Chapter
30
The Monetary
System
TENTH EDITION
Interactive PowerPoint Slides by:
V. Andreea Chiritescu
Eastern Illinois University
Mankiw, Principles of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
1
IN THIS CHAPTER
• What assets are considered “money”?
What are the functions of money? The
types of money?
• What is the Federal Reserve System?
• What role do banks play in the monetary
system? How do banks “create money”?
• How does the Federal Reserve control the
money supply?
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2
The Meaning of Money – 1
• Barter
– Exchange one good or service for another
– Requires a double coincidence of wants: unlikely
occurrence that two people each have a good or service
the other wants.
– Waste of resources: people spend time searching for
others to trade with
• Using money
– Solves those problems
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3
The Meaning of Money – 2
• Money
– The set of assets in an economy that people regularly use
to buy goods and services
• Money has three functions:
– Medium of exchange, a unit of account, and a store of
value.
– Distinguish money from other assets
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4
The Functions of Money
1. Medium of exchange
– Item that buyers give to sellers when they want to purchase
goods and services
2. Unit of account
– Yardstick people use to post prices and record debts
3. Store of value
– Item that people can use to transfer purchasing power from
the present to the future
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5
Store of Value
• Transfer purchasing power from the present to the future
– Hold money or nonmonetary assets
• Wealth
– The total of all stores of value, including both money and
nonmonetary assets
• Liquidity
– The ease with which an asset can be converted into the
economy’s medium of exchange
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6
The Kinds of Money
• Commodity money:
– Money that takes the form of a commodity with intrinsic
value
• The item would have value even if it were not used as money
• Gold coins, cigarettes in POW camps
• Fiat money:
– Money without intrinsic value, used as money because of
government decree
• The U.S. dollar
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7
Money in the U.S. Economy
• Money stock:
– The quantity of money circulating in the economy
• Currency:
– Paper bills and coins in the hands of the (non-banking)
public
• Demand deposits:
– Balances in bank accounts that depositors can access on
demand by writing a check
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8
The Money Stock
• M1 includes
– Currency, demand deposits at banks, some other
liquid deposits (balances in savings accounts)
• M2 includes
– Everything in M1 plus small time deposits and
money market funds (except those held in
restricted retirement accounts).
The money stock includes not only currency but also
deposits in banks and other financial institutions that
can be readily accessed and used to buy goods and
services.
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9
Active Learning 1: Calculating the money stock
Suppose the entire economy has:
• $150 dollars kept in coffee cans and wallets
• $300 in saving accounts
• $200 in credit card limits
• $350 in checking accounts
• $75 in time deposits
• $175 in restricted retirement accounts
• $400 in money market funds
Calculate the money stock M2.
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10
Active Learning 1: Answers
• Money stock M2 = (Currency + Demand
deposits + Other liquid deposits like savings
accounts ) + small time deposits + money
market funds
• M2 = (150 + 350 + 300) + 75 + 400
= $1,275
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11
The Federal Reserve System
• Federal Reserve (Fed)
– The central bank of the United States
• Central bank
– An institution designed to oversee the banking system and
regulate the quantity of money in the economy
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12
The Fed’s Organization
• The Federal Reserve System consists of:
– Board of Governors
• 7 members appointed by the president and confirmed by the
Senate
• 14-year terms, located in Washington, DC
• Jerome Powell, Chair of the Fed, appointed in 2017 and
reappointed in 2021
– 12 regional Federal Reserve Banks located around the
U.S.
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13
The Fed’s Jobs
1. Regulate banks, ensure the health of the banking
system
– Monitors each bank’s financial condition
– Facilitates bank transactions (clearing checks)
– A bank’s bank: makes loans to banks; lender of
last resort
2. Control the money supply (quantity of money
available in the economy)
– Connected to level of interest rates in short run.
– Monetary policy: decisions concerning the
money supply and interest rates
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14
The Federal Open Market Committee, FOMC
• FOMC:
– All 7 members of the Board of Governor
– Plus 5 of the 12 regional bank presidents
• All 12 regional presidents attend each FOMC meeting, but only
the 5 get to vote
– Open-market operations, OMO:
• Buy U.S. government bonds to increase the money supply
• Sell U. S. government bonds to decrease the money supply
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15
Bank Reserves
• Fractional reserve banking system:
– Banks keep a fraction of deposits as reserves
and use the rest to make loans.
• Reserves
– Deposits that banks have received but have
not loaned out.
• The reserve ratio, R
= fraction of deposits that banks hold as reserves
= total reserves as a percentage of total deposits
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16
The T-Account
• T-account: a simplified accounting statement that
shows a bank’s assets and liabilities.
FIRST NATIONAL BANK
Assets
Reserves $ 10
Loans
Liabilities
Deposits
$100
$ 90
• Banks’ liabilities: amount the bank owes (deposits,
bank borrowing, etc.)
• Assets: amount the bank owns (reserves, loans,
securities, etc.)
• Reserve ratio R = 100×($10/$100) = 10% or 0.1
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17
EXAMPLE 1: Changes in money supply
Suppose $5,000 of currency is in circulation.
To determine banks’ impact on money supply, we calculate
the money supply in 3 different cases:
A. No banking system
B. 100% reserve banking system (banks hold 100% of deposits
as reserves, make no loans)
C. Fractional reserve banking system (banks hold 20% of
deposits as reserves, extend loans with the rest), R = 20%
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18
EXAMPLE 1: Solution, A
A. No banking system
• Public holds the $5,000 as currency.
• Money supply = $5,000.
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19
EXAMPLE 1: Solution, B
B: 100% reserve banking system. Public deposits
the $5,000 at First National Bank (FNB).
FIRST NATIONAL BANK
Assets
Reserves $5,000
Loans
$
Liabilities
Deposits
$5,000
0
• FNB holds 100% of deposit as reserves
• Money supply = currency + deposits = $0 +
$5,000 = $5,000
If banks hold all deposits in reserve, banks do not
influence the supply of money.
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20
EXAMPLE 1: Solution, C – 1
C: Fractional reserve banking system, R = 20%
FNB loans all but 20% of the deposit to
Isabella:
FIRST NATIONAL BANK
Assets
Liabilities
Reserves
$1,000 Deposits
$5,000
Loans
$4,000
• Depositors have $5,000 in deposits, Isabella (the
borrower) has $4,000 in currency.
Money supply = currency + deposits = $4,000 +
$5,000 = $9,000 (!!!)
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21
Changes in Money Supply
How did the money supply suddenly grow?
• When banks make loans, they create money.
• Isabella (the borrower) gets:
• $4,000 in currency—an asset counted in the money supply
• $4,000 in new debt (loans)—a liability that does not have an
offsetting effect on the money supply
A fractional reserve banking system creates money, but not
wealth.
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22
EXAMPLE 1: Solution, C – 2
C: Fractional reserve banking system
• Isabella deposits the $4,000 at Second
National Bank. So, SNB’s T-account looks
like this:
• If R = 20% for SNB, it will loan all but 20% of the
deposit to Kerem, and SNB T-account will change
to:
SECOND NATIONAL BANK
Assets
Assets
Reserves
$4,000
$ 800
Loans
Liabilities
Liabilities
Deposits
Deposits $4,000
$4,000
$$3,200
0
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23
EXAMPLE 1: Solution, C – 3
C: Fractional reserve banking system
• Kerem (SNB’s borrower) deposits the $3,200
at Third National Bank. So, TNB’s Taccount looks like this:
• If R = 20% for TNB, it will loan all but 20% of the
deposit to Dalia, and TNB T-account changes to:
THIRD
THIRDNATIONAL
NATIONALBANK
BANK
Assets
Liabilities
Assets
Liabilities
Reserves
Reserves
$3,200
$ 640
Loans
Loans
$ $2,560
0
Deposits
Deposits $3.200
$3,200
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24
EXAMPLE 1: Solution, C – 4
C: Fractional reserve banking system
The process continues, and money is created with each new loan.
Original deposit
= $5,000.00
FNB lending
= $4,000.00
SNB lending
= $3,200.00
TNB lending
= $2,560.00
…
…
_________________________________________________________________
Total money supply
= $25,000.00
In this example, $5,000 of reserves generates $25,000 of money.
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25
The Money Multiplier
• Money multiplier = 1/R
– Amount of money that results from each dollar of reserves
– Is the reciprocal of the reserve ratio
• The higher the reserve ratio
– The less of each deposit banks loan out,
– And the smaller the money multiplier
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26
Active Learning 2: Banks and the money supply
While cleaning his apartment, Hakeem finds a $50 bill under
the couch. He deposits the bill in his checking account at
Chase Bank.
The reserve ratio is 10% of deposits.
A. What is the maximum amount that the money supply could
increase?
B. What if R = 5%? What is the maximum amount that the
money supply could increase
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27
Active Learning 1: Answers, A
R = 10%. Hakeem deposits $50 in his
checking account.
A. Maximum increase in money supply?
• If banks hold 10% in reserve, then
money multiplier = 1/R = 1/0.1 = 10
• The maximum possible increase in deposits is
10 x $50 = $500
• But money supply also includes currency,
which falls by $50.
• Hence, max increase in money supply = $450.
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28
Active Learning 1: Answers, B
R = 5%. Hakeem deposits $50 in his checking
account.
C. Maximum increase in money supply if R =
5%?
• Money multiplier increases to 1/0.5 = 20
• If banks hold 5% in reserve, the max
increase in money supply is
= new deposits (20 x $50) – currency
($50) = $950.
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29
A More Realistic Balance Sheet
• Assets: Reserves, loans, securities (stocks and bonds)
• Liabilities: Deposits, debt, and equity.
• Bank capital (owner’s equity):
– The resources a bank obtains by issuing equity to its owners
– Equals bank assets minus bank liabilities
• Leverage:
– The use of borrowed funds to supplement existing funds for
investment purposes
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30
EXAMPLE 2A: A More Realistic Balance Sheet
MORE REALISTIC NATIONAL BANK
Assets
Reserves
$
Loans
Securities
Liabilities
400
Deposits
$ 1,500
$ 1,000
Debt
$
400
$
Capital
$
100
600
Leverage ratio = Assets / Capital = $2,000/$100 = 20
– For every $1 of capital the bank owners have
contributed, the bank has $20 of assets.
– Of the $20 of assets, $19 are financed with
borrowed money (taking in deposits, issuing debt)
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31
EXAMPLE 2B: Appreciation or Depreciation
• If bank assets appreciate by 5%, from $2,000
to $2,100.
– Bank capital increases from $100 to $200,
doubling owners’ equity.
• If bank assets decrease by 5%, from $2,000
to $1,900
– Bank capital falls from $100 to $0.
• If bank assets decrease more than 5%, bank
capital is negative, and the bank is insolvent.
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32
Capital Requirement
• Capital requirement:
– A government regulation specifying a minimum amount of bank
capital
– Intended to ensure banks will be able to pay off depositors and
debts
• Financial crisis of 2008–2009
– Banks find themselves with too little capital to satisfy capital
requirements
– Credit crunch: the shortage of capital induced the banks to reduce
lending
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33
The Fed’s Tools of Monetary Control
• Banks create money in a system of fractional-reserve
banking
– The Fed’s control of the money supply is indirect
• Two groups of tools:
– Those that influence the quantity of reserves (OMO, Fed
lending)
– Those that influence the reserve ratio and money multiplier
(regulate reserve requirement, change interest on reserves)
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34
Open-Market Operations
• Open-Market Operations (OMOs):
– The purchase and sale of U.S. government bonds by the Fed.
• To increase the money supply:
– The Fed buys a government bond from the public, and pays for
the bonds with newly created dollars,
• Increase the number of dollars in economy
• Some of these new dollars are held as currency and some are
deposited in banks.
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35
Fed Lending to Banks – 1
• Banks borrow from Fed’s discount window
– Paying an interest rate called the discount rate
– Increasing reserves in the banking system, and increasing the
money supply
– If the Fed lowers the discount rate, it encourages banks to borrow
more, increasing the quantity of reserves and the money supply
• Term Auction Facility (2007-2010)
– Fed sets a quantity of reserves it will loan, then banks bid against
each other for these loans.)
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36
Fed Lending to Banks – 2
• The Fed lends to help financial institutions
– Stock market crash of 1987
– The fall in housing prices in 2008 and 2009
– In early 2020 when the stock and bond markets tumbled in
response to the coronavirus pandemic
– Fed Chair Jerome Powell pledged to support banks and the
economy “until we are confident that we are solidly on the
road to recovery.”
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37
How the Fed Influences the Reserve Ratio
• The Fed changes reserve requirements:
– Regulations on the minimum amount of reserves banks must hold
against deposits.
– Reducing reserve requirements would lower the reserve ratio and
increase the money multiplier.
• Interest on reserves (2008)
– The interest rate paid to banks on the reserves held in deposit at
the Fed
– Raising it: increase the reserve ratio, lower the money multiplier,
and lower the money supply
– One of the most important tools
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38
Problems in Controlling the Money Supply
• The Fed does not control:
– The amount of money that households choose to hold as
deposits in banks
– The amount that bankers choose to lend
• Yet, the Fed can compensate for household and bank
behavior to retain fairly precise control over the money
supply.
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39
Bank Runs and the Money Supply
• A run on banks:
– If people suspect their banks are in trouble, they “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:
banks may have to close.
– Also, banks may make fewer loans and hold more reserves to
satisfy depositors.
• These events increase R,
– Reverse the process of money creation, cause money supply to
fall.
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40
Bank Runs and the Money Supply
• 2007, bank run in the U.K.
– Northern Rock bank - was eventually taken over by the British
government.
• 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.
• Since then, federal deposit insurance, FDIC
– Helped prevent bank runs in the U.S.
– A more stable banking system
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41
The Federal Funds Rate
• The federal funds rate
– Interest rate at which banks make overnight loans
to other banks
– If a bank finds itself short of reserves, it can
borrow reserves from another bank
• Decisions by the FOMC
– To change the target for the federal funds rate are
also decisions to change the money supply
• A decrease in the target for federal funds rate
– Means an expansion in the money supply
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42
The Fed funds rate and other rates, 1970–2022
FRED Graph
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43
EXAMPLE 3: Monetary policy
To raise fed funds
rate, Fed sells
government bonds
(OMO).
• This removes
reserves from the
banking system,
reduces supply of
federal funds,
• causes rf to rise.
Federal
funds
rate, rf
Federal Funds market
S2
S1
1.75%
1.50%
D1
F2 F1
F
Quantity of federal funds
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44
THINK-PAIR-SHARE
Suppose you are a personal friend of the chair of the
Board of Governors of the Federal Reserve System (Jerome
Powell). He comes over to your house for lunch and notices
your couch. He is so struck by the beauty of your couch that
he simply must have it for his office. He buys it from you for
$1,000 and, since it is for his office, he pays you with a check
drawn on the Federal Reserve Bank of New York.
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45
THINK-PAIR-SHARE
A. Are there more dollars in the economy
than before? Why or why not?
B. Why do you suppose that the Fed doesn’t
buy and sell couches, real estate, and so
on instead of government bonds when they
desire to change the money supply?
C. If the Fed doesn’t want the money supply
to rise when it purchases new furniture,
what might it do to offset the purchase?
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46
CHAPTER IN A NUTSHELL
• The term money refers to assets that people
regularly use to buy goods and services. Money
serves three functions.
• As a medium of exchange, it is the item used to
make transactions.
• As a unit of account, it provides a measure with
which to record prices and other economic
values.
• As a store of value, it offers a way to transfer
purchasing power from the present to the future.
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47
CHAPTER IN A NUTSHELL
• Commodity money (gold) = money that has
intrinsic value: It would be valued even if it were
not used as money.
• Fiat money (paper dollars)= money without
intrinsic value: It would be worthless if it were not
used as money.
• In the U.S. economy, money takes the form of
currency and various types of bank deposits, such
as checking accounts.
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48
CHAPTER IN A NUTSHELL
• The Federal Reserve, the central bank of the
United States, is responsible for overseeing the
U.S. monetary system. The Fed chair is appointed
by the president and confirmed by the Senate. The
chair is the head of the Federal Open Market
Committee, which sets monetary policy.
• When people deposit money in banks and banks
use a fraction of these deposits to make loans to
the public, the quantity of money in the economy
increases. Because the banking system affects the
money supply in this way, the Fed’s control of the
money supply is imperfect.
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49
CHAPTER IN A NUTSHELL
• Bank owners provide the resources necessary to
start a bank, called bank capital. Because of
leverage (the use of borrowed funds for investment),
a small change in the value of a bank’s assets can
lead to a large change in the value of its capital. To
protect depositors, regulators require banks to hold a
certain minimum amount of capital.
• The Fed can expand the money supply: buying
bonds in open-market operations, reducing the
discount rate, increasing its lending to banks,
lowering reserve requirements, or decreasing
interest rate on reserves.
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50
CHAPTER IN A NUTSHELL
• It can contract the money supply by selling bonds in
open-market operations, increasing the discount rate,
reducing its lending to banks, raising reserve
requirements, or increasing interest rate on reserves.
• Historically, open-market operations were the Fed’s
primary tool, but since 2008, it has relied more on the
interest rate it pays on reserves.
• In recent years, the Fed has conducted monetary
policy by setting a target for the federal funds rate, a
short-term interest rate at which banks lend to one
another. As the Fed pursues its target, it adjusts the
money supply.
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51