Chapter 14: Banks, Money & the

Federal Reserve
Macroeconomics, 9th Edition — Hubbard
Complete Study Notes

📌 Chapter Overview: This chapter covers: (1) What money is and its 4 functions, (2) How
the U.S. measures its money supply, (3) How banks create money through lending, (4) The
role of the Federal Reserve, and (5) The Quantity Theory of Money.
Section 14.1 — What Is Money and Why Do We Need
It?
The Problem Before Money: Barter
Before money existed, people traded through barter — directly exchanging goods/services for
other goods/services. This required a double coincidence of wants: both parties had to want
exactly what the other had, at the same time. This was extremely inefficient.

Definition of Money
📚 Definition: Money is any asset that people are generally willing to accept in exchange for
goods/services or for payment of debts.

An asset is anything of value owned by a person or firm.

Commodity Money vs. Fiat Money

Early societies used commodity money — goods used as money that also have independent
value (e.g., gold, silver, animal skins, cowrie shells, cigarettes in prisons). The existence of
commodity money allowed specialization and made trade easier.

Over time, paper money emerged (starting in China in the 10th century), initially backed by gold.
Today, all modern currencies are fiat money:

📚 Definition: Fiat money is money authorized by a central bank or government that does
NOT need to be exchanged for gold or any commodity. Its value rests entirely on public
trust.

Fiat money advantage: Central banks have more flexibility in creating money.
Fiat money risk: If people lose confidence in the currency, it loses its value.

The 4 Functions of Money

Term Definition
Medium of Exchange Money is accepted by most people as payment for
goods/services. Eliminates the need for barter.
Unit of Account Money provides a standard measure of value, making it easy to
compare prices across goods.
Store of Value Money allows people to save purchasing power for later. It is
especially useful because it is liquid (easily converted to goods).
Standard of Deferred Money facilitates exchanges across time (e.g., loans, installment
Payment plans) because its future value is somewhat predictable.

What Makes a Good Money? (Key Characteristics)

• Acceptable to most people
• Standardized quality — any two units are identical
• Durable — doesn’t wear out quickly
• Valuable relative to weight — easy to carry large amounts
• Divisible — can be broken into small amounts for low-cost purchases

Real-World Applications
🎯 Apply the Concept: Some businesses (like Dig Inn in Manhattan in 2017) refuse cash,
requiring digital payment. This is LEGAL — firms are not required to accept currency.
Countries like Sweden are nearly cashless. The COVID-19 pandemic accelerated cashless
payments.
Section 14.2 — How Is Money Measured in the U.S.?
Two Main Measures: M1 and M2
The U.S. Federal Reserve uses two primary definitions of the money supply:

Term Definition
M1 (Narrow) Currency in circulation + Checking account deposits + Savings
account deposits. As of Sept 2023: ~$18.1 trillion.
M2 (Broad) M1 + Small-denomination time deposits + Non-institutional
money market fund shares. As of Sept 2023: ~$20.8 trillion.

Key Facts About U.S. Currency

• Only ~13% of M1 (~$2.3 trillion) is physical currency — about $6,600 per U.S. resident.
• 75% of U.S. paper currency is $100 bills — the largest denomination in circulation.
• U.S. holds unusually high amounts of cash globally, partly because people in other
countries hold dollars when they distrust their local currency or to support underground
economies.

Debit Cards vs. Credit Cards

⚠️Important: Debit cards directly access your checking account balance. The CARD is not
money — the balance is. Credit cards are short-term loans — they do NOT represent
money until the loan is repaid.

Is Bitcoin Money?
Bitcoin is a decentralized digital currency not issued by any government. It can be traded for
other currencies and accepted by some vendors. Currently NOT included in official money
supply measures (M1/M2), but may be in the future if it gains widespread adoption.
Section 14.3 — How Do Banks Create Money?
Banks as Businesses
Banks are profit-making firms. They earn money by paying depositors a low interest rate, and
charging borrowers a higher interest rate. Their balance sheets list:
• Assets: Reserves, loans, securities, buildings, other assets
• Liabilities: Customer deposits, short-term borrowing, long-term debt

Why Do We Need Banks? (Economic Role)

Rather than borrowing and lending directly from each other, people use banks for two key
reasons:
• Reduce transaction costs: Banks use economies of scale and specialization (loan
evaluation, legal documentation) to process transactions cheaply.
• Reduce information problems: Banks deal with asymmetric information — situations
where borrowers know more about their risk than lenders do. Banks use statistical
analysis and relationship banking to assess creditworthiness.

Reserves
📚 Definition: Reserves are deposits a bank keeps as cash in its vault or on deposit with
the Federal Reserve. Banks do NOT keep 100% of deposits as reserves — they lend out
most of it (fractional reserve banking).

Historical note: The Fed previously required banks to hold 10% of checking deposits as required
reserves. In March 2020, the Fed reduced this to 0%. In Pakistan, the required reserve ratio is
currently 5% (as of Jan 2026).

The Money Creation Process (Step-by-Step)

Here is how banks create money through lending:

You deposit $1,000 cash at Bank of America. Its reserves increase by $1,000,
Step
1
deposits increase by $1,000. Net change in money supply = $0 (cash leaves
circulation, deposits increase).

Step Bank of America keeps 10% ($100) as reserves, lends out $900. A new $900
2 checking account deposit is created. Money supply INCREASES by $900.

Step The $900 gets spent and deposited at PNC Bank. PNC keeps 10% ($90) and lends
3 out $810. Money supply increases again.
 Step This process continues — called the multiple expansion of deposits. The original
4 $1,000 deposit can generate much more money in the banking system.

💡 Key Insight: This system is called fractional reserve banking. Banks create money not
by printing it, but by making loans that become new deposits.

The Money Multiplier

The money multiplier = Money Supply (M) ÷ Monetary Base (B)
Monetary Base = Currency in Circulation + Reserves
The multiplier was stable from the mid-1990s through 2007, but has become unstable since
then. Because of this, the Fed now focuses on controlling interest rates rather than directly
controlling the money supply.

Interest on Reserve Balances (IORB)

• Before 2008: Fed did NOT pay interest on reserves → Scarce-reserves regime (banks
held minimal reserves).
• From Oct 2008: Fed began paying IORB → Ample-reserves regime (banks now hold far
more reserves than required).

Why Does the Money Multiplier Fluctuate?

• Changes in bank reserve behavior: When banks lend more, they create more deposits,
raising the multiplier.
• Changes in public cash-holding: If people hold more physical cash, less is available for
banks to lend, reducing the multiplier.
Section 14.4 — The Federal Reserve System
Bank Runs and Bank Panics
Term Definition
Bank Run Many depositors simultaneously try to withdraw their money
from a bank, fearing it will fail. This can become self-fulfilling.
Bank Panic Many banks experience bank runs at the same time, threatening
the entire financial system.

📊 Real Example: Silicon Valley Bank (SVB) had $200B+ in assets on March 8, 2023 —
and collapsed just 2 days later on March 10, 2023, taken over by the FDIC. This was a
classic bank run by large depositors whose balances exceeded FDIC insurance limits.

History of the Federal Reserve

The U.S. experienced multiple bank panics in the late 1800s–early 1900s. In response,
Congress established the Federal Reserve System in 1914.
• The Fed acts as lender of last resort — it makes emergency loans to banks, preventing
panic by assuring depositors their money is safe.
• During the Great Depression (1930s), the Fed refused to lend to many struggling banks
→ 9,000+ banks failed. Many economists blame this for worsening the Depression.
• In 1934, Congress created the FDIC (Federal Deposit Insurance Corporation) to insure
deposits up to $250,000 per account.

Structure of the Federal Reserve

Term Definition
Board of Governors 7 members appointed by the President for 14-year non-
renewable terms. Oversees the entire Fed. Chair serves 4-year
renewable term (Jerome Powell as of 2023).
12 District Banks Divide the U.S. into 12 regions, providing services to local
banks.
FOMC Federal Open Market Committee — 12 members (7 Governors +
NY Fed President + 4 rotating district presidents). Meets 8x/year.
Controls monetary policy and open market operations.
Monetary Policy Tools
1. Open Market Operations (Most Common Tool)
• Buy Treasury securities → injects money into the banking system → increases money
supply → lowers interest rates.
• Sell Treasury securities → removes money from the banking system → decreases
money supply → raises interest rates.
• Can be done quickly and is easily reversible.

2. Discount Rate
The interest rate the Fed charges banks for discount loans (emergency borrowing). Lowering
the discount rate encourages borrowing, increasing the money supply.

Moral Hazard in Banking

When a bank fails, regulators face a dilemma:
• Preventing panic: Protecting all depositors (even those above $250K) prevents a wider
crisis.
• Avoiding moral hazard: If banks know they’ll be bailed out, managers may take
excessive risks.

After SVB’s 2023 failure, the FDIC protected all depositors, including those above the $250K
limit — preventing panic but potentially encouraging future risky behavior.

The Shadow Banking System

Since the 1990s, non-bank financial institutions have become major sources of credit:
Term Definition
Investment Banks Don't take household deposits; create/trade securities like
mortgage-backed securities. Example: Goldman Sachs.
Money Market Mutual Sell shares to investors; invest in short-term Treasury bills and
Funds commercial paper.
Hedge Funds Raise money from wealthy investors for high-risk, non-standard
investments.

📚 Definition: Securitization is the process of transforming loans (like mortgages) into

tradable securities. This allows banks to sell off their loans rather than holding them,
spreading risk throughout the system — a key factor in the 2007–2009 financial crisis.
Bank Regulation
Banks are regulated by multiple bodies: the Fed, FDIC, state regulators, and the Office of the
Comptroller of the Currency. One key requirement is the Liquidity Coverage Ratio (LCR) —
banks must hold enough high-quality liquid assets to cover expected cash outflows even under
stress.
Section 14.5 — The Quantity Theory of Money
Historical Background
In the 16th century, Spain brought massive amounts of gold and silver from the Americas to
Europe. This increased the money supply and caused persistent price inflation — one of the first
documented connections between money supply and price levels.

The Quantity Equation (Irving Fisher, early 20th century)

The Quantity Equation: M × V = P × Y where: M = Money Supply V = Velocity of Money
(how many times each dollar is spent per year) P = Price Level Y = Real Output (Real GDP)

Term Definition
M (Money Supply) Measured using M2
V (Velocity) How many times, on average, each dollar is used to buy goods
in GDP. Calculated as: V = (P × Y) ÷ M = Nominal GDP ÷ M
P (Price Level) Measured using the GDP deflator
Y (Real Output) Measured using Real GDP

Example (2022): V = Nominal GDP ÷ M2 ≈ a value calculable from the data.

The Quantity Theory of Money

📚 Definition: The Quantity Theory of Money assumes that the velocity of money (V) is
constant. If V is constant, then any increase in M relative to Y must cause inflation (a rise in
P).

Deriving the Inflation Rate

Converting the quantity equation to growth rates:
Growth rate of M + Growth rate of V = Inflation rate + Growth rate of Y
Since V is assumed constant (growth rate of V = 0), we get:
Inflation Rate = Growth Rate of Money Supply − Growth Rate of Real GDP
Predictions of the Quantity Theory
• If money supply grows FASTER than real GDP → Inflation
• If money supply grows SLOWER than real GDP → Deflation
• If money supply grows at THE SAME RATE as real GDP → Stable prices

Note: Velocity is NOT perfectly constant in the real world. But the theory still holds as a long-run
insight: sustained inflation is caused by money supply growing faster than real GDP.

Hyperinflation
📚 Definition: Hyperinflation = inflation exceeding 50% per month. Caused by central banks
printing money far faster than real GDP grows, often to finance government spending.

Term Definition
Zimbabwe (2000s) Prices rose more than 10,000% per year. By 2008, inflation hit
15 billion percent.
Venezuela (2019) Inflation exceeded 2 million percent.
Germany (1922–1923) After WWI, Germany was forced to pay war reparations. Unable
to do so from taxes, they had the Reichsbank print money. The
German price index rose from 1,440 to 126,160,000,000,000 —
wiping out all savings held in German marks.

Hyperinflation is consistently associated with slow economic growth or severe recession.

Key Terms — Quick Reference

Term Definition
Money Any asset widely accepted as payment for goods, services, or
debts.
Commodity Money Money with intrinsic value (e.g., gold, silver).
Fiat Money Government-issued currency not backed by a physical
commodity.
M1 Narrow money supply: currency + checking + savings deposits.
M2 Broad money supply: M1 + time deposits + money market funds.
Fractional Reserve Banks hold only a fraction of deposits as reserves, lending the
Banking rest.
Monetary Base Currency in circulation + Bank reserves held at the Fed.
Money Multiplier Ratio of money supply to monetary base (M ÷ B).
Federal Reserve (Fed) The central bank of the United States (est. 1914).
Bank Run Mass withdrawal of deposits by fearful depositors.
FDIC Federal Deposit Insurance Corporation; insures deposits up to
$250,000.
Open Market Operations Fed buying/selling Treasury securities to control money supply.
Discount Rate Interest rate the Fed charges banks for emergency loans.
FOMC Federal Open Market Committee; sets U.S. monetary policy.
Securitization Converting loans into tradable financial securities.
Lender of Last Resort The Fed’s role: providing emergency credit to prevent bank
panics.
Velocity of Money (V) Average number of times each dollar is spent per year in GDP
transactions.
Quantity Theory Theory that V is constant, so M growth directly drives inflation.
Hyperinflation Extremely high inflation (50%+ per month), usually from money
printing.
Moral Hazard Risk that protecting banks encourages future reckless behavior
by bank managers.
Asymmetric Information When one party to a transaction knows more than the other
(e.g., borrowers know more about their risk than lenders).
Reserves (Bank) Cash in vault + deposits held at the Federal Reserve.
IORB Interest on Reserve Balances — the Fed pays banks interest on
reserves held at the Fed.