Chapter 4: The Monetary
System: What It Is and How It
Works
What Is Money?
Money: the stock of assets that can be readily used to make
transactions.
Functions of Money
Money serves three primary functions:
1. Medium of Exchange: It is what people use to buy goods and
services. The ease with which an asset can be converted into a
medium of exchange is called liquidity; money is the economy's
most liquid asset.
2. Store of Value: It is a way to transfer purchasing power from
the present to the future (It is not a perfect store of value if prices
are rising).
3. Unit of Account: It is the standard denomination of money by
which everyone measures prices and values, providing the terms
in which people quote prices and record debts.
Types of Money
1. Fiat Money: Money that has no intrinsic value, such as the
paper currency we use. it is a legal instrument for all transactions
purposes. Fiat money is money that some authority, generally a
government, has ordered to be accepted as a medium of
exchange.
2. Commodity Money: Money that has intrinsic value, meaning
it has value even if it were not used as money (e.g., gold coins
when they are used the economy is called gold standard).
Intrinsic value: real value, work of object.
Checks are not money but the funds in checking accounts are
money
Credit cards are a means of deferring payment.
Certificates of deposits or time deposits are a store of value.
They are measured in money units, but they are not readily
spendable.
The Quantity of Money and Banking
Money Supply (M)
The money supply (M) is the quantity of money available in the
economy = amount of money = quantity of money = the total value of all
assets in the economy that can be used as money.
M=C+D
Where:
C = Currency (the physical money held by the public).
D = Demand Deposits (balances in checking accounts).
Measures of Money:
M1 includes currency, checkable deposits, and traveler's
checks.
M2 includes M1 plus less liquid assets such as small savings
deposits (<100,000), money market mutual funds.
Money market mutual funds: place limits on the amounts of
the checks that can be written in a certain period.
Important Rule: Each successive measure of the money
supply (e.g., M2) is bigger and less liquid than the one it
follows.
Monetary policy: control over money supply made by the
central bank.
To control the money supply in the US, the Fed (Federal
reserve) uses open market operations (selling and purchasing
of the treasury bills and government securities by the central
bank to regulate money supply in the economy).
The Role of Banks
The money supply includes demand deposits: checking
accounts, saving/term deposit accounts, and money market
accounts.
Banks take deposits (D) from depositors
Banks also borrow money (by selling bonds). This is called
their debt
The owners of a bank must also invest their own money in
their bank. This is called the bank’s capital (or, equity)
Reserves: bank’s funds kept in the bank’s vaults (portion of
deposits that bank have not lent)
The interest: is a source of income for the bank.
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 deposit as reserves.
Money Creation: Fractional-reserve banking creates money
(but not wealth) because banks' loans are deposited, which then
become new demand deposits, thus increasing the money
supply.
Bank capital: is the resources a bank’s owners have put into
the bank
Bank Balance Sheet Components:
Assets (What the bank owns): Reserves (R), Loans, and
Securities purchases.
Liabilities & Capital (Sources of funds): Deposits (D), Debt
(borrowed money), and Bank Capital (owner's equity).
Reserves + loans + securities = deposits + debt + capital
4. Bank Capital, Leverage & Risk
4.1 Bank Capital
Owner’s equity:
Capital=Assets−Liabilities
4.2 Leverage
Use of borrowed funds (deposits + debt) to increase investments.
Leverage Ratio
Total Assets
Leverage Ratio=
Capital
High leverage → big profits if assets rise, big losses if assets fall.
Example
Assets = 1000, Capital = 50
Leverage Ratio=20
If assets fall 5%:
New assets = 950
Liabilities = 950
Capital = 0 → bank insolvent
⭐ 5. Monetary Base (B)
The monetary base or high-powered money:
B = C + R
Controlled directly by central bank.
Variables:
B = exogenous
C, D, R = endogenous
⭐ 6. The Money Multiplier (m)
Money creation depends on:
Currency–deposit ratio (cr)
Reserve–deposit ratio (rr)
Monetary base (B)
6.1 Definitions
Currency–Deposit Ratio
C
cr =
D
Measures preference for holding cash vs. deposits.
Reserve–Deposit Ratio
R
rr=
D
Determined by bank behavior + regulations.
6.2 Derivation of the Money Multiplier
C R
M =C + DB=C + Rcr = rr =
D D
Substitute:
C=crD , R=rrD
Then:
B
B=(crD)+(rrD)=D(cr +rr) D=
cr + rr
Money supply:
M =C + D=crD+ D=D (1+cr )
Substitute D:
\textbf{M = \frac{1+cr}{cr+rr} \times B}
Thus:
⭐ Money Multiplier
1+ cr
m=
cr +rr
⭐ Money Supply
M =m ⋅B
⭐ 7. How Each Variable Affects Money
Supply
1. Monetary Base (B)
B↑ ⇒ M ↑
2. Reserve Ratio (rr)
Banks lend less → creation of deposits slows.
rr ↑ ⇒ m↓ ⇒ M ↓
3. Currency Ratio (cr)
People hold cash → banks have fewer deposits.
cr ↑ ⇒ m↓ ⇒ M ↓
⭐ 8. Monetary Policy Tools
1. Open Market Operations (OMO)
Fed buys or sells government bonds.
Buy bonds → pay with new money → B ↑ → M ↑
Sell bonds → remove money → B ↓ → M ↓
OMO is most used tool.
2. Discount Rate
Rate at which banks borrow from central bank.
Lower discount rate → borrowing easier → R ↑ → B ↑ → M ↑
Higher discount rate → M ↓
3. Reserve Requirements
Minimum reserves banks must hold.
Increase RR → rr ↑ → m ↓ → M ↓
Decrease RR → M ↑
Rarely used.
4. Interest on Reserves
Fed pays interest on reserves held at central bank.
Higher interest → banks hold more reserves → m ↓ → M ↓
Lower interest → m ↑ → M ↑
⭐ 9. Why the Fed Cannot Precisely Control
M
Because part of the money creation depends on:
Banks choosing the level of excess reserves
People choosing how much cash to hold
So m ≠ constant.
⭐ 10. Case Studies
A. Quantitative Easing (QE)
Nontraditional tool:
Fed buys long-term bonds and mortgage securities.
Used when interest rates are already near 0%.
Goal: reduce long-term interest rates + stimulate credit.
But:
Banks held excess reserves after 2008 → multiplier fell.
B. Bank Failures in the 1930s
9,000 banks failed
Currency–deposit ratio ↑ sharply
Reserve–deposit ratio ↑
Money multiplier collapsed
Money supply ↓ 28%
Aggravated the Great Depression.
Today deposit insurance prevents massive bank runs.
⭐ 11. Final Chapter Summary
Money
Functions: medium, store of value, unit of account
Types: commodity vs fiat
Money Supply
M =C + D
Monetary Base
B=C + R
Money Multiplier
1+ cr
m= M =mB
cr +rr
Fed Tools
Open market operations
Discount rate
Reserve requirements
Interest on reserves