THE MONETARY SYSTEM

ETP Economics 102

Jack Wu
MONEY
 Money is the set of assets in an economy that
people regularly use to buy goods and services
from other people.
FUNCTIONS OF MONEY
 Money has three functions in the economy:
 Medium of exchange
 Unit of account
 Store of value
MEDIUM OF EXCHANGE
 Medium of Exchange
 A medium of exchange is an item that buyers give to
sellers when they want to purchase goods and
services.
 A medium of exchange is anything that is readily
acceptable as payment.
UNIT OF ACCOUNT
 Unit of Account
 A unit of account is the yardstick people use to post
prices and record debts.
STORE OF VALUE
 Store of Value
 A store of value is an item that people can use to
transfer purchasing power from the present to the
future.
LIQUIDITY
 Liquidity
 Liquidity is the ease with which an asset can be
converted into the economy’s medium of exchange.
KINDS OF MONEY
 Commodity money takes the form of a
commodity with intrinsic value.
 Examples: Gold, silver, cigarettes.
 Fiat money is used as money because of
government decree.
 It does not have intrinsic value.
 Examples: Coins, currency, check deposits.
MONEY IN THE ECONOMY
 Currency is the paper bills and coins in the
hands of the public.
 Demand deposits are balances in bank accounts
that depositors can access on demand by writing
a check.
MONEY SUPPLY
 M1
_ M1A
_ M1B
 M2
 MONEY IN THE U.S. ECONOMY

Billions
of Dollars
M2
$5,455
• Savings deposits
• Small time deposits
• Money market
mutual funds
• A few minor categories
($4,276 billion)

M1
$1,179
• Demand deposits
• Everything in M1
• Traveler’s checks
($1,179 billion)
• Other checkable deposits
($599 billion)
• Currency
($580 billion)
0

Copyright© 2003 Southwestern/Thomson Learning

ACTIVE LEARNING 1: CALCULATING M1
AND M2

Suppose the entire economy has:

• $150 dollars kept in coffee cans and
wallets
• $300 in saving accounts
• $200 in credit card limits
• $20 in traveler’s checks
• $350 in checking accounts
• $400 in money market mutual funds
Calculate M1 and M2.
ACTIVE LEARNING 1: ANSWERS, M1 AND M2
 M1 = Currency + Demand deposits + Traveler’s
checks + Other checkable deposits.
M1 = 150 + 350 + 20 + 0 = $520
 M2 = M1 + Savings deposits + Small time
deposits + Money market mutual funds + A few
minor categories.
M2 = 520 + 300 + 0 + 400 + 0 = $1,220
FEDERAL RESERVE
 The Federal Reserve (Fed) serves as the nation’s
central bank.
 It is designed to oversee the banking system.
 It regulates the quantity of money in the economy.
FEDERAL RESERVE SYSTEM
 The Structure of the Federal Reserve System:
 The primary elements in the Federal Reserve System
are:
 1) The Board of Governors
 2) The (12) Regional Federal Reserve Banks

 3) The Federal Open Market Committee

BOARD OF GOVERNORS
 The Board of Governors
 Seven members
 Appointed by the president
 Confirmed by the Senate
 Serve staggered 14-year terms so that one comes
vacant every two years.
 President appoints a member as chairman to serve a
four-year term.
FEDERAL OPEN MARKET COMMITTEE
 The Federal Open Market Committee (FOMC)
 Serves as the main policy-making organ of the
Federal Reserve System.
 Meets approximately every six weeks to review the
economy.
MONETARY POLICY
 Monetary policy is conducted by the Federal
Open Market Committee.
 Monetary policy is the setting of the money supply by
policymakers in the central bank
 The money supply refers to the quantity of money
available in the economy.
PRIMARY FUNCTIONS OF FED
 Three Primary Functions of the Fed
 Regulates banks to ensure they follow federal laws
intended to promote safe and sound banking
practices.
 Acts as a banker’s bank, making loans to banks and
as a lender of last resort.
 Conducts monetary policy by controlling the money
supply.
OPEN-MARKET OPERATIONS
 Open-Market Operations
 The money supply is the quantity of money available
in the economy.
 The primary way in which the Fed changes the
money supply is through open-market operations.
 The Fed purchases and sells U.S. government bonds.
OPEN-MARKET OPERATIONS: CONTINUED
 Open-Market Operations
 To increase the money supply, the Fed buys
government bonds from the public.
 To decrease the money supply, the Fed sells
government bonds to the public.
BANKS AND MONEY SUPPLY
 Banks can influence the quantity of demand
deposits in the economy and the money
supply.
 Reserves are deposits that banks have
received but have not loaned out.
 In a fractional-reserve banking system, banks
hold a fraction of the money deposited as
reserves and lend out the rest.
 Reserve Ratio
 The reserve ratio is the fraction of deposits that
banks hold as reserves.
MONEY CREATION
 When a bank makes a loan from its reserves,
the money supply increases.
 The money supply is affected by the amount
deposited in banks and the amount that banks
loan.
 Deposits into a bank are recorded as both assets and
liabilities.
 The fraction of total deposits that a bank has to keep

as reserves is called the reserve ratio.

 Loans become an asset to the bank.
MONEY CREATION: CONTINUED
 When one bank loans money, that money is
generally deposited into another bank.
 This creates more deposits and more reserves to
be lent out.
 When a bank makes a loan from its reserves, the
money supply increases.
MONEY MULTIPLIER
 How much money is eventually created in this
economy?
 The money multiplier is the amount of money the
banking system generates with each dollar of
reserves.
MONEY MULTIPLIER:CONTINUED
 The money multiplier is the reciprocal of the
reserve ratio:
M = 1/R
 With a reserve requirement, R = 20% or 1/5,

 The multiplier is 5.
EXAMPLE 1: CHANGES IN MONEY
SUPPLY

Suppose $1,000 of currency is in circulation.

To determine banks’ impact on money supply, we
calculate the money supply in 3 different cases:
A. No banking system
B. 100% reserve banking system (banks
hold 100% of deposits as reserves,
make no loans)
C. Fractional reserve banking system, R
= 20%
EXAMPLE 1: SOLUTION, A
A. No banking system

 Public holds the $1,000 as currency.

 Money supply = $1,000.
EXAMPLE 1: SOLUTION, B
B: 100% reserve banking system. Public
deposits the $1,000 at First National Bank
(FNB). FIRST NATIONAL BANK
Assets Liabilities
Reserves $1,000 Deposits $1,000
Loans $ 0

 FNB holds 100% of deposit as reserves

 Money supply = currency + deposits = $0 +
$1,000 = $1,000
In a 100% reserve banking system, banks do
not affect size of money supply.
EXAMPLE 1: SOLUTION, C – 1
C: Fractional reserve banking system, R = 20%
FNB loans all but 20% of the deposit to
Isabella:
FIRST NATIONAL BANK
Assets Liabilities
Reserves $200 Deposits $1,000
Loans $800
 Depositors have $1,000 in deposits, Isabella
(the borrower) has $800 in currency.
Money supply = currency + deposits = $800 +
$1,000 = $1,800 (!!!)
EXAMPLE 1: SOLUTION, C – 2
C: Fractional reserve banking system
 Isabella deposits the $800 at Second
National Bank.
 If R = 20% for SNB, it will loan all but 20%
of the deposit to Kerem, and it’s T-account
will change to:

SECOND NATIONAL BANK

SECOND NATIONAL BANK
Assets Liabilities
Assets Liabilities
Reserves $800 Deposits $800
Reserves $160 Deposits $800
Loans $ 0
Loans $640
EXAMPLE 1: SOLUTION, C – 3
C: Fractional reserve banking system
 Kerem (SNB’s borrower) deposits the $640 at
Third National Bank.
 If R = 20% for TNB, it will loan all but 20% of
the deposit to Dalia, and it’s T-account will
change to:

THIRD NATIONAL
THIRD NATIONAL BANK
BANK
Assets
Assets Liabilities
Liabilities
Reserves $128
Reserves $640 Deposits
Deposits $640
$640
Loans
Loans $512
$0
EXAMPLE 1: SOLUTION, C – 4
C: Fractional reserve banking system
The process continues, and money is
created with each new loan.
Original deposit = $1,000.00
FNB lending = $ 800.00
SNB lending = $ 640.00
TNB lending = $ 512.00
………………………………………………………….

Total money supply = $5,000.00

In this example, $1,000 of reserves generates $5,000
of money.
ACTIVE LEARNING 2: BANKS AND THE
MONEY SUPPLY

While cleaning his apartment, Hakeem finds a $50 bill

under the couch. He deposits the bill in his checking
account at Chase Bank.
The Fed’s reserve requirement is 10% of deposits.
A. What is the maximum amount that the
money supply could increase?
B. What is the minimum amount that the
money supply could increase?
C. How would your answers to A and B
change if R = 5%?
 ACTIVE LEARNING 2: ANSWERS, A

R = 10%. Hakeem deposits $50 in his checking account.

A. Maximum increase in money supply?

 If banks hold no excess reserves, then

money multiplier = 1/R = 1/0.1 = 10
 The maximum possible increase in deposits is
10 x $50 = $500
 But money supply also includes currency,
which falls by $50.
 Hence, max increase in money supply = $450.
 ACTIVE LEARNING 2: ANSWERS, B

R = 10%. Hakeem deposits $50 in his checking account.

B. Minimum increase in the money supply?

Answer: $0
 If Chase Bank makes no loans from Hakeem’s deposit,
currency falls by $50, deposits increase by $50, money
supply does not change.
 When banks hold all deposits in reserve, banks do not
influence the supply of money.
 ACTIVE LEARNING 2: ANSWERS, C

R = 5%. Hakeem deposits $50 in his checking account.

C. Maximum and minimum increase in money supply if R
= 5%?
 Money multiplier increases to 20

 If banks hold no excess reserves, the max increase in

money supply is new deposits (20 x $50) – currency ($50)
= $950.
 If banks keep all deposits in reserve, the change in money
supply is $0, regardless of R.
TOOLS OF MONEY CONTROL
 The Fed has three tools in its monetary toolbox:
 Open-market operations
 Changing the reserve requirement
 Changing the discount rate
OPEN-MARKET OPERATIONS
 Open-Market Operations
 The Fed conducts open-market operations when it
buys government bonds from or sells government
bonds to the public:
 When the Fed buys government bonds, the money supply
increases.
 The money supply decreases when the Fed sells
government bonds.
RESERVE REQUIREMENTS
 Reserve Requirements
 The Fed also influences the money supply with
reserve requirements.
 Reserve requirements are regulations on the
minimum amount of reserves that banks must hold
against deposits.
CHANGE THE RESERVE REQUIREMENT
 Changing the Reserve Requirement
 The reserve requirement is the amount (%) of a
bank’s total reserves that may not be loaned out.
 Increasing the reserve requirement decreases the money
supply.
 Decreasing the reserve requirement increases the money
supply.
CHANGE DISCOUNT RATE
 Changing the Discount Rate
 The discount rate is the interest rate the Fed charges
banks for loans.
 Increasing the discount rate decreases the money supply.
 Decreasing the discount rate increases the money supply.
PROBLEMS IN CONTROLLING MONEY
SUPPLY
 The Fed’s control of the money supply is not
precise.
 The Fed must wrestle with two problems that
arise due to fractional-reserve banking.
 The Fed does not control the amount of money
that households choose to hold as deposits in
banks.
 The Fed does not control the amount of money
that bankers choose to lend.