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How does the Fed create money
and regulate it?
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The Monetary System
11
CHAPTER CHECKLIST
When you have completed your
study of this chapter, you will be able to
1 Define money and describe its functions.
2 Describe the functions of banks.
3 Describe the functions of the Federal Reserve
System (the Fed).
4 Explain how the banking system creates money and
how the Fed controls the quantity of money.
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11.1 WHAT IS MONEY?
< Definition of Money
Money is any commodity or token that is generally
accepted as a means of payment.
A Commodity or Token
Money is something that can be recognized.
Money can be divided up into small parts.
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11.1 WHAT IS MONEY?
Generally Accepted
Money can be used to buy anything and everything.
Means of Payment
A means of payment is a method of settling a debt.
<The Functions of Money
Money performs three vital functions:
• Medium of exchange
• Unit of account
• Store of value
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11.1 WHAT IS MONEY?
Medium of Exchange
Medium of exchange is a object that is generally
accepted in return for goods and services.
Without money, you would have to exchange goods and
services directly for other goods and services—an
exchange called barter.
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11.1 WHAT IS MONEY?
Unit of Account
A unit of account is an
agreed-upon measure for
stating the prices of goods
and services.
Table 11.1 shows how a
unit of account simplifies
price comparisons.
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11.1 WHAT IS MONEY?
Store of Value
A store of value is any commodity or token that can be
held and exchanged later for goods and services.
The more stable the value of a commodity or token, the
better it can act as a store of value and the more useful it
is as money.
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11.1 WHAT IS MONEY?
< Money Today
Money in the world today is called fiat money.
Fiat money is objects that are money because the law
decrees or orders them to be money.
The objects that we use as money today are
• Currency
• Deposits at banks and other financial institutions
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11.1 WHAT IS MONEY?
Currency
The notes (dollar bills) and coins that we use in the
United States today are known as currency.
Notes are money because the government declares
them to be with the words printed on every dollar bill:
“This note is legal tender for all debts, public and
private.”
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11.1 WHAT IS MONEY?
Deposits
Deposits at banks, credit unions, savings banks, and
savings and loan associations are also money.
Deposits are money because they can be converted
into currency on demand and are used directly to
make payments.
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11.1 WHAT IS MONEY?
Currency Inside Banks Is Not Money
Bank deposits are one form of money, and currency
outside the banks is another form.
Currency inside the banks is not money.
When you get some cash from the ATM, you convert
your bank deposit into currency.
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11.1 WHAT IS MONEY?
< Official Measures of Money: M1 and M2
M1 consists of currency by individuals and businesses,
traveler’s checks, and checkable deposits owned by
individuals and businesses.
M2 consists of M1 plus savings deposits and small time
deposits, money market funds, and other deposits.
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11.1 WHAT IS MONEY?
Figure 11.1 shows two
measures of money.
M1
• Currency and
traveler’s checks
• Checkable deposits
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11.1 WHAT IS MONEY?
M2
• M1
• Savings deposits
• Small time
deposits
• Money market
funds and other
deposits
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11.1 WHAT IS MONEY?
Are M1 and M2 Means of Payment?
The test of whether something is money is whether it is
generally accepted as a means of payment.
M1 passes this test and is money.
Some savings deposits in M2 are just as much a means
of payment as the checkable deposits in M1.
Other savings deposits, time deposits, and money
market funds are not instantly convertible and are not a
means of payment.
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11.1 WHAT IS MONEY?
< Checks, Credit Cards, Debit Cards and
Mobile Wallets
Checks
A check is not money. It is an instruction to a bank to
make a payment.
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11.1 WHAT IS MONEY?
Credit Cards
A credit card is not money because it does not make a
payment.
When you use your credit card, you create a debt (the
outstanding balance on your card account), which you
eventually pay off with money.
Debit Cards
A debit card is not money. It is like an electronic check.
It is an electronic equivalent of a paper check.
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11.1 WHAT IS MONEY?
Mobile Wallet
A mobile wallet is an electronic version of a physical
wallet.
It is a smartphone, tablet, or smartwatch app that
stores and accesses credit card or debit card data to
make purchases.
So like the credit cards and debit cards whose data
it stores, a mobile wallet isn’t money.
< An Embryonic New Money: E-Cash
Works like money and when it becomes widely
acceptable, it will be money.
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11.1 WHAT IS MONEY?
< An Embryonic New Money: E-Cash
Electronic cash (or e-cash) is an electronic equivalent of
paper notes (dollar bills) and coins.
It is an electronic currency, and for people who are
willing to use it, e-cash works like other forms of money.
But for e-cash to become a widely used form of money,
it must evolve some of the characteristics of physical
currency.
PayPal and Bitcoin are examples
of electronic cash.
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11.2 THE BANKING SYSTEM
The banking system consists of
• The Federal Reserve
• The banks and other institutions that accept deposits
and that provide the services that enable people and
businesses to make and receive payments.
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11.2 THE BANKING SYSTEM
Figure 11.2 shows
the institutions of
the banking system.
The Federal
Reserve regulates
and influences the
activities of the
commercial banks,
thrift institutions, and money market funds,
whose deposits make up the nation’s money.
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11.2 THE BANKING SYSTEM
< Commercial Banks
A commercial bank is a firm that is licensed by the
Comptroller of the Currency in the U.S. Treasury (or by a
state agency) to accept deposits and make loans.
In 2016, about 5,260 commercial banks operated in the
United States.
Because of mergers, this number is down from 15,000 in
the 1980s and during the financial crisis of 2008–2009,
more than 130 banks failed.
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11.2 THE BANKING SYSTEM
Bank Deposits
A commercial bank accepts three types of deposits:
• Checkable deposits
• Savings deposits
• Time deposits
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11.2 THE BANKING SYSTEM
Profit and Risk: A Balancing Act
The goal of a commercial bank is to maximize the long-
term wealth of its stockholders.
To achieve this goal, banks borrow from depositors and
others and lend for long-terms at high interest rates.
Lending is risky, so a bank must be prudent in the way it
uses its depositors’ funds and balance security for
depositors and stockholders against high but risky
returns.
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11.2 THE BANKING SYSTEM
To trade off between risk and profit, a bank divided its
assets into four parts:
• Reserves
• Liquid assets
• Securities
• Loans
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11.2 THE BANKING SYSTEM
Reserves
A bank’s reserves consist of currency in the bank’s
vaults plus the balance on its reserve account at a
Federal Reserve Bank.
The Fed requires the banks and other financial
institutions to hold a minimum percentage of deposits as
reserves, called the required reserve ratio.
Banks’ desired reserves might exceed the required
reserves, especially when the cost of borrowing reserves
is high.
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11.2 THE BANKING SYSTEM
Liquid Assets
Banks’ liquid assets are short-term Treasury bills and
overnight loans to other banks.
When banks have excess reserves, they can lend them
to other banks that are short of reserves in an interbank
loans market.
The interbank loans market is called federal funds
market and the interest rate on interbank loans is the
federal funds rate.
The Fed’s policy actions target the federal funds rate.
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11.2 THE BANKING SYSTEM
Securities and Loans
Securities held by banks are bonds issued by the U.S.
government and by other organizations.
A bank earns a moderate interest rate on securities, but
it can sell them quickly if it needs cash.
Loans are the funds that banks provide to businesses
and individuals and include outstanding credit card
balances.
Loans earn the bank a high interest rate, but they are
risky and cannot be called in before the agreed date.
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11.2 THE BANKING SYSTEM
Bank Assets and Liabilities: The Relative
Magnitudes
In 2013, checkable deposits at commercial banks in the
United States, included in M1, were about 9 percent of
total commercial bank deposits.
Another 46 percent of deposits were savings deposits
and small time deposits, which are part of M2.
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11.2 THE BANKING SYSTEM
Figure 11.3 shows that
in 2016, commercial
banks held:
17 percent of total
assets as reserves
22 percent as
securities
61 percent as loans
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11.2 THE BANKING SYSTEM
The source of the
funds allocated was
Deposits in M1 and
M2: 75 percent
Borrowing from
bondholders:
13 percent
From banks’ stock
holders—the banks’
net worth:
12 percent
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11.2 THE BANKING SYSTEM
< Thrift Institutions
Three types of thrift institutions are savings and loan
associations, savings banks, and credit unions.
A savings and loan association (S&L) is a financial
institution that accepts checkable deposits and savings
deposits and that makes personal, commercial, and
home-purchase loans.
A savings bank is a financial institution that accepts
savings deposits and makes mostly consumer and
home-purchase loans.
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11.2 THE BANKING SYSTEM
A credit union is a financial institution owned by a social
or economic group, such as a firm’s employees, that
accepts savings deposits and makes mostly consumer
loans.
Like commercial banks, thrift institutions hold reserves
and must meet minimum reserve ratios set by the Fed.
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11.2 THE BANKING SYSTEM
< Money Market Funds
A money market fund is a financial institution that
obtains funds by selling shares and uses these funds to
buy assets such as U.S. Treasury bills.
Money market fund shares act like bank deposits.
Shareholders can write checks on their money market
fund accounts.
There are restrictions on most of these accounts.
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11.3 THE FEDERAL RESERVE SYSTEM
< The Federal Reserve System
The Federal Reserve System (the Fed) is the central
bank of the United States.
A central bank is a public authority that provides
banking services to banks and regulates financial
institutions and markets.
The Fed’s main task is to regulate the interest rate and
quantity of money to achieve low and predictable
inflation and sustained economic growth.
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11.3 THE FEDERAL RESERVE SYSTEM
Figure 11.4
shows the 12
Federal Reserve
districts.
Each Federal
Reserve district
has its own
Federal Reserve
Bank.
The Board of Governors of the Federal Reserve System
is located in Washington, D.C.
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11.3 THE FEDERAL RESERVE SYSTEM
< The Structure of the Federal Reserve
The key elements in the structure of the Federal
Reserve are
• The Chair of the Board of Governors
• The Board of Governors
• The Regional Federal Reserve Banks
• The Federal Open Market Committee
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11.3 THE FEDERAL RESERVE SYSTEM
The Chair of the Board of Governors
The Chair is the Fed’s chief executive,
public face, and center of power and
responsibility.
The current chair is Janet Yellen.
The Board of Governors:
• Consists of 7 members, appointed by the President of
the United States and confirmed by the Senate.
• Each for a 14-year term.
• The President appoints one board member as Chair
for a term of 4 years, which is renewable.
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11.3 THE FEDERAL RESERVE SYSTEM
The Regional Federal Reserve Banks
• There are 12 Federal Reserve banks, one for each of
12 Federal Reserve districts.
• Each Federal Reserve Bank has nine directors, three
of whom are appointed by the Board of Governors
and six of whom are elected by the commercial banks
in the Federal Reserve district.
• The Federal Reserve Bank of New York implements
some of the Fed’s most important policy decisions.
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11.3 THE FEDERAL RESERVE SYSTEM
The Federal Open Market Committee
The Federal Open Market Committee (FOMC) is the
Fed’s main policy-making committee.
The FOMC consists of
• The Chair and other six members of the Board of
Governors.
• The president of the Federal Reserve Bank of New York.
• Four presidents of the other regional Federal Reserve
banks (on a yearly rotating basis).
The FOMC meets approximately every six weeks.
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11.3 THE FEDERAL RESERVE SYSTEM
< The Fed’s Policy Tools
The Fed uses four main policy tools:
• Required reserve ratios
• Discount rate
• Open market operations
• Extraordinary crisis measures
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11.3 THE FEDERAL RESERVE SYSTEM
Required Reserve Ratios
Banks hold reserves.
These reserves are
• Currency in the institutions’ vaults and ATMs
• Deposits held with other banks or with the Fed
Banks and thrifts are required to hold a minimum
percentage of deposits as reserves, a required reserve
ratio.
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11.3 THE FEDERAL RESERVE SYSTEM
Discount Rate
The discount rate is the interest rate at which the Fed
stands ready to lend reserves to commercial banks.
A change in the discount rate begins with a proposal to
the FOMC by at least one of the 12 Federal Reserve
banks.
If the FOMC agrees that a change is required, it
proposes the change to the Board of Governors for its
approval.
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11.3 THE FEDERAL RESERVE SYSTEM
Open Market Operations
An open market operation is the purchase or sale of
government securities—U.S. Treasury bills and bonds—
by the New York Fed in the open market.
When the New York Fed conducts an open market
operation, the New York Fed does not transact with the
federal government.
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11.3 THE FEDERAL RESERVE SYSTEM
Extraordinary Crisis Measures
Following the collapse of Lehman Brothers, the Fed
(working closely with the U.S. Treasury Department)
took a number of major policy moves that created new
policy tools.
These new tools can be grouped under three broad
headings:
• Quantitative easing
• Credit easing
• Operation Twist
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11.3 THE FEDERAL RESERVE SYSTEM
Quantitative Easing (QE)
When the Fed creates bank reserves by conducting a
large-scale open market purchase at a low or possibly
zero federal funds rate, the action is called quantitative
easing.
This action differs from a normal open market purchase
in its scale and purpose, and it might require the Fed to
buy any of a number of private securities rather than
government securities.
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11.3 THE FEDERAL RESERVE SYSTEM
Credit Easing
When the Fed buys private securities or makes loans to
financial institutions to stimulate their lending, the action
is called credit easing.
Operation Twist
When the Fed buys long-term government securities and
sells short-term government securities, the action is
called operation twist.
The idea is to lower long-term interest rates and
stimulate borrowing and investment.
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11.3 THE FEDERAL RESERVE SYSTEM
< How the Fed’s Policy Tools Work
The Fed’s normal policy tools work by changing either
the demand for or the supply of monetary base, which in
turn changes the interest rate.
The monetary base is the sum of coins, Federal
Reserve notes, and banks’ reserves at the Fed.
The monetary base is so called because it acts like a
base that supports the nation’s money.
The larger the monetary base, the greater is the quantity
of money that it can support.
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11.3 THE FEDERAL RESERVE SYSTEM
By increasing the required reserve ratio, the Fed can
force banks to hold a larger quantity of monetary base.
By raising the discount rate, the Fed can make it more
costly for the banks to borrow reserves—borrow
monetary base.
By selling securities in the open market, the Fed can
decrease the monetary base.
All these actions lead to an increase in the interest rate.
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11.3 THE FEDERAL RESERVE SYSTEM
By decreasing the required reserve ratio, the Fed can
permit the banks to hold a smaller quantity of monetary
base.
By lowering the discount rate, the Fed can make it less
costly for the banks to borrow monetary base.
By buying securities in the open market, the Fed can
increase the monetary base.
All these actions lead to a decrease in the interest rate.
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11.4 REGULATING THE QUANTITY OF MONEY
< Creating Deposits by Making Loans
Banks create deposits when they make loans and the
new deposits created are new money.
The quantity of deposits that banks can create is limited
by three factors:
• The monetary base
• Desired reserves
• Desired currency holding
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11.4 REGULATING THE QUANTITY OF MONEY
The Monetary Base
The monetary base is the sum of Federal Reserve
notes, coins, and banks’deposits at the Fed.
The size of the monetary base limits the total quantity of
money that the banking system can create because
1)Banks have desired reserves.
2)Households and firms have desired currency holdings.
And both of these desired holdings of monetary base
depend on the quantity of money.
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11.4 REGULATING THE QUANTITY OF MONEY
Desired Reserves
A bank’s actual reserves consists of notes and coins in
its vault and its deposit at the Fed.
The fraction of a bank’s total deposits held as reserves is
the reserve ratio.
The desired reserve ratio is the ratio of reserves to
deposits that a bank wants to hold. This ratio exceeds
the required reserve ratio by the amount that the bank
determines to be prudent for its daily business.
Excess reserves equal the bank’s actual reserves
minus its desired reserves.
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11.4 REGULATING THE QUANTITY OF MONEY
Desired Currency Holding
We hold money in the form of currency and bank
deposits and some fraction of their money as currency.
So when the total quantity of money increases, so does
the quantity of currency that people want to hold.
Because desired currency holding increases when
deposits increase, currency leaves the banks when they
make loans and increase deposits.
This leakage of currency is called the currency drain.
The ratio of currency to deposits is called the currency
drain ratio.
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11.4 REGULATING THE QUANTITY OF MONEY
The Fed constantly takes actions that influence the
quantity of money, and open market operations are the
Fed’s major policy tool.
An open market operation is the purchase or sale of
government securities by the Fed in the open market.
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11.4 REGULATING THE QUANTITY OF MONEY
< How Open Market Operations Change the
Monetary Base
When the Fed buys securities in an open market
operation, it pays for them with newly created bank
reserves and money.
With more reserves in the banking system, the supply of
interbank loans increases, the demand for interbank
loans decreases, and the federal funds rate falls.
The federal funds rate is the interest rate on loans in
the interbank market.
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11.4 REGULATING THE QUANTITY OF MONEY
Similarly, when the Fed sells securities in an open
market operation, buyers pay for them with bank
reserves and money.
With fewer reserves in the banking system, the supply of
interbank loans decreases, the demand for interbank
loans increases, and the federal funds rate rises.
The Fed sets a target for the federal funds rate and
conducts open market operations on the scale needed to
hit its target.
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11.4 REGULATING THE QUANTITY OF MONEY
A change in the federal funds rate is only the first stage
in an adjustment process that follows an open market
operation.
If banks’ reserves increase, they increase their lending,
which increases the quantity of money.
If banks’ reserves decrease, they decrease their lending,
which decreases the quantity of money.
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11.4 REGULATING THE QUANTITY OF MONEY
The Fed Buys Securities
Suppose the Fed buys $100 million of U.S. government
securities in the open market.
The seller might be:
• A commercial bank
• The nonbank public
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11.4 REGULATING THE QUANTITY OF MONEY
Figure 11.5 shows what happens when the Fed buys
securities from a commercial bank.
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11.4 REGULATING THE QUANTITY OF MONEY
Figure 11.6
shows what
happens
when the
Fed buys
securities
from the
public.
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11.4 REGULATING THE QUANTITY OF MONEY
The Fed Sells Securities
Suppose the Fed sells $100 million of U.S. government
securities in the open market.
The Fed’s assets decrease by $100 million.
The reserves of the banking system decrease by $100
million and banks borrow in the interbank market to meet
their desired reserve ratio.
The change in bank reserves is just the beginning.
A multiplier effect on the quantity of money begins.
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11.4 REGULATING THE QUANTITY OF MONEY
< The Multiplier Effect of an Open Market
Operation
An open market purchase that increases bank reserves
also increases the monetary base.
The increase in the monetary base equals the amount of
the open market purchase.
The quantity of bank reserves increases and gives the
banks excess reserves that they can start to lend.
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11.4 REGULATING THE QUANTITY OF MONEY
The following sequence of events takes place:
• An open market purchase creates excess reserves.
• Banks lend excess reserves.
• Bank deposits increase.
• The quantity of money increases.
• New money is used to make payments.
• Some of the new money is held as currency—
currency drain.
• Some of the new money remains on deposit in banks.
• Banks’ desired reserves increase.
• Excess reserves decrease but remain positive.
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11.4 REGULATING THE QUANTITY OF MONEY
Figure 11.7
illustrates this
sequence of
events.
The process
repeats until
excess reserves
have been
eliminated.
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11.4 REGULATING THE QUANTITY OF MONEY
< The Money Multiplier
The money multiplier is the number by which a change
in the monetary base is multiplied to find the resulting
change in the quantity of money.
It is also the ratio of the change in the quantity of money
to the change in the monetary base.
The magnitude of the money multiplier depends on the
desired reserve ratio (R) and the currency drain ratio
(the ratio of currency to deposits C).
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11.4 REGULATING THE QUANTITY OF MONEY
The larger the currency drain and the larger the desired
reserve ratio, the smaller is the money multiplier.
Desired reserves = R
Currency = C
Monetary base, MB, is the sum of reserves and
currency, so
MB = (R + C)
The quantity of money, M, is the sum of deposits and
currency, so
M = Deposits + Currency = (D + C)
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11.4 REGULATING THE QUANTITY OF MONEY
M = (D + C)
MB = (R + C)
So
M (D + C)
=
MB (R + C)
Money multiplier = (1 + C/D)
(R/D + C/D)
The quantity of money changes by the change in the
monetary base multiplied by (1 + C/D)/(R/D + C/D).
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During the Great Depression, many banks failed, bank
deposits were destroyed, and the quantity of money
crashed by 25 percent.
Most economists believe that it was these events that
turned an ordinary recession in 1929 into a deep and
decade-long depression.
Figure 1 on the next slide shows what the Fed did to
avoid another great depression.
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The Fed pumped
reserves into the
banking system.
During the months after
Lehman Brothers
collapsed, using QE1
the Fed doubled the
monetary base.
In 2010 and 2011, QE2
took the monetary base
to more than 3 times its
pre-crisis level.
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In 2012 and 2013, QE3
took the monetary base
to more than 4 times its
normal level.
This extraordinary
increase in the
monetary base did not
bring a similar increase
in the quantity if
money.
Figure 2 on the next
slide shows the reason.
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The currency drain ratio
(ratio of currency to M2
deposits) remained
steady.
In 2008, banks’ desired
reserve ratio increased
tenfold from 1.2 to 12
percent.
The money multiplier
collapsed from its
normal value of 9 to 5.
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The surge in the
desired reserve ratio is
the sole reason for the
collapse of the money
multiplier.
The collapse of Lehman
signaled to banks that
they faced high risk.
Banks responded by
boosting their desired
reserve ratio.
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As the risk faced by
banks returns to
normal, the desired
reserve ratio will fall.
When this happens,
the Fed will need to
decrease the
monetary base or
face an explosion in
the quantity of
money.
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