Money, Banking and the
Federal Reserve
What Is Money?
Money is any asset that can easily be used to purchase goods and
services.
• Fiat money : Money, such as paper currency, that is authorized by a
central bank or governmental body and that does not have to be
exchanged by the central bank for gold or some other commodity
money.
• Commodity money: A good used as money that also has value
independent of its use as money.
Currency in circulation: Cash held by the public.
Checkable bank deposits: Bank accounts on which people can write
checks.
Money Supply: The total value of financial assets in the economy that
are considered money.
Roles of Money
1. A medium of exchange is an asset that
individuals acquire for the purpose of trading
rather than for their own consumption.
2. A store of value is a means of holding
purchasing power over time.
3. A unit of account is a measure used to set prices
and make economic calculations.
4. Money is useful because it can serve as a standard of
deferred payment in borrowing and lending.
Measuring the Money Supply
Monetary aggregate:
An overall measure of the money supply.
The Fed uses three measures of the money supply
known as M1, M2, and M3.
Near-moneys:
Financial assets that can’t be directly used as a
medium of exchange but can readily be converted
into cash or checkable bank deposits.
M1
•M1 is the narrowest definition of the
money supply and is also the most liquid.
1 Currency, which is all the paper money and coins that are in circulation,
where “in circulation” means not held by banks or the government
2 The value of all checking account deposits at banks
3 The value of traveler’s checks (although this last category is so small—less
than $7 billion in May 2007—we will ignore it in our discussion of the
money supply)
M2
•M2 is a broader definition. Includes M1 +
other assets that are “almost” checkable.
–M1 +
–Near Moneys
•Savings Account Deposits
•Money Market Funds
•Time Deposits
Measuring the Money Supply, August 2011
(a)
M1
= $2,108.8 billion
(b)
M2
= $9,545 billion
What about Credit Cards and Debit Cards?
Many people buy goods and services with credit cards,
yet credit cards are not included in definitions of the
money supply.
Because balances in checking account deposits are included in the
money supply, banks play an important role in the process by which
the money supply increases and decreases.
Monetary Role of Banks
Financial intermediary:
Uses liquid assets in the form of bank deposits
to finance the illiquid investments of borrowers.
Bank reserves: Currency banks hold in their
vaults plus their deposits at the Federal Reserve.
These don’t count as “currency in circulation.”
Reserve ratio: Fraction of bank deposits that a
bank holds as reserves.
Banks
Reserves: Deposits that a bank keeps as cash in its vault or on deposit with the
Federal Reserve.
Required reserves: Reserves that a bank is legally required to hold, based on its
checking account deposits.
Required reserve ratio: The minimum fraction of deposits banks are required by
law to keep as reserves.
Excess reserves: Reserves that banks hold over and above the legal requirement.
Fractional reserve banking system: A banking system in which banks keep less
than 100 percent of deposits as reserves.
Balance Sheet for Wachovia Bank, December 31,
2006
T-Account
•T-account summarizes a bank’s financial position.
How Banks Create Money
1. If banks did not exist, the money supply
would simply be equal to the amount of
currency in circulation.
2. Remember that “Checkable Deposits” ARE
INCLUDED in the money supply measure M1.
3. Because banks lend out the majority of their
deposits the total checkable deposits can
exceed the amount of currency in circulation.
4. Thus, banks “create money”
Bank Regulations
Reserve Requirements - rules set by the Federal
Reserve that determine the minimum reserve
ratio for a bank.
For example, in the United States, the minimum
reserve ratio for checkable bank deposits is 10%.
Excess Reserves and Deposits
Excess Reserves:
Bank reserves over and above its required
reserves. i.e. Money available for lending.
Example:
$10 Million in Deposits / 10% Reserve Requirement (rr)
1. What is the Minimum $$ Reserve Requirement?
2. Before making any loans, how much is available to
lend as “Excess Reserves”?
Bank Runs
A bank run is a phenomenon in which many of a
bank’s depositors try to withdraw their funds
due to fears of a bank failure.
Bank panic: A situation in which many banks
experience runs at the same time.
Historically, they have often proved contagious,
with a run on one bank leading to a loss of faith
in other banks, causing additional bank runs.
Bank Regulations
Deposit Insurance - guarantees that a bank’s
depositors will be paid even if the bank can’t
come up with the funds.
The FDIC currently guarantees the first $100,000
of each account.
What negative consequences might there be
from providing deposit insurance?
Learning Objective 13.3
How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create Money
Learning Objective 13.3
How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create Money
Learning Objective 13.3
How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create Money
Learning Objective 13.3
How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create Money
The Money Multiplier
Recall “The Multiplier” from our discussion of
MPC and GDP.
“Fractional Reserve Banking” has a similar
multiplying effect from lending out deposits in
multiple rounds.
The Money Multiplier
Assume a “Checkable Deposits Only” economy.
i.e. All money is put in the bank, no currency is
held in circulation.
Increase in Bank Deposits from an initial $1,000
in excess reserves.
1
Simple deposit multiplier 
RR
1
Change in checking account deposits  Change in bank reserves x
RR
The Money Multiplier
Total Increase in Deposits = $1,000/rr
So, if the Reserve Requirement (rr) = 10% what
is the total increase in deposits?
Answer: $10,000
This means that each $1 of reserves supports
$10 in checkable deposits in the system.
Money Multiplier: In Reality
The monetary base is the sum of currency in circulation
and bank reserves.
The money multiplier is the ratio of the money supply
to the monetary base.
Money Multiplier
=
Money Supply
÷
Monetary Base
The Federal Reserve
System
The Federal Reserve System
The Federal Reserve is a central bank—an
institution that oversees and regulates the
banking system, and controls the monetary
base.
“Independent” means it is not really part of the
U.S. government, but it is not really private
either.
The Federal Reserve System
1. Board of Governors in Washington, D.C.
a. 7 Members Appointed by the President and
Confirmed by the Senate for 14 Year Terms
b. The Chairman is appointed every 4 years but
usually serves for long periods.
2. Twelve Federal Reserve Banks serving their
respective 12 geographic regions in the U.S.
Federal Reserve Districts
To which Federal Reserve District(s) does New Mexico belong?
Monetary policy The actions the Federal Reserve takes to
manage the money supply
Open Market Operations
Federal Open Market Committee (FOMC) The Federal Reserve committee
responsible for open market operations and managing the money supply in
the United States.
Open market operations The buying and selling of Treasury securities by
the Federal Reserve in order to control the money supply.
Discount Policy
Discount loans Loans the Federal Reserve makes to banks.
Discount rate The interest rate the Federal Reserve charges on
discount loans.
Reserve Requirements
When the Fed reduces the required reserve ratio, it converts
required reserves into excess reserves.
The Quantity Theory of Money
The Quantity Theory Explanation of Inflation
Quantity theory of money: A theory of the connection between money and
prices that assumes that the velocity of money is constant.
In the early twentieth century, Irving Fisher, an economist at Yale, formalized
the connection between money and prices using the quantity equation:
M xV  P x Y
We can rewrite the above equation by taking logs as:
M+V=P+Y
Growth rate of the money supply + Growth rate of velocity = Growth rate of
the price level (or inflation rate) + Growth rate of real output
Velocity Approach to Money Demand
Velocity of money: The average number of times each dollar in
the money supply is used to purchase goods and services included
in GDP.
The velocity of money is nominal GDP divided by the nominal
quantity of money.
Nominal
GDP
According to the velocity of money approach to money demand,
the real quantity of money demanded is proportional to real
aggregate spending.
Nominal
GDP
The Quantity Theory of Money
The Quantity Theory Explanation of Inflation
The growth rate of the price level is just the inflation rate, so
we can rewrite the quantity equation to help us understand
the factors that determine inflation:
Inflation rate = Growth rate of the money supply +
Growth rate of velocity − Growth rate of real output
If Irving Fisher was correct that velocity is constant, then the
growth rate of velocity will be zero. This allows us to rewrite
the equation one last time:
Inflation rate = Growth rate of the money supply − Growth
rate of real output
The Quantity Theory of Money
The Quantity Theory Explanation of Inflation
This equation leads to the following predictions:
1 If the money supply grows at a faster rate than real
GDP, there will be inflation.
2 If the money supply grows at a slower rate than real
GDP, there will be deflation. (Recall that deflation is a
decline in the price level.)
3 If the money supply grows at the same rate as real
GDP, the price level will be stable, and there will be
neither inflation nor deflation.
Quantity Theory of Money
If V and Y are fixed then both = zero
ΔM + ΔV = ΔP + ΔY
ΔM = ΔP
M and P will generally move in the same direction!
Printing money causes inflation !!!
U.S. Example to Prove It
ΔM = ΔP + ΔY
Calculate Change in Y (real GDP):
Real GDP Q3 2006: 11,336.7 billion
Real GDP Q3 2007: 11,630.7 billion
2.59 %
Calculate Change in P (CPI):
CPI October 2006: 201.8
CPI October 2007: 208.936
3.52%
U.S. Example to Prove Relationship
ΔM = ΔP + ΔY
Predicted ΔM = 3.52% + 2.59%
Predicted ΔM  6.11%
So, using the Quantity Theory and real data on the
U.S. economy we would predict that the U.S.
Money Supply increased by 6.11%
What really happened? Let’s look up M2 which is
our best measure of the Money Supply.
The Quantity Theory of Money
High Rates of Inflation
Very high rates of inflation—in excess of hundreds or
thousands of percentage points per year—are known
as hyperinflation.
Economies suffering from high inflation usually also
suffer from very slow growth, if not severe recession.
Making
the
Connection
•The German Hyperinflation
of the Early 1920s
During the hyperinflation of the 1920s,
people in Germany used paper currency
to light their stoves.