Chapter 4 The Monetary System: What It Is

and How It Works

 The definition, functions, and types of money
 How banks “create” money
 What a central bank is and how it controls the
money supply

Money is the stock of assets that can be

readily used to make transactions.
 Money: Functions
 Medium of exchange: we use it to buy stuff
 Store of value: transfers purchasing power from the present to the
future
 Unit of account: the common unit by which everyone measures
prices and values

Money: Types
1. Fiat money
 has no intrinsic value
 example: the paper currency we use
2. Commodity money
 has intrinsic value
 examples: gold coins, cigarettes in P.O.W. camps
 NOW YOU TRY
Discussion Question
Which of these are money?
a. Currency: Yes
b. Checks: No (The check itself is not money, but the funds in
the checking account are money)
c. Deposits in checking accounts (“demand deposits”): Yes
d. Credit cards: No. They are a means of deferred payment.
e. Certificates of deposit (“time deposits”): No. Depends on the
length of time; they are a store of value and are measured in
money units (dollars, for example) but are not easily spent
(medium of exchange)
 Federal Government Policies
 Fiscal Policy: the decision about spending, taxation, and subsidy.
 Congress: pass a budget resolution & set spending limit
 Executive Branch: collect tax, submit budget proposal, & sign/veto
 Monetary Policy: central bank activities that are directed toward the
influencing the quantity of money and credit in an economy
 The Federal Reserve Independence
 Labor Policy: minimum wage, benefit program, equality, job security, etc.
 Trade Policy: tariff, import quota, export subsidy, trade agreement, etc.
 Antitrust Policy: promote competition and prevent unjustified monopolies
 Industrial Policy: strategic efforts to promote specific industries that are
critical for national security or economic competitiveness
 Environmental Policy: emission quota, air quality regulation, pollution
prevention, carbon tax, etc.
 Roles and Goals of the Central Bank
 Roles and Powers:
 Monopoly supplier of the currency
 Banker to the government and the banker’s bank
 Lender of last resort
 Conductor of monetary policy
 Supervisor of the banking system
 Regulator of the payment system
 General Objectives:
 Low and stable inflation
 Maximum employment/economic growth
 Financial stability
 Payment security & efficiency
 (In some countries) exchange rate targeting
The Fed System
Twelve Federal Reserve Districts
Money supply measures, July 2023

Amount in July 2023

Symbol Assets Included
(billions of dollars)
C Currency outside Treasury, Fed, $ 2,338.5
and depository banks
M1 Currency plus demand deposits, 18,355.0
traveler’s checks, and other
checkable deposits
M2 M1 plus retail money market 20,783.6
mutual fund balances, saving
deposits (including money
market deposit accounts), and
small time deposits

Source: https://www.federalreserve.gov/releases/h6/current/default.htm
Banks’ role in the monetary system
 The money supply equals currency plus
demand (checking account) deposits:
M=C+D
 Since the money supply includes demand
deposits, the banking system plays an
important role.
A few preliminaries

 Reserves (R ): the portion of deposits that banks

have not lent.
 A bank’s liabilities include deposits;
assets include reserves and outstanding loans.
 100-percent-reserve banking: a system in
which banks hold all deposits as reserves.
 Fractional-reserve banking:
a system in which banks hold a fraction of their
deposits as reserves.
 Banks’ role in the monetary system
 To understand the role of banks, we will consider three
scenarios:
1. No banks
2. 100-percent-reserve banking
(banks hold all deposits as reserves)
3. Fractional-reserve banking
(banks hold a fraction of deposits as reserves, use the rest
to make loans)
 In each scenario, we assume C = $1,000.
 SCENARIO 1: No banks
 With no banks, D = 0 and M = C = $1,000.
SCENARIO 2:
100-percent-reserve banking
 Initially C = $1000, D = $0, M = $1,000.
 Now suppose households deposit the $1,000 at
“Firstbank.”
 After the deposit:
C = $0,
FIRSTBANK’S
D = $1,000,
balance sheet
M = $1,000
Assets Liabilities
reserves $1,000 deposits $1,000
 LESSON:
100%-reserve
banking has no
impact on size of
money supply.
SCENARIO 3:
Fractional-reserve banking
 Suppose banks hold 20% of deposits in reserve,
making loans with the rest.
 Firstbank will make $800 in loans. The money supply
now equals $1,800:
FIRSTBANK’S  Depositor has
$1,000 in
balance sheet
demand deposits.
Assets Liabilities
 Borrower holds
reserves $1,000
$200 deposits $1,000 $800 in currency.
loans $800

In a fractional-reserve banking system, banks create money.

SCENARIO 3:
Fractional-reserve banking
 Suppose the borrower deposits the $800 in
Secondbank.
 Initially, Secondbank’s balance sheet is:
SECONDBANK’S  Secondbank will
balance sheet loan 80% of this
Assets Liabilities deposit.
$800 deposits $800
reserves $160
loans $0
$640
SCENARIO 3:
Fractional-reserve banking
 If this $640 is eventually deposited in Thirdbank,
 Then Thirdbank will keep 20% of it in reserve
and loan the rest out:

THIRDBANK’S
balance sheet
Assets Liabilities
$640 deposits $640
reserves $128
loans $0
$512
Finding the total amount of money:

Original deposit = $1000

+ Firstbank lending = $ 800
+ Secondbank lending = $ 640
+ Thirdbank lending = $ 512
+ other lending…

Total money supply = (1/rr ) × $1,000

where rr = ratio of reserves to deposits
In our example, rr = 0.2, so M = $5,000
Money creation in the banking system

A fractional-reserve banking system creates

money, but it doesn’t create wealth:
Bank loans give borrowers some new money
and an equal amount of new debt.
Bank capital, leverage, and capital
requirements
 Bank capital: the resources a bank’s owners have
put into the bank
 A more realistic balance sheet:

Liabilities and
Assets
Owners’ Equity
Reserves $200 Deposits $750

Loans 500 Debt 200

Capital
Securities 300 50
(owners’ equity)
Bank capital, leverage, and capital
requirements
 Leverage: the use of borrowed money to supplement
existing funds for purposes of investment
 Leverage ratio = assets/capital
= $(200 + 500 + 300)/$50 = 20
Liabilities and
Assets
Owners’ Equity
Reserves $200 Deposits $750

Loans 500 Debt 200

Capital
Securities 300 50
(owners’ equity)
Bank capital, leverage, and capital
requirements
 Being highly leveraged makes banks vulnerable.
 Example: Suppose a recession causes our bank’s
assets to fall by 5%, to $950.
 Then, capital = assets – liabilities = 950 – 950 = 0
Liabilities and
Assets
Owners’ Equity
Reserves $200 Deposits $750

Loans 500 Debt 200

Capital
Securities 300 50
(owners’ equity)
Bank capital, leverage, and capital
requirements
Capital requirement:
 minimum amount of capital mandated by regulators
 intended to ensure banks will be able to pay off
depositors
 higher for banks that hold more risky assets
2008-2009 financial crisis:
 Losses on mortgages shrank bank capital, slowed
lending, exacerbated the recession.
 Government injected billions of dollars of capital into
banks to ease the crisis and encourage more lending.
 A model of the money supply
 Monetary base, B = C + R
controlled by the central bank (exogenous variables)
 Reserve-deposit ratio, rr = R/D
depends on regulations & bank policies
 Currency-deposit ratio, cr = C/D
depends on households’ preferences
 Solving for the money supply:

where
The money multiplier

 where
 If rr < 1, then m > 1
 If monetary base changes by ΔB,
then ΔM = m × ΔB
 m is the money multiplier,
the increase in the money supply
resulting from a one-dollar increase
in the monetary base.
 NOW YOU TRY
The money multiplier
where
Suppose households decide to hold more of their money as currency
and less in the form of demand deposits.

1. Determine impact on money supply.

2. Explain the intuition for your result.

Impact of an increase in the currency-deposit ratio Δcr > 0.
3. An increase in cr increases the denominator of m proportionally
more than the numerator. So m falls, causing M to fall.
4. If households deposit less of their money, then banks can’t make
as many loans, so the banking system won’t be able to
create as much money.
The instruments of monetary policy
The Fed can change the monetary base using:
 open market operations (the Fed’s preferred method): To
increase B, the Fed could buy government bonds, paying
with new dollars.
 the discount rate: the interest rate the Fed charges on loans
to banks: To increase B, the Fed could lower the discount
rate, encouraging banks to borrow more reserves.
The Fed can change the reserve-deposit ratio using:
 reserve requirements: Fed regulations that impose a
minimum rr: To reduce the reserve-deposit ratio, the Fed
could reduce rr.
 interest on reserves: the Fed pays interest on bank
reserves deposited with the Fed: To reduce the reserve-
deposit ratio, the Fed could pay a lower interest rate on
reserves.
The instruments of monetary policy
 1. open market operation
 Purchase government bonds: B↑ ⇒ M↑
 Sell government bonds: B↓ ⇒ M↓
 2. discount rate on reserve↑ ⇒ B↓ ⇒ M↓
discount rate on reserve↓ ⇒ B↑ ⇒ M↑
 3. minimum reserve-deposit ratio↑ ⇒ rr↑⇒ m↓ ⇒ M↓
minimum reserve-deposit ratio↓ ⇒ rr↓ ⇒ m↑ ⇒ M↑
 4. interest rate on reserve↑ ⇒ rr↑⇒ m↓ ⇒ M↓
interest rate on reserve↓ ⇒ rr↓ ⇒ m↑ ⇒ M↑
 Additional Fed Policy Instruments
 Not all financial institutions have direct access to place reserves at
Fed. A repurchase agreement (repo): A dealer sells government
securities to investors, usually on an overnight basis, and buys them
back in a short period of time at a slightly higher price.
 Repos ⇒ Fed purchases & resells ⇒ similar to Fed issuing a loan to
the banking system ⇒ adds temporary liquidity
 Reverse Repos ⇒ Fed sells & repurchases ⇒ similar to Fed taking
out a loan from the banking system ⇒ temporarily drains liquidity
 Fed sets the annualized rates of Repo & Reverse Repo to achieve
its target federal funds rate range.
 Term Deposit Facility: Fed offers interest-bearing term deposits to
eligible institutions. An increase in term deposits drains the reserve
balances from the banking system.
Why the Fed can’t precisely control M

 where
 Households can change cr,
causing m and M to change.
 Banks often hold excess reserves
(reserves above the reserve requirement).
If banks change their excess reserves,
then rr, m, and M change.
CASE STUDY: Quantitative Easing

 From 8/2008 to 8/2011,  From 1/2020 to 1/2021,

the monetary base tripled, the monetary base increased by
but M2 grew only about 22%. 52%, M2 grew only about 25%.
CASE STUDY:
Quantitative Easing
 Quantitative easing: the Fed bought long-term government
bonds instead of Treasury-bills to reduce long-term rates.
 The Fed also bought mortgage-backed securities to help
the housing market.
 In 2020, the Fed started buying state and local government
debt and corporate debt.
 But after losses on bad loans, banks tightened lending
standards and increased excess reserves, causing money
multiplier to fall.
 If banks start lending more as economy recovers, rapid
money growth may cause inflation. To prevent, the Fed is
considering various “exit strategies.”