Money and the monetary system
Definition of money
Money is any commodity or token that is generally
accepted as a means of payment.
Money is an institution human societies devised to
reduce transaction costs. Money performs three
vital functions:
Medium of exchange
Unit of account
Store of value
Medium of exchange:
If our economy did not use money, all transactions
would have to take place by barter. This means that
goods and services would be exchanged directly for
other goods and services. Barter requires a double
coincidence of wants.
Unit of account:
This means that the prices of goods and services are
expressed in terms of the monetary unit, which
significantly reduces the number of relative prices we
need to deal with and therefore reduces transaction
costs.
Store of value:
Because money can be held and exchanged later for
goods and services, it may be held for spending at
some later date. When it is held in this way, it is a
store of value, or store of wealth.
Forms of money
The earliest money was commodity money. Many
different commodities have been used as a medium
of exchange, but gold and silver have always had an
appeal because they have remained stable in value
over long periods of time and relatively small
quantities have had sufficient value to be used for
most ordinary exchanges.
Money further developed with the introduction of
paper money that could be redeemed, i.e.,
exchanged, for specific quantities of metal at banking
institutions.
When paper money is redeemable for specific
quantities of a commodity, the monetary system is
said to be based on a commodity standard.
Our modern paper money is fiat money, which is
non-redeemable money established by law (“fiat”
means “decree”).
In a modern economy, most financial transactions do
not involve either coins or paper money: payments are
made by the transfer of funds that are on deposit in
depository institutions, called checkable deposits.
Money in the United States
Coins in the U.S. originally contained their face
value’s worth of metal (either gold or silver) and for
this reason were known as full bodied coins, but our
modern coins are token coins.
The paper money in the U.S. consists of Federal
Reserve Notes issued by the Federal Reserve
System.
The Federal Reserve System, or Fed, is the central
bank of the United States. A central bank is a public
authority that provides banking services to the banks,
regulates financial institutions and markets and, most
importantly, supplies money to the economy and
regulates the money supply.
Currency, coin and checkable deposits are highly
liquid assets.
Liquid assets are assets that may be turned into the
means of payment rapidly, at low cost and without
capital loss.
Illiquid assets are assets that are difficult or costly to
change into the means of payment, particularly if the
change is likely to result in a capital loss.
The Federal Reserve maintains statistics for several
different definitions of the money supply.
Money Supply M1:
The narrowest and most liquid definition, M1, is
currency and coin in circulation among the public,
i.e., not in banks’ vaults, and checkable deposits
owned by individuals and businesses and traveler’s
checks.
Money Supply M2
M2, which is broader and includes somewhat less
liquid assets, is M1 plus savings deposits, small
time deposits (less than $100,000), money market
mutual funds and money market deposits.
Structure of the Federal Reserve System
There are 12 Federal Reserve districts and each has
a district Federal Reserve Bank (FRB).
Each district’s FRB has nine directors. The nine
directors of each FRB appoint the FRB’s president.
Functions of the FRBs:
serving as a clearing house for checks between banks
withdrawing damaged currency from circulation and
issuing new currency
making discount loans to banks in their districts
regulating banks
collecting data and doing research on business
conditions in their districts
Board of Governors of the Federal Reserve System:
There are seven governors, each appointed by the
President of the United States and confirmed by the
U.S. Senate. The governors serve nonrenewable
14-year terms.
The chairman of the Board of Governors (currently
Ben Bernanke) is chosen by the President of the
United States from among the seven governors. The
chairman serves a four-year renewable term.
The Board of Governors sets reserve requirements
for commercial banks and determines the discount
rate charged by the FRBs for discount loans to
commercial banks.
The Federal Open Market Committee (FOMC):
The FOMC consists of the seven members of the
Board of Governors, the president of the FRB of New
York, and four other FRB presidents on a rotating
basis. The chairman of the Board of Governors also
chairs the FOMC.
The FOMC determines the conduct of open market
operations, the buying and selling of government
securities in the bond market, which, as we will see,
is the most important instrument used by the Fed to
regulate the money supply and interest rates.
Money creation and control
Because the Fed’s ability to control the supply of
money to the economy works through the banking
system, we begin by examining a simplified balancesheet of a commercial bank:
Assets
Reserves
cash
deposits with Fed
Loans
Securities
Liabilities
Deposits
Borrowings
A deposit of, say, $100 by a member of the public
in a bank has the following effect on the bank’s
balance sheet:
Assets
Reserves +$100
Liabilities
Deposits +$100
A loan of $100 by the bank to a member of the public
has the following effect on the bank’s balance sheet:
Assets
Loans +$100
Liabilities
Deposits +$100
The bank makes a loan by crediting the borrower’s
checking account by the amount of the loan, i.e., by
adding $100 to the balance in the borrower’s deposit
account held with the bank.
For every additional dollar of bank lending, bank
deposits are increased by a dollar. Lending does not
deplete reserves. Reserves are unaffected. Rather,
it creates new deposits out of thin air! This
represents an increase in the money supply, M1,
because checkable deposits are part of M1. Bank
lending creates new money.
Now we turn to the Fed’s balance sheet:
Monetary base
Assets
Liabilities
Government securities
Discount loans
Currency in circulation
Reserves
Reserves are divided into: required reserves, which
the banks are required by the Fed to hold, defined as
a percentage of the banks’ total deposit liability to the
public; and excess reserves, which are additional
reserves the banks might choose to hold.
Currency in circulation plus reserves are the monetary
base of the economy.
The monetary base is also called high-powered
money because increases in it will, as we shall see,
lead to multiple increases in the money supply,
everything else held constant. Even a small change
in the monetary base has a magnified effect on total
deposits and hence on the money supply:
Money supply
Monetary base
Reserves in the banking system are only a fraction of
total deposits. This is made possible by the fact that
deposits are created out of thin air as a consequence
of bank lending.
If the reserve requirement ratio, for example, is 10%,
then each $1 of reserves potentially supports $10 of
deposits, i.e., a $1 increase in reserves (monetary
base) produces a $10 increase in deposits and hence
in the overall money supply.
Therefore a large money supply rests on a small
monetary base.
Control of the monetary base
If the Fed wants to increase or decrease the money
supply, all it has to do is increase or decrease the
monetary base.
The main way in which the Fed brings about changes
in the monetary base is by altering the amount of
reserves in the banking system through open market
operations, which consist of either
open market purchases, which are purchases of
government securities – U.S. Treasury bonds – by
the Fed in the bond market
or
open market sales, which are sales of government
securities by the Fed.
An open market purchase
Suppose that the Fed purchases $100 of government
securities from a bank:
Banking system
Assets
Liabilities
Reserves +$100
Securities -$100
The same transaction is shown on the Fed’s balance
sheet as follows:
Fed
Assets
Government securities +$100
Liabilities
Reserves +$100
The net result is that reserves have increased by
$100. Because there has been no change in
currency, the monetary base has also increased by
$100 (recall that monetary base = currency +
reserves).
Now let’s suppose, more realistically, that the Fed
buys the $100 of government securities not from the
banks but from a member of the nonbank public.
To pay for the securities, the Fed issues a check,
drawn on itself, for $100.
Suppose that the member of the public who receives
the check deposits it in an account at a bank:
Banking system
Assets
Reserves
Liabilities
+$100
Deposits +$100
The effect on the Fed’s balance sheet is as follows:
Fed
Assets
Securities +$100
Liabilities
Reserves +$100
Again, the net result of a $100 open market purchase
from a member of the nonbank public is a $100
increase in reserves and the monetary base, the
same result that occurred when the Fed purchased
the securities directly from the banks.
Thus we can conclude that an open market purchase
causes an increase in the monetary base by the
same amount as the amount of the open market
purchase.
An open market sale
Suppose that the Fed sells $100 of government
securities and the securities are bought by one of
the banks in the banking system.
Banking system
Assets
Reserves -$100
Securities +$100
Liabilities
The effect of the open market sale on the Fed’s
balance sheet is as follows:
Fed
Assets
Securities
Liabilities
-$100
Reserves
-$100
The net result is that reserves have decreased by
$100. Because there has been no change in
currency, the monetary base has also decreased by
$100.
Thus we can conclude that an open market sale
causes a decrease in the monetary base by the
same amount as the amount of the open market
sale.
Discount loans
In addition to open market operations, the Fed can
also increase reserves in the banking system, and
hence increase the monetary base, by making
discount loans to the banks.
A $100 discount loan to a bank:
Banking system
Assets
Reserves
+$100
Liabilities
Discount loan from Fed +$100
Fed
Assets
Discount loan +$100
Liabilities
Reserves +$100
The monetary base has increased by $100.
We can conclude that if the volume of discount
lending increases, the monetary base increases; if
the volume of discount lending decreases, the
monetary base decreases.
Normally banks do not borrow from the Fed but
prefer to borrow reserves from each other in an
overnight interbank lending market called the federal
funds market. The interest rate prevailing in this
market is called the federal funds rate.
The Fed’s open market operations affect the federal
funds rate:
Open market purchases increase the supply of bank
reserves and therefore cause a decrease in the
market equilibrium federal funds rate.
Open market sales decrease the supply of bank
reserves and therefore cause an increase in the
market equilibrium federal funds rate.
In fact, the Fed normally announces its monetary
policy by stating a target for the federal funds rate.
Changes in the federal funds rate, which is the basic
cost of funds to the banks, then affect all other short
term interest rates.
A simple model of multiple deposit creation
We have seen that the Fed supplies reserves to the
banking system. Under fractional reserve banking,
any increase in bank reserves supplied by the Fed
brings about an even bigger increase in bank
deposits created through bank lending, a response
known as multiple deposit creation.
Any increase in reserves, whether created through
an open market purchase or through a discount
loan, will enable the banks to increase their lending
and deposits and thus expand the money supply.
Suppose the Fed purchases $100 of government
securities from Bank A. The effect of this open
market purchase on Bank A and on the Fed is as
follows:
Bank A
Assets
Liabilities
Reserves +$100
Securities -$100
Fed
Assets
Securities +$100
Liabilities
Reserves +$100
What does Bank A do with its $100 of new reserves?
Assume:
the banks do not wish to hold excess
reserves, above and beyond the amount of
reserves they are required to hold,
members of the nonbank public deposit all of
the proceeds of loans in deposit accounts and
do not hold any portion in currency, i.e., there
is no currency drain of newly created deposits
out of the banking system,
the reserve requirement ratio, the ratio of
required reserves to deposit liability which is
dictated by the Fed, is 10%.
Presumably, before the injection of $100 of new
reserves, Bank A was holding an amount of reserves
that was exactly equal to 10% of its deposit liability.
Now that Bank A has received $100 of new reserves,
without any change in its deposit liability, it must be
the case that the entire $100 is excess reserves.
By increasing its lending, Bank A can use up its
excess reserves. But how much will it lend?
If it lends less than $100, it will still have some
excess reserves, which is contrary to our assumption
that the banks do not wish to hold excess reserves.
It will be extremely dangerous for the bank to lend
more than $100, however, because, as we shall see,
there is always the possibility that the proceeds of the
loan might clear to a different bank, in which case
Bank A will lose reserves equal to the amount of the
loan.
Therefore it follows that the maximum amount that
Bank A can lend is the amount it can afford to lose,
i.e., the amount of its excess reserves.
Bank A will make a loan equal to its excess reserves,
i.e., a loan of $100. Combining the effects of the
$100 open market purchase by the Fed with the
$100 loan on a single balance sheet gives the
following:
Bank A
Assets
Reserves +$100
Loans
+$100
Securities -$100
Liabilities
Deposits +$100
But now assume that the customer who borrowed
$100 from Bank A writes a check in that amount and
pays it to another individual who deposits it in his or
her deposit account in Bank B.
When the Fed clears the funds from Bank A to Bank B,
Bank A’s balance-sheet position will be as follows:
Bank A
Assets
Liabilities
Reserves +$100
-$100
$0
Loans
+$100
Securities -$100
Deposits +$100
-$100
$0
When the check clears, Bank B receives a new deposit
of $100 and new reserves of $100. Bank B’s balance
sheet changes as follows:
Bank B
Assets
Reserves +$100
Liabilities
Deposits +$100
By how much have Bank B’s excess reserves
increased?
Although Bank B’s total reserves have increased by
$100, its excess reserves are $90, because it is
required to hold reserves equal to 10% of $100, i.e.,
$10, in fulfillment of the reserve requirement for its new
deposit liability of $100.
Again the same rule applies to Bank B as applied
previously to Bank A: The maximum amount by
which Bank B can increase its lending is the amount
of its excess reserves, which is $90, because this is
the amount that Bank B can afford to lose if the loan
proceeds should clear to another bank.
Bank B’s balance sheet changes as follows:
Bank B
Assets
Reserves +$100
Loans
+$90
Liabilities
Deposits +$100
+$90
+$190
But now assume that the customer who borrowed
$90 from Bank B writes a check in that amount and
pays it to another individual who deposits it in his or
her deposit account in Bank C.
When the Fed clears the funds from Bank B to Bank C,
Bank B’s balance-sheet position will be as follows:
Bank B
Assets
Liabilities
Reserves +$100
-$90
+$10
Loans
+$90
Deposits +$100
+$90
-$90
+$100
When the check clears, Bank C receives a new deposit
of $90 and new reserves of $90. Bank C’s balance
sheet changes as follows:
Bank C
Assets
Reserves
Liabilities
+$90
Deposits +$90
By how much have Bank C’s excess reserves
increased?
Although Bank C’s total reserves have increased by
$90, its excess reserves are $81, because it is required
to hold reserves equal to 10% of $90, i.e., $9, in
fulfillment of the reserve requirement for its new deposit
liability of $90.
Again the same rule applies to Bank C as applied
previously to Banks A and B: The maximum amount
by which Bank C can increase its lending is the
amount of its excess reserves, which is $81, because
this is the amount that Bank C can afford to lose if
the loan proceeds should clear to another bank.
Bank C’s balance sheet changes as follows:
Bank C
Assets
Reserves
Loans
Liabilities
+$90
+$81
Deposits
+$90
+$81
+$171
But now assume that the customer who borrowed
$81 from Bank C writes a check in that amount and
pays it to another individual who deposits it in his or
her deposit account in Bank D.
When the Fed clears the funds from Bank C to Bank D,
Bank C’s balance-sheet position will be as follows:
Bank C
Assets
Reserves
Loans
Liabilities
+$90
-$81
+$9
+$81
Deposits
+$90
+$81
-$81
+$90
And so on … Clearly there is a pattern here: each
successive bank creates loans and hence deposits
equal to 90 percent of its newly-acquired reserves, the
other 10 percent being required reserves. These
newly-created deposits then clear to the next bank as
reserves, and this bank then increases loans and
deposits by 90 percent of this amount, etc.
Each bank is effectively creating new money because
each loan results in a new deposit at the next bank.
If all banks make loans equal to the increase in their
excess reserves, then the multiple expansion of
deposits is illustrated in the following table:
Bank
Increase in deposits
A
B
C
D
E
F
.
.
.
$0
$100
$90
$81
$72.90
$65.61
.
.
.
________
$1,000.00
Total
Increase in loans
$100
$90
$81
$72.90
$65.61
$59.05
.
.
.
________
$1,000.00
Increase in
reserves
$0
$10
$9
$8.10
$7.29
$6.56
.
.
.
_________
$100.00
For the whole banking system, the increase in
reserves is $100 and the increase in deposits is
$1,000. Thus, the increase in deposits is ten times
the increase in reserves.
This number 10 is called the deposit multiplier. It is
the number that tells us the amount of deposits that
can be supported by a given amount of reserves, or,
in other words, it is the number that we multiply a
change in reserves by to find the resulting change in
deposits.
Deposits = Deposit multiplier X Reserves.
(“” means “change in”)
In our example, Reserves = $100 and the multiplier
= 10. Therefore:
$1,000 = 10 X $100.
The deposit multiplier is the reciprocal of the reserve
requirement ratio, i.e.,
Deposit multiplier =
1
_________________________ .
Reserve requirement ratio
In our example, the reserve requirement ratio is 0.10.
Therefore the deposit multiplier is:
1
_____
0.10
= 10.
How do we know that the deposit multiplier is the
reciprocal of the reserve requirement ratio? If the
banks do not hold excess reserves, then,
R = rD X D, where
R = Reserves
E.g., $100 = 0.10 X $1,000.
rD = Reserve requirement ratio
D = Deposits.
Dividing both sides by rD,
1
D = ___
rD
X
R.
Taking the change () in both sides,
D
1
= ___
rD
X
R.
i.e., Deposits = Deposit multiplier X Reserves.
In our example, R = $100, rD = 0.10, therefore,
D =
1
____
0.10
X
$100
= 10 X $100 = $1,000.
We can summarize the effects of the $100 open
market purchase with a single balance sheet for the
entire banking system:
Banking system
Assets
Reserves
Loans
Securities
Liabilities
+$100
+$1,000
-$100
Deposits
+$1,000
Note that each individual bank can only create
deposits equal to its excess reserves, but the banking
system as a whole can generate a multiple expansion
of deposits.
By changing the reserve requirement ratio, the Fed
can change the deposit multiplier and thus bring
about an increase or decrease in total bank deposits
and hence in the overall money supply.
If the Fed raises the reserve requirement ratio, for
example, the deposit multiplier will decrease, which
means that any given amount of reserves or monetary
base will support less deposits, and hence less money
supply.
Conversely, if the Fed lowers the reserve requirement
ratio, the deposit multiplier will increase, meaning that
any given amount of reserves or monetary base will
support more deposits and hence more money supply.
Recall that the foregoing analysis requires that we
assume that (i) the banks lend all of their excess
reserves, and (ii) members of the nonbank public
deposit all of the proceeds of loans in deposit
accounts and do not hold any portion in currency, i.e.,
there is no currency drain from the banking system.
If either of these assumptions does not hold, the
multiple deposit expansion will be smaller than we
have indicated, i.e., the multiplier will be smaller.
In effect, the ten-fold increase in deposits, and
therefore money supply, over and above the initial
injection of monetary base, is a maximum, assuming
no excess reserve holdings and no currency drain.
Any excess reserve holdings or currency drain will
lower the multiplier below ten.