Chapter Twenty Six
The Money Supply and
the Federal Reserve
System
What is Money?
 Medium of exchange
 Store of value
 Unit of Account
Liquidity property of money
Forms of Money
Commodity money
Convertible paper money
Fiat money
Legal tender
Money -- Official Definitions
M1
–Currency held outside banks,
plus Demand Deposits and other
checkable deposits, plus
Traveler’s Checks, etc.
M2
–M1 plus Savings Deposits, plus
Money Market Accounts, etc.
Components of M1
- Transactions Money Currency (held outside of banks)
Demand Deposits
Traveler’s checks
Other checkable deposits
M1
Currency
Components of M1
Demand Deposits
Other
1200.0
1000.0
Dollars
800.0
600.0
400.0
200.0
0.0
1963
1967
1971
1975
1979
Year
1983
1987
1991
Components of M1
Components of M1, 1980
Components of M1, 1994
Demand Deposits
Currency
Other
As definition of money becomes broader,
less liquid assets are added.
Liquid Asset: an asset which can be
easily converted into a means of
payment at a predictable price
Growth of M1 and M2
Reserve Requirements
Reserves: The amount of funds
which a member bank must legally
keep on deposit with the Federal
Reserve or in its vault as cash.
Based on the total deposits of the
bank, a fixed percentage of deposits
must be held as reserves.
Reserves
Required reserve ratio: The
percentage of its total deposits that a
bank must keep at the Federal
Reserve…that amount is called the
bank’s required reserves.
Excess reserves: The difference
between a bank’s actual reserves and
its required reserves.
Reserves Example
Suppose the reserve ratio is 20%
You deposit $20,000 into your
checking account
Money Supply = $20,000
Bank
$20,000
What happens to the deposit?
$4,000 stays at the bank as
reserves
$16,000 is available for loans
Your friend borrows
$16,000 for a new car
Bank
$20,000
Loans = $16,000
Reserves = $4,000
Banks Creating Money
The money supply is now equal to
$36,000 -- $20,000 plus $16,000 -- what
you deposited plus what your friend has
borrowed.
The loan created money.
Money Supply = $36,000
Banks Creating Money
Suppose your friend
deposits
the $16,000 in a bank...
Bank
$16,000
The bank must hold 20%
as reserves ($3,200),
and lends out the rest...
Bank
$16,000
Loans = $12,800
Reserves = $3,200
The money supply is now equal to
$48,800 -- $20,000 plus $16,000
plus $12,800-- what you deposited
plus what your friend has borrowed
plus the final loan.
The loan created money.
How much money can be
created from a $20,000
deposit?
Total Money = $20,000/0.2 =
$100,000
This is the maximum amount
of money that can be created.
Total Money = $20,000/0.2 =
$100,000
Money Multiplier
Multiple by which deposits
increase for every dollar increase
in reserves
Money Multiplier =
1/required reserve ratio
Money Multiplier
The money multiplier might be
smaller because…
Banks hold excess reserves
Households don’t deposit all of their
cash holdings
Federal Reserve System
Board of Governors
Alan Greenspan,
Chair,
Federal Reserve Board
Federal Reserve System
FOMC
Board of Governors
12 Federal Reserve Banks
National Banking System:
Commercial Banks, Savings and Loans, Credit Unions
The 12 Federal Reserve
Banks
Functions of the Fed
Control the money supply
Clear interbank payments
Lender of last resort
Monetary Policy
An attempt to alter the economy by
changing the money supply
Controlled by the Fed
–FOMC: Federal Open Market
Committee
How the Fed Controls the Money
Supply
Tools of Monetary Policy
Required Reserve Ratio
Discount Rate
Open Market Operations
Reserve Requirements
Required reserves: the percentage
of deposits banks must hold in cash
or on deposit with the Fed
Decreasing the reserve ratio
increases the money supply
Increasing the reserve ratio
decreases the money supply
Discount Rate
 The interest rate at which the
Fed lends reserves to member
banks
 Increase in the discount rate
decreases the supply of money
Decrease in the discount rate
increases the supply of money
Open Market Operations
(OMO)
Open market operations refers to the
buying and selling of government
bonds in order to change the supply
of money.
Government Bonds: The
debt of the federal
government. Sold in
various maturities.
Selling Bonds
If the Fed sells a bond, the
money supply decreases by the
price of the bond.
Purchasing Bonds
If the Fed purchases bonds in
the open market this increases
the money supply by the price
of the bonds.
Money Market
Interest
Rate
15%
10%
Ms
Real
Money
Supply
5%
Quantity of
Real Money
Review Terms & Concepts
 Barter
 Fiat, or token money
 Commodity monies
 Financial intermediaries
 Currency debasement  Legal tender
 Discount rate
 Lender of last resort
 Excess reserves
 Liquidity property of
 Federal Open Market
money
 M1 (transactions money)
 M2 (broad money)
 Medium of exchange
Committee (FOMC)
 Federal Reserve
System (Fed)
Review Terms & Concepts (cont.)
 Money multiplier
 Reserves
 Moral suasion
 Run on a bank
 Near monies
 Store of value
 Open Market Desk
 Unit of account
 Open market
operations
 Required reserve ratio