MONEY, BANKS, AND
THE FEDERAL RESERVE
10
CHAPTER
Objectives
After studying this chapter, you will able to
 Define money and describe its functions
 Explain the economic functions of banks and other
depository institutions and describe how they are
regulated
 Explain how banks create money
 Describe the structure of the Federal Reserve System
(the Fed), and the tools used by the Fed to conduct
monetary policy
 Explain what an open market operation is, how it works,
and how it changes the quantity of money
Money makes the World Go Around
Money has taken many forms; what is money now?
What do banks do, and can they create money?
What is the Fed and what does it do?
How does the Fed ensure that the economy has the right
amount of money to function properly?
What is Money?
Money is any commodity or token that is generally
acceptable as a means of payment.
A means of payment is a method of settling a debt.
Money has three other functions:
 Medium of exchange
 Unit of account
 Store of value
What is Money?
Medium of Exchange
A medium of exchange is an object that is generally
accepted in exchange for goods and services.
In the absence of money, people would need to exchange
goods and services directly, which is called barter.
Barter requires a double coincidence of wants, which is
rare, so barter is costly.
Unit of Account
A unit of account is an agreed measure for stating the
prices of goods and services.
What is Money?
Store of Value
As a store of value, money can be held for a time and later
exchanged for goods and services.
Money in the United States Today
Money in the United States consists of
 Currency
 Deposits at banks and other depository institutions
Currency is the general term for bills and coins.
What is Money?
The two main official measures of money in the United
States are M1 and M2.
M1 consists of currency outside banks, traveler’s checks,
and checking deposits owned by individuals and
businesses.
M2 consists of M1 plus time deposits, savings deposits,
and money market mutual funds and other deposits.
What is Money?
Figure 10.1 illustrates the
composition of these two
measures in 2001 and
shows the relative
magnitudes of the
components of money.
What is Money?
The items in M1 clearly meet the definition of money; the
items in M2 do not do so quite so clearly but still are quite
liquid.
Liquidity is the property of being instantly convertible into
a means of payment with little loss of value.
Checkable deposits are money, but checks are not–
checks are instructions to banks to transfer money.
Credit cards are not money. Credit cards enable the holder
to obtain a loan quickly, but the loan must be repaid with
money.
Depository Institutions
A depository institution is a firm that accepts deposits
from households and firms and uses the deposits to make
loans to other households and firms.
The deposits of three types of depository institution make
up the nation’s money:
 Commercial banks
 Thrift institutions
 Money market mutual funds
Depository Institutions
Commercial Banks
A commercial bank is a private firm that is licensed to
receive deposits and make loans.
A commercial bank’s balance sheet summarizes its
business and lists the bank’s assets, liabilities, and net
worth.
The objective of a commercial bank is to maximize the net
worth of its stockholders.
Depository Institutions
To achieve its objective, a bank makes risky loans at an
interest rate higher than that paid on deposits.
But the banks must balance profit and prudence; loans
generate profit, but depositors must be able to obtain their
funds when they want them.
So banks divide their funds into two parts: reserves and
loans.
Reserves are the cash in a bank’s vault and deposits at
Federal Reserve Banks.
Bank lending takes the form of liquid assets, investment
securities, and loans.
Depository Institutions
Thrift Institutions
The thrift institutions are
 Savings and loan associations
 Savings banks
 Credit unions.
Depository Institutions
A savings and loan association (S&L) is a depository
institution that accepts checking and savings deposits and
that make personal, commercial, and home-purchase
loans.
A savings bank is a depository institution owned by its
depositors that accepts savings deposits and makes
mainly mortgage loans.
A credit union is a depository institution owned by its
depositors that accepts savings deposits and makes
consumer loans.
Depository Institutions
Money Market Mutual Funds
A money market fund is a fund operated by a financial
institution that sells shares in the fund and uses the
proceeds to buy liquid assets such as U.S. Treasury bills.
Depository Institutions
The Economic Functions of Depository Institutions
Depository institutions make a profit from the spread
between the interest rate they pay on their deposits and
the interest rate they charge on their loans.
This spread exists because depository institutions
 Create liquidity
 Minimize the cost of obtaining funds
 Minimize the cost of monitoring borrowers
 Pool risk
Financial Regulation, Deregulation, and
Innovation
Financial Regulation
Depository institutions face two types of regulations
 Deposit insurance
 Balance sheet rules
Financial Regulation, Deregulation, and
Innovation
Deposits at banks, S&Ls, savings banks, and credit unions
are insured by the Federal Deposit Insurance Corporation
(FDIC).
This insurance guarantees deposits in amounts of up to
$100,000 per depositor.
This guarantee gives depository institutions the incentive
to make risky loans because the depositors believe their
funds to be perfectly safe; because of this incentive
balance sheet regulations have been established.
Financial Regulation, Deregulation, and
Innovation
There are four main balance sheet rules
 Capital requirements
 Reserve requirements
 Deposit rules
 Lending rules
Financial Regulation, Deregulation, and
Innovation
Deregulation in the 1980s and 1990s
During the 1980s many restrictions on depository
institutions were lifted and distinctions between banks and
others depository institutions ended.
In 1994 the Riegle-Neal Interstate Banking and Branching
Efficiency Act was passed, which permits U.S. banks to
establish branches in any state.
This change in the law led to a wave of bank mergers.
Financial Regulation, Deregulation, and
Innovation
Financial Innovation
The 1980s and 1990s have been marked by financial
innovation—the development of new financial products
aimed at lowering the cost of making loans or at raising
the return on lending.
Financial innovation occurred for three reasons
 The economic environment--high inflation
 Massive technological change
 Avoid regulation
Financial Regulation, Deregulation, and
Innovation
Deregulation, Innovation, and Money
The combination of deregulation and innovation has
produced large changes in the composition of money, both
M1 and M2.
How Banks Create Money
Reserves: Actual and Required
The fraction of a bank’s total deposits held as reserves is
the reserve ratio.
The required reserve ratio is the fraction that banks are
required, by regulation, to keep as reserves. Required
reserves are the total amount of reserves that banks are
required to keep.
Excess reserves equal actual reserves minus required
reserves.
How Banks Create Money
Creating Deposits by Making Loans
To see how banks create deposits by making loans,
suppose the required reserve ratio is 25 percent.
A new deposit of $100,000 is made.
The bank keeps $25,000 in reserve and lends $75,000.
This loan is credited to someone’s bank deposit.
The person spends the deposit and another bank now has
$75,000 of extra deposits.
This bank keeps $18,750 on reserve and lends $56,250.
How Banks Create Money
The process
continues and
keeps repeating
with smaller and
smaller loans at
each “round.”
Figure 10.2
illustrates the
money creation
process.
The Federal Reserve System
The Federal Reserve System, or the Fed, is the central
bank of the United States.
A central bank is the public authority that regulates a
nation’s depository institutions and controls the quantity of
money.
The Federal Reserve System
The Fed’s Goals and Targets
The Fed conducts the nation’s monetary policy, which
means that it adjusts the quantity of money in circulation.
The Fed’s goals are to keep inflation in check, maintain full
employment, moderate the business cycle, and contribute
toward achieving long-term growth.
In pursuit of its goals, the Fed pays close attention to
interest rates and sets a target that is consistent with its
goals for the federal funds rate, which is the interest rate
that the banks charge each other on overnight loans of
reserves.
The Federal Reserve System
The Structure of the Fed
The key elements in the structure of the Fed are
 The Board of Governors
 The regional Federal Reserve banks
 The Federal Open Market Committee.
The Federal Reserve System
The Board of Governors has seven members appointed
by the president of the United States and confirmed by the
Senate.
Board terms are for 14 years and overlap so that one
position becomes vacant every 2 years.
The president appoints one member to a (renewable) fouryear term as chairman.
Each of the 12 Federal Reserve Regional Banks has a
nine-person board of directors and a president.
The Federal Reserve System
Figure 10.3 shows
the regions of the
Federal Reserve
System.
The Federal Reserve System
The Federal Open Market Committee (FOMC) is the
main policy-making group in the Federal Reserve System.
It consists of the members of the Board of Governors, the
president of the Federal Reserve Bank of New York, and
the 11 presidents of other regional Federal Reserve banks
of whom, on a rotating basis, 4 are voting members.
The FOMC meets every six weeks to formulate monetary
policy.
The Federal Reserve System
Figure 10.4 summarizes the Fed’s
structure and policy tools.
The Federal Reserve System
The Fed’s Power Center
In practice, the chairman of the Board of Governors (since
1987 Alan Greenspan) is the center of power in the Fed.
He controls the agenda of the Board, has better contact
with the Fed’s staff, and is the Fed’s spokesperson and
point of contact with the federal government and with
foreign central banks and governments.
The Federal Reserve System
The Fed’s Policy Tools
The Fed uses three monetary policy tools
 Required reserve ratios
 The discount rate
 Open market operations
The Federal Reserve System
The Fed sets required reserve ratios, which are the
minimum percentages of deposits that depository
institutions must hold as reserves.
The Fed does not change these ratios very often.
The discount rate is the interest rate at which the Fed
stands ready to lend reserves to depository institutions.
An open market operation is the purchase or sale of
government securities—U.S. Treasury bills and bonds—by
the Federal Reserve System in the open market.
The Federal Reserve System
The Fed’s Balance Sheet
On the Fed’s balance sheet, the largest and most
important asset is U.S. government securities.
The most important liabilities are Federal Reserve notes in
circulation and banks’ deposits.
The sum of Federal Reserve notes, coins, and banks’
deposits at the Fed is the monetary base.
Controlling the Quantity of Money
How Required Reserve Ratios Work
An increase in the required reserve ratio boosts the
reserves that banks must hold, decreases their lending,
and decreases the quantity of money.
How the Discount Rate Works
An increase in the discount rate raises the cost of
borrowing reserves from the Fed, decreases banks’
reserves, which decreases their lending and decreases
the quantity of money.
Controlling the Quantity of Money
How an Open Market Operation Works
When the Fed conducts an open market operation by
buying a government security, it increases banks’
reserves.
Banks loan the excess reserves.
By making loans, they create money.
The reverse occurs when the Fed sells a government
security.
Controlling the Quantity of Money
Although the details differ, the ultimate process of how an
open market operation changes the money supply is the
same regardless of whether the Fed conducts its
transactions with a commercial bank or a member of the
public.
An open market operation that increases banks’ reserves
also increases the monetary base.
Controlling the
Quantity of Money
Figure 10.5 illustrates both
types of open market
operation.
Controlling the Quantity of Money
Bank Reserves, the Monetary Base, and the Money
Multiplier
The money multiplier is the amount by which a change in
the monetary base is multiplied to calculate the final
change in the money supply.
An increase in currency held outside the banks is called a
currency drain.
Such a drain reduces the amount of banks’ reserves,
thereby decreasing the amount that banks can loan and
reducing the money multiplier.
Controlling the Quantity of Money
The money multiplier differs from the deposit multiplier.
The deposit multiplier shows how much a change in
reserves affects deposits.
The money multiplier shows how much a change in the
monetary base affects the money supply.
Controlling the Quantity of Money
The Multiplier Effect of an Open Market Operation
When the Fed conducts an open market operation, the
ultimate change in the money supply is larger than the
initiating open market operation.
Banks use excess reserves from the open market
operation to make loans so that the banks where the loans
are deposited acquire excess reserves which they, in turn,
then loan.
Controlling the Quantity of Money
Figure 10.6 illustrates a round in the multiplier process
following an open market operation.
Controlling the Quantity of Money
Figure 10.7 illustrates the multiplier effect of an open
market operation.
Controlling the Quantity of Money
The Size of the Multiplier
To calculate the size of the money multiplier, first define:
R = reserves
C = currency in circulation
D = deposits
M = quantity of money
B = monetary base
c = ratio of currency to deposits
r = required reserve ratio
Controlling the Quantity of Money
The quantity of money, M, is:
M = C + D = (1 + c)  D
The monetary base, B, is:
B = R + C = (r + c)  D
Divide the first equation above by the second one to get:
M/B = (1 + c)/(r + c)
or
M = [(1 + c)/(c + r)]  B
Controlling the Quantity of Money
The money multiplier is [(1 + c)/(c + r)]—the amount by
which a change in B is multiplied to determine the
resulting change in M.
With c = 0.5 and r = 0.1, the money multiplier is
1.5/0.6 = 2.5.
THE END