be used to pay for goods and services
» They fail the acceptability test
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Measuring the Money Supply
• Amount of money in circulation can affect macroeconomy
• Money Supply
– Total amount of money held by the public
• In practice, measuring money supply is not as
straightforward as it might seem
• Governments have decided best way to deal with them is
to have different measures of the money supply
– In effect, alternative ways of defining what is and what is not
money
– Each measure includes a selection of assets that are widely
acceptable as a means of payment and are relatively liquid
• An asset is considered liquid if it can be converted to cash quickly and
at little cost
– An illiquid asset can be converted to cash only after a delay, or at
considerable cost
3
Assets and Their Liquidity
• Most liquid asset is cash in the hands of the public
• Next in line are asset categories of about equal liquidity
– Demand deposits
• Checking accounts held by households and business firms at commercial
banks
– Other checkable deposits
• Catchall category for several types of checking accounts that work very much
like demand deposits
– Travelers checks
• Specially printed checks that you can buy from banks or other private
companies, like American Express
– Savings-type accounts
• At banks and other financial institutions
• Are less liquid than checking-type accounts, since they do not allow you to
write checks
• Next on the list are deposits in retail money market mutual funds
– Time deposits (sometimes called certificates of deposit, or CDs)
• Require you to keep your money in the bank for a specified period of time
(usually six months or longer)
– Impose an interest penalty if you withdraw early
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Figure 1: Monetary Assets and Their
Liquidity (July 14, 2003)
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M1 And M2
• Standard measure of money stock is M1
– Sum of the first four assets in our list
• M1 = cash in the hands of the public + demand deposits + other
checking account deposits + travelers checks
– When economists or government officials speak about “money
supply,” they usually mean M1
• Another common measure of money supply, M2, adds
some other types of assets to M1
– M2 = M1 + savings-type accounts + retail MMMF balances + small
denomination time deposits
• Other official measures of money supply besides M1 and
M2 that add in assets that are less liquid than those in M2
– M1 and M2 have been most popular, and most commonly watched,
definitions
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M1 And M2
• Important to understand that M1 and M2 money stock
measures exclude many things that people use regularly
as a means of payment
• Technological advances—now and in the future—will
continue trend toward new and more varied ways to make
payments
• We will assume money supply consists of just two
components
– Cash in the hands of the public and demand deposits
• Our definition of the money supply corresponds closely to
liquid assets that our national monetary authority—the
Federal Reserve—can control
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The Banking System: Financial
Intermediaries
• What are banks?
– Financial intermediaries—business firms that specialize in
• Assembling loanable funds from households and firms whose
revenues exceed their expenditures
• Channeling those funds to households and firms (and sometimes the
government) whose expenditures exceed revenues
• An intermediary helps to solve problems by combining a
large number of small savers’ funds into custom-designed
packages
– Then lending them to larger borrowers
• Intermediaries must earn a profit for providing brokering
services
– By charging a higher interest rate on funds they lend than rate they
pay to depositors
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The Banking System: Financial
Intermediaries
• United States boasts a wide variety of financial
intermediaries, including
–
–
–
–
–
–
Commercial banks
Savings and loan associations
Mutual savings banks
Credit unions
Insurance companies
Some government agencies
• There are four types of depository institutions
–
–
–
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Savings and Loan associations
Mutual savings banks
Credit unions
Commercial banks
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Commercial Banks
• A commercial bank (or just “bank” for short) is a
private corporation that provides services to the
public
– Owned by its stockholders
• For our purposes, most important service is to
provide checking accounts
– Enables bank’s customers to pay bills and make
purchases without holding large amounts of cash that
could be lost or stolen
• Banks provide checking account services in order
to earn a profit
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A Bank’s Balance Sheet
• A balance sheet is a two-column list that provides information about
financial condition of a bank at a particular point in time
– In one column, bank’s assets are listed
• Everything of value that it owns
– On the other side, the bank’s liabilities are listed
• Amounts bank owes
• Bond
– A promise to pay back borrowed funds, issued by a corporation or
government agency
• Loan
– An agreement to pay back borrowed funds, signed by a household or
noncorporate business
• Next come two categories that might seem curious
– “Vault cash”
– “Account with the Federal Reserve”
• Why does the bank hold them?
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A Bank’s Balance Sheet
• Explanations for vault cash and accounts with Federal
Reserve
– On any given day, some of the bank’s customers might want to
withdraw more cash than other customers are depositing
– Banks are required by law to hold reserves
• Sum of cash in vault and accounts with Federal Reserve
• Required reserve ratio tells banks the fraction of their
checking accounts that they must hold as required
reserves
– Set by Federal Reserve
• Net worth = Total assets – Total liabilities
– Include net worth on liabilities side of balance sheet because it is,
in a sense, what bank would owe to its owners if it went out of
business
• A balance sheet always balances
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The Federal Reserve System
• Every large nation controls its money supply with a central
bank
– A nation’s principal monetary authority
– Most developed countries established central banks long ago
• England’s central bank—Bank of England—was created in 1694
• France established Banque de France in 1800
• United States established Federal Reserve System in 1913
• U.S. waited such a long time to establish a central
authority because of
– Suspicion of central authority that has always been part of U.S.
politics and culture
– Large size and extreme diversity of our country
– Fear that a powerful central bank might be dominated by the
interests of one region to the detriment of others
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The Federal Reserve System
• Our central bank is different in form from its European
counterparts
• One major difference is indicated in the very name of the
institution
– Does not have the word “central” or “bank” anywhere in its title
• Another difference is the way the system is organized
• Another interesting feature of Federal Reserve System is
its peculiar status within government
– Strictly speaking, it is not even a part of any branch of government
– Both President and Congress exert some influence on Fed through
their appointments of key officials
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Figure 2: The Geography of the
Federal Reserve System
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Figure 3: The Structure of the
Federal Reserve System
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The Structure of the Fed
• Board of Governors
– Consists of seven members who are appointed by President and
confirmed by Senate for a 14-year term
– In order to keep any President or Congress from having too much
influence over Fed
• Four-year term of the chair is not coterminous with four-year term of the
President
• Each of 12 Federal Reserve Banks is supervised by nine directors
– Three of whom are appointed by Board of Governors
– Other six are elected by private commercial banks—the official
stockholders of the system
– Directors of each Federal Reserve Bank choose a president of that bank,
who manages its day-to-day operations
• Only about 3,500 of the 8,000 or so commercial banks in United
States are members of Federal Reserve System
– But they include all national banks and state banks
– All of the largest banks in United States are nationally chartered banks
and therefore member banks as well
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The Federal Open Market
Committee
• Federal Open Market Committee (FOMC)
– A committee of Federal Reserve officials that
establishes U.S. monetary policy
• Most economists regard FOMC as most important
part of Fed
• Consists of all 7 governors of Fed, along with 5 of
the 12 district bank presidents
• Not even President of United States knows details
behind the decisions, or what FOMC actually
discussed at its meeting, until summary of
meeting is finally released
– Committee exerts control over nation’s money supply
by buying and selling bonds in public (“open”) bond
market
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The Functions of the Federal
Reserve
• Federal Reserve, as overseer of the
nation’s monetary system, has a variety of
important responsibilities including
– Supervising and regulating banks
– Acting as a “bank for banks”
– Issuing paper currency
– Check clearing
– Controlling money supply
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The Fed and the Money Supply
• Suppose Fed wants to change nation’s money
supply
– It buys or sells government bonds to bond dealers,
banks, or other financial institutions
• Actions are called open market operations
• We’ll make two special assumptions to keep our
analysis of open market operations simple for now
– Households and business are satisfied holding the
amount of cash they are currently holding
• Any additional funds they might acquire are deposited in their
checking accounts
• Any decrease in their funds comes from their checking
accounts
– Banks never hold reserves in excess of those legally
required by law
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How the Fed Increases the Money
Supply
• To increase money supply, Fed will buy government bonds
– Called an open market purchase
• Suppose Fed buys $1,000 bond from Lehman Brothers,
which deposits the total into its checking account
– Two important things have happened
• Fed has injected reserve into banking system
• Money supply has increased
– Demand deposits have increased by $1,000 and demand deposits are
part of money supply
– Lehman Brothers’ bank now has excess reserves
» Reserves in excess of required reserves
» If required reserve ratio is 10% bank has excess reserves of $900 to
lend
» Demand deposits increase each time a bank lends out excess
reserves
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The Demand Deposit Multiplier
• How much will demand deposits increase in total?
– Each bank creates less in demand deposits than the bank before
– In each round, a bank lent 90% of deposit it received
• Whatever the injection of reserves, demand deposits will
increase by a factor of 10, so we can write
– ΔDD = 10 x reserve injection
• Demand deposit multiplier is number by which we must
multiply injection of reserves to get total change in demand
deposits
• Size of demand deposit multiplier depends on value of
required reserve ratio set by Fed
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The Demand Deposit Multiplier
• For any value of required reserve ratio (RRR),
formula for demand deposit multiplier is 1/RRR
• Using general formula for demand deposit
multiplier, can restate what happens when Fed
injects reserves into banking system as follows
– ΔDD = (1 / RRR) x ΔReserves
• Since we’ve been assuming that the amount of
cash in the hands of the public (the other
component of the money supply) does not
change, we can also write
– ΔMoney Supply = (1 / RRR) x ΔReserves
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The Fed’s Influence on the Banking
System as a Whole
• Can also look at what happened to total demand
deposits and money supply from another
perspective
– Where did additional $1,000 in reserves end up?
– In the end, additional $1,000 in reserves will be
distributed among different banks in system as required
reserves
• After an injection of reserves, demand deposit multiplier stops
working—and the money supply stops increasing—only when
all reserves injected are being held by banks as required
reserves
• In the end, total reserves in system have
increased by $1,000
– Amount of open market purchase
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How the Fed Decreases the Money
Supply
• Just as Fed can increase money supply by purchasing
government bonds
– Can also decrease money supply by selling government bonds
• An open market sale
• Process of calling in loans will involve many banks
– Each time a bank calls in a loan, demand deposits are destroyed
– Total decline in demand deposits will be a multiple of initial
withdrawal of reserves
– Keeping in mind that a withdrawal of reserves is a negative change
in reserves
• Can still use our demand deposit multiplier—1/(RRR)—and our
general formula
• ΔDD = (1/RRR) x ΔReserves
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Some Important Provisos About the
Demand Deposit Multiplier
• Although process of money creation and
destruction as we’ve described it illustrates
the basic ideas, formula for demand deposit
multiplier—1/RRR—is oversimplified
– In reality, multiplier is likely to be smaller than
formula suggests, for two reasons
• We’ve assumed that as money supply changes,
public does not change its holdings of cash
• We’ve assumed that banks will always lend out all of
their excess reserves
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Other Tools for Controlling the
Money Supply
• While other tools can affect the money supply,
open market operations have two advantages
over them
– Precision and secrecy
– This is why open market operations remain Fed’s
primary means of changing money supply
• Fed’s ability to conduct its policies in secret—and
its independent status in general—is controversial
– In recent years, because Fed has been so successful in
guiding economy, controversy has largely subsided
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Other Tools for Controlling the
Money Supply
• There are two other tools Fed can use to increase
or decrease money supply
– Changes in required reserve ratio
– Changes in discount rate
• Changes in either required reserve ratio or
discount rate could set off the process of deposit
creation or deposit destruction in much the same
way outlined in this chapter
– In reality, neither of these policy tools is used very often
• Why are these other tools used so seldom?
– Partly because they can have unpredictable effects
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Using the Theory: Bank Failures
and Banking Panics
• A bank failure occurs when a bank cannot meet its
obligations to those who have claims on the bank
– Includes those who have lent money to the bank, as well as those
who deposited their money there
• Historically, many bank failures have occurred when
depositors began to worry about a bank’s financial health
• Run on the bank
– An attempt by many of a bank’s depositors to withdraw their funds
• Ironically, a bank can fail even if it is in good financial
health, with more than enough assets to cover its liabilities
– Just because people think bank is in trouble
• Banking panic occurs when many banks fail
simultaneously
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Using the Theory: Bank Failures
and Banking Panics
• Banking panics can cause serious problems for the nation
– Hardship suffered by people who lose their accounts when their
bank fails
– Even when banks do not fail, withdrawal of cash decreases
banking system’s reserves
• Money supply can decrease suddenly and severely, causing a serious
recession
• Banking panic of 1907 convinced Congress to establish
Federal Reserve System
– But creation of Fed did not, in itself, solve problem
• Great Depression is a good example of this problem
– Officials of Federal Reserve System, not quite grasping
seriousness of the problem, stood by and let it happen
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Using the Theory: Bank Failures
and Banking Panics
• For five-year period ending in May 2003, a total of 26
banks failed—an average of about 6 per year
– Why the dramatic improvement?
• Federal Reserve learned an important lesson from Great Depression
– It now stands ready to inject reserves into system more quickly in a crisis
• In 1933 Congress created Federal Deposit Insurance Corporation
(FDIC) to reimburse those who lose their deposits
• FDIC has had a major impact on the psychology of
banking public
• FDIC protection for bank accounts has not been costless
• To many observers, experience of late 1980s and early
1990s was a reminder of the need for a sound insurance
system and close monitoring of banking system
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Figure 4: Bank Failures in the United
States, 1921-1999
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