CHAPTER 13
MONEY AND BANKING
After reading Chapter 13, MONEY AND BANKING, you should be able to:








List and explain the three functions of money.
Define the NARROW (M1) and BROAD (M2) money-supply measures.
Understand the definition of LIQUIDITY.
Explain the main entries on a bank's balance sheet and tell how banks are able to engage in fractional
reserve banking.
Discuss the institutional structure of the FEDERAL RESERVE.
Define the MONETARY BASE.
Explain how the system of banks can create deposits in excess of its reserves.
Recount the instruments the Fed can use to change the nation's money supply and tell how each tool
works.
CHAPTER OUTLINE
I. THREE FUNCTIONS OF MONEY
A.
B.
C.
D.
Money is anything that serves the three functions of money:
1. MEDIUM OF EXCHANGE: Money can be used to buy things and pay debts.
2. UNIT OF VALUE: Money is the unit in which prices are listed.
3. STORE OF VALUE: Money can be retained rather than promptly spent and things can be
purchased with the money after it has been held for a time.
LIQUIDITY measures how closely an asset substitutes for money.
The NARROW (M1) definition of money is the sum of currency, coins, checking account deposits
held by the public, travelers' checks, and other deposits upon which checks may be drawn.
The BROAD (M2) definition of money equals M1 plus savings deposits, small time deposits,
money-market mutual-fund shares and a few other highly liquid assets.
II. BANKS
A.
B.
C.
D.
E.
Banks are FINANCIAL INTERMEDIARIES that link lenders and borrowers.
The main assets of a bank are its loans, investments, and securities. Reserves (reserves are held at
the Fed and as vault cash) are somewhat less than 2 percent of all assets.
Banks' liabilities are the deposits it has accepted from the public, including transactions or demand
deposits, savings and time deposits, and other debts.
Banks earn a profit by accepting deposits and loaning the funds out to borrowers.
Banks hold as reserves only a small fraction of their total deposits. This is known as a
FRACTIONAL-RESERVE BANKING SYSTEM.
97
III. THE FEDERAL RESERVE
A.
B.
C.
D.
IV.
A.
B.
The FEDERAL RESERVE (FED) is the central bank (a bank for banks) of the United States.
1. The Fed regulates and also assists the nation's banking system.
2. The Fed controls the nation's money supply.
The seven-member Board of Governors, appointed by the President of the United States, directs the
Fed.
The Federal Open Market Committee (FOMC) consists of the seven Board members and presidents
of five of the twelve regional Federal Reserve banks. The FOMC determines the amount of the
nation's money supply.
Reserve requirements are rules stating the amount of reserves banks must keep to back their
deposits
1. The Fed sets REQUIRED RESERVE RATIOS, which tell the amount of reserves required
for each dollar of deposits.
2. A bank's deposits at the Fed plus its vault cash are the bank's legal reserves.
3. EXCESS RESERVES are reserves a bank holds beyond the quantity it is legally mandated to
have.
THE MONETARY BASE AND THE MONEY SUPPLY
The MONETARY BASE is the sum of bank reserves on deposit at the Fed plus currency in
circulation.
1. Whenever the Fed buys (sells) something, the monetary base expands (contracts).
2. The monetary base can be thought of as the Fed's currency liability.
When the Fed expands the monetary base, banks have excess reserves.
1. When any one bank has excess reserves, it loans the excess, which thereby winds up as
deposits in another bank.
2. After the deposit is made at the second bank, it has some excess reserves. This bank loans
these excess reserves, which will end up as deposits in a third bank.
3. The banking system, as a whole, increases its loans and deposits until it no longer has
undesired excess reserves. By so doing, the banking system creates more deposits than the
initial increase in base money.
4. The DEPOSIT MULTIPLIER is the ratio of the change in deposits to excess reserves. This
equals the reciprocal of the reserve requirement.
V. HOW THE FED CONTROLS THE MONEY SUPPLY
A.
The Fed has three instruments it can use to control the money supply:
1. OPEN-MARKET OPERATIONS are buying and selling by the Federal Reserve of federal
government securities.
a. When securities are purchased, the monetary base expands; when they are sold, the
monetary base shrinks.
b. Open-market operations are the Fed's major tool of monetary control.
2. When the Fed changes the RESERVE REQUIREMENTS imposed on banks, it alters the
deposit multiplier.
a. If reserve requirements are increased (lowered), the deposit multiplier falls (rises),
therefore shrinking (raising) the M1 money supply.
b. This tool is seldom used.
98
3.
The DISCOUNT RATE is the interest rate charged by the Fed to banks that borrow reserves
from the Fed. If the Fed lowers (raises) the discount rate, banks borrow more (less), and the
monetary base expands (contracts).
REVIEW QUESTIONS
True or False
If the statement is correct, write true in the space provided; if it is wrong, write false. Below the question
give a short statement that supports your answer.
____ 1.
Financial intermediaries borrow funds from ultimate lenders and lend it to ultimate borrowers.
____ 2.
One of the largest assets on banks' balance sheets is demand deposits.
____ 3.
A bank keeps on hand as reserves all of the money entrusted to it as deposits.
____ 4.
The broad (M2) definition of money includes some assets excluded from the narrow (M1)
definition.
____ 5.
The major component of M1 is checking accounts and other checkable deposits.
____ 6.
The Federal Reserve is overseen by the seven-member Board of Governors.
____ 7.
Open-market operations are the purchase or sale of government securities by commercial banks.
____ 8.
Anytime the Fed buys something, it removes money from the economy.
____ 9.
Commercial banks are completely free to determine the amount of reserves they keep on hand to
back their deposits.
____ 10. The monetary base is changed whenever a bank customer withdraws funds from his or her
checking account.
____ 11. Each bank can create additional demand deposits equal in amount to its excess reserves.
____ 12. A bank's excess reserves equal its total reserves minus its required reserves.
____ 13. An increase in the required reserve ratio increases the deposit multiplier.
____ 14. If people decide they want to hold more currency and fewer demand deposits, the M1 money
supply eventually falls.
____ 15. Open-market purchases of government bonds by the Federal Reserve increase the nation's
money supply.
____ 16. The discount rate is the interest rate the Federal Reserve pays on the reserves banks keep at the
Federal Reserve.
99
Multiple Choice
Circle the letter corresponding to the correct answer.
1.
Which of the following assets is most liquid?
a. Shares of stock in IBM
b. US government securities
c. Land
d. Gold
e. Currency
2.
Money must fulfill all of the following functions except
a. be a medium of exchange.
b. serve as the unit of value.
c. be a store of value.
d. be generally accepted as a means of purchasing commodities
e. The above are all functions of money.
3.
The M1 money supply equals
a. the sum of coins and currency.
b. the sum of coins, currency, travelers' checks, checking accounts at banks, and other accounts upon
which checks may be drawn.
c. the sum of coins, currency, travelers' checks, checking accounts at banks, other accounts upon
which checks may be drawn, and savings and time deposits.
d. the sum of all accounts upon which checks may be drawn.
e. the sum of currency in circulation and bank reserves held at the Federal Reserve.
4.
M1 increases when the Fed
a. raises the discount rate.
b. sells a government security.
c. raises the required reserve ratio.
d. buys a government security.
e. All of these actions lower the money supply.
5.
Which of the following statements about the Federal Reserve is false?
a. The Federal Reserve sets required reserve ratios that commercial banks must meet.
b. The Federal Reserve is overseen by the seven-member Board of Governors.
c. Federal Reserve actions can change the amount of the nation's money supply.
d. The Federal reserve can increase or decrease the monetary base.
e. None of the above; that is, they are all true statements.
Essay Questions
Write a short essay or otherwise answer each question.
1. Why isn't the line of credit on credit cards counted as part of the nation's money supply?
100
2. Suppose the First Federal Bank has demand deposits of $100 million. If the required reserve ratio is 15
percent, what amount of reserves is First Federal required to keep? What if the required reserve ratio is
10 percent?
For the next 5 questions, assume the required reserve ratio is 10 percent.
3. Suppose the balance sheet of Mellon bank is initially given by
Assets
What
Mellon's
Transactions deposits
$900
total
reserves?
required
reserves?
excess
increase its loans by the maximum possible, how much
Liabilities
Vault Cash
$ 80
Reserves at Fed
$ 70
Loans
$750
reserves? If Mellon decided it wanted to
Mellon increase its loans?
are
Its
Its
can
4. Continuing from Question 3, suppose Mellon made the maximum loan possible to U.S. Steel. After
Mellon made the loan, but before U.S. Steel has spent the loan, what is Mellon's balance sheet?
5. From Question 4, suppose U.S. Steel withdraws its loan by taking cash. After U.S. Steel withdraws its
loan, what is Mellon's balance sheet? What are Mellon's total reserves? Its required reserves? Its excess
reserves?
6. Suppose U.S. Steel uses the proceeds of its loan to pay its electric bill (in cash) to its electric company,
Duquesne Light. If Duquesne Light deposits this in its checking account with Pittsburgh National Bank,
what will be the bank's balance sheet after the deposit if its balance sheet before the deposit is
Assets
Vault Cash
Liabilities
$ 40
Transactions deposits
$700
7. Using
the
balance sheet
Reserves at Fed
$ 30
in Question
6,
before
Loans
$630
Duquesne
Light
deposited its funds in Pittsburgh National Bank, what were the bank's total reserves? Required reserves?
Excess reserves? By how much could the bank increase its loans? After the funds are deposited, what
are the bank's total reserves? Required reserves? Excess reserves? By how much can Pittsburgh National
increase its loans?
8. If the required reserve ratio is 10 percent, what is the deposit multiplier? If the Fed raises the monetary
base and excess reserves by $1000, by how much can the money supply ultimately change? If the
required reserve ratio is 20 percent, what can be the increase in the money supply from the $1000
change?
9. The boxed example in this chapter uses the concept of moral hazard to explain the Asian Crisis of 1997
and 1998. Write an essay explaining how the belief in an ultimate lender of last resort, such as the
International Monetary Fund, helped create the Asian Crisis.
101
ANSWERS TO REVIEW QUESTIONS
True or False
True
1.
A bank is a good example of an intermediary: it borrows from people (the ultimate lenders) by
accepting their deposits and then loans to other individuals or firms (the ultimate borrowers).
False
2.
Transactions (demand) deposits are a liability—not an asset—to the bank because the deposits
are owned by others. The bank must pay them back to their owners upon request.
False
3.
Banks keep on hand as reserves only about 2 percent of the total deposits.
True
4.
These assets include time deposits, savings deposits, and shares in money-market mutualfunds.
True
5.
Checkable deposits, including demand deposits, comprise about 70 percent of M1.
True
6.
Members of the board are appointed for fourteen-year terms by the President of the United
States.
False
7.
Open market operations are the purchase or sale of government securities by the Federal
Reserve.
False
8.
Anytime the Fed buys something, it injects money into the economy.
False
9.
The Fed sets legally required reserve ratios that constrain banks to hold at least a certain level
of reserves.
False
10. The monetary base is changed only when the Federal Reserve injects or withdraws currency or
bank reserves.
True
11. Each bank is free to create additional demand deposits by loaning the amount of its excess
reserves to a customer.
True
12. This is the definition of excess reserves.
False
13. The deposit multiplier equals the reciprocal of the required reserve ratio, so an increase in the
required reserve ratio lowers the deposit multiplier.
True
14. When people withdraw more currency from banks, banks' reserves fall. In order to maintain
their required level of reserves, banks must reduce the loans they grant. This reduction sets off
a multiple contraction of the M1 money supply.
True
15. The Fed pays for its purchases by either increasing the amount of currency (thereby raising
M1 directly) or by increasing the reserves accounts banks maintain at the Fed. This latter
action raises banks' excess reserves, thereby leading to a multiple expansion of the M1 money
supply.
102
103
False
16. The discount rate is the interest rate the Federal Reserve charges banks when the banks borrow
reserves from it.
Multiple Choice
1.
e. Currency is the most liquid of any asset.
2.
e. If an asset meets these functions, it is considered money.
3.
b. This is the definition of M1.
4.
d. Purchasing a government security is an open-market operation that raises the base money supply
and banks' excess reserves. This leads to a multiple expansion of the money supply.
5.
e. All of the statements about the Federal Reserve are correct and, because the Federal Reserve plays
a significant role in the nation's economy, all of the statements are important.
Essay Questions
1. Credit cards merely allow their owners very easy and convenient access to a loan. Ultimately the loan
must be repaid using money, either currency or checking account money. Thus the credit limit on credit
cards is a loan limit and not part of the money supply.
2. When the required reserve ratio is 15 percent, $15 million in reserves is required [($100 million) 
(.15)]. When the reserve ratio is 10 percent, $10 million must be kept as reserves. Lowering the reserve
requirement reduces the legally required amount of reserves. Such a decrease gives banks more excess
reserves that they may use to loan out, thereby creating more money.
3. Total reserves are $150 (the sum of vault cash plus reserves at the Fed). Required reserves are $90 (the
required reserve ratio, .10, times the total amount of transactions [demand] deposits, $900). Excess
reserves are $60 (the difference between total reserves and required reserves). Mellon may increase its
loans by $60. A bank may increase its loans by the amount of its excess reserves.
104
4.
Assets
Liabilities
Vault Cash
$ 80
Reserves at Fed
$ 70
Loans
$810
Transactions deposits
$960
The new balance sheet is given above. Mellon has loaned $60 to U.S. Steel by opening a checking
account for U.S. Steel in the amount of the loan. Thus total transactions deposits (checking accounts)
rise by $60 and total loans rise by $60.
5.
Assets
Liabilities
Vault Cash
$ 20
Reserves at Fed
$ 70
Loans
$810
Transactions deposits
$900
As shown above, U.S. Steel withdraws its loan by reducing its checking account by $60, so transactions
deposits fall by $60. Since U.S. Steel takes its funds in the form of currency, vault cash falls by $60.
Mellon's total reserves are $90 (the sum of vault cash plus reserves at Fed). Required reserves are $90
(the required reserve ratio times the total deposits). Its excess reserves are $0 (the difference between
actual and required reserves). Mellon now has no excess reserves with which to make loans.
6.
Assets
Vault Cash
Liabilities
$100
Transactions deposits
$760
The balance
after
the
Reserves at Fed
$ 30
deposit
is
shown above.
Loans
$630
Duquesne
Light
deposits the $60 in its checking account, so transactions deposits, as well as cash, rise by $60.
105
7.
Before the Deposit
After the Deposit
Total reserves:
$70
Total reserves:
$130
Required
reserves:
$70
Required
reserves:
$76
Excess reserves:
$0
Excess reserves:
$54
Maximum loan:
$0
Maximum loan:
$54
As shown above, notice that Pittsburgh National Bank is now in a position to increase its loans. Were it
to do so, the money supply would continue to grow.
8. The deposit multiplier is 10. It equals 1/(required reserve ratio) or 1 / (0.1) = 10. If the monetary base is
increased, the money supply can ultimately change by the deposit multiplier (10) times the change in the
monetary base ($1,000) or by $10,000. If the required reserve ratio is 20 percent, the deposit multiplier
is 5. Thus, if the monetary base is raised by $1,000, the money supply ultimately can change by $5,000.
As the required reserve ratio is increased, banks are forced to retain more of any additional deposit as
reserves. Hence they loan out less, so the money supply does not increase by as much as when the
required reserve ratio is smaller.
9. When lenders believe that there is a lender-of-last-resort, such as the International Monetary Fund, they
will be willing to grant risky loans without much research on the underlying solvency of borrowers
because they can rely on being automatically bailed out by the lender-of-last-resort. This tendency to
make risky loans in this situation has been termed a “moral hazard” problem.
106