Eco 192 Introduction to Macroeconomics

by Associate Professor (Doçent Dr.)

Salvatore Joseph Terregrossa
Lecture 7:
Central Bank and the Monetary System
Part 1
The Nation’s Central Bank and the Monetary System 1

•The Nation’s Central Bank and the

Monetary System

•Eco 192
•Intro to Macroeconomics

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In this chapter, we attempt to answer to these
questions:

• What is a nation’s Central Bank?

• What are the functions of a nation’s Central Bank?
• How does a nation’s Central Bank exert control of the
nation’s money supply?
• What role do private comercial banks play in the
monetary system?
• Specifically, how do banks “create money”?

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CH 29 THE MONETARY SYSTEM
The Money Supply 3

• The money supply (or money stock):

the quantity of money held in the economy:
• A nation’s money supply has two major components:
• Currency-in-circulation: the paper bills and coins in the hands of
the (non-bank) public;
• Demand deposits: balances in bank accounts that depositors can
access on demand, with an internet transaction; or an ATM
transaction, or by writing a check.

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 Central Bank & Monetary Policy 4

• A nation’s Central Bank: is a government institution that:

• A) Oversees, protects, and regulates the nation’s commercial banking
system;
• B) Acts to maintain public confidence in the nation’s commercial
banking system;
• C) Regulates and controls the level of the nation’s supply of money, to
conduct monetary policy.

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 Central Bank & Monetary Policy 5

• Monetary policy:
• The expansion or contraction of the money supply;
• Implemented by policymakers in the Central Bank;
• A CB implements monetary policy with a nonpolitical
agenda;
• Which means: Implementation of monetary policy
that is in the best economic interests of the nation.

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Commercial Bank Reserves 6

• In a fractional reserve banking system:

banks are required to keep a fraction (%) of deposits as required reserves (cash
in the vault);
and can use the rest to make loans.
• A nation’s Central Bank establishes reserve requirements: regulations on the
minimum amount of reserves that commercial banks must hold against deposits
(called required reserves).
• Banks may hold more than this minimum amount (called required reserves) if
they choose.
• The reserve ratio, R
= fraction of deposits that banks must hold as reserves
= required reserves as a percentage of total deposits.

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 Bank T-account
• T-account: a simplified accounting statement
that shows a bank’s assets & liabilities.
• Example:
FIRST NATIONAL BANK
Assets Liabilities
Total Reserves Deposits 100 ₺
100 ₺
(= cash in the
vault)

CH 29 THE MONETARY SYSTEM 7

Bank T-account
• T-account: a simplified accounting statement
that shows a bank’s assets & liabilities.
• Example:
FIRST NATIONAL BANK

Assets Liabilities
Required Deposits 100 ₺
Reserves: 10 ₺
Excess
Reserves: 90 ₺
 R = 10%:
 R is the Required Reserve Ratio:
 Which the % of total deposits that banks must hold as cash in the
vault (i.e. Required reserves)
8
 Bank T-account
• T-account: a simplified accounting statement
that shows a bank’s assets & liabilities.
• Example:
FIRST NATIONAL BANK
Assets Liabilities
Required Deposits 100 ₺
Reserves 10 ₺
Loans 90 ₺
 Banks’ liabilities include deposits,
assets include loans & reserves.
 In this example, notice that R =10₺/100₺ = 10%.
CH 29 THE MONETARY SYSTEM 9
Banks and the Money Supply: An Example 10

Suppose 100 ₺ of currency is in circulation.

To determine banks’ impact on money supply,
we calculate the money supply in 3 different cases:
1. Case 1: No banking system;
2. Case 2: 100% reserve banking system:
banks hold 100% of deposits as reserves (cash in the vault), and
make no loans;
3. Case 3: Fractional reserve banking system.

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Banks and the Money Supply: An Example 11

CASE 1: No banking system

Public holds the 100 ₺ as currency in circulation.
Money supply = 100 ₺.

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Banks and the Money Supply: An Example
CASE 2: 100% reserve banking system
Public deposits the 100 ₺ at First National Bank (FNB).

FNB holds
100% of FIRST NATIONAL BANK
deposit Assets Liabilities
as reserves:
Reserves 100 ₺ Deposits 100 ₺
Loans 0₺
Money supply
= currency + deposits = 0 ₺ +100 ₺ = 100 ₺
In a 100% reserve banking system,
banks do not affect size of money supply.
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 Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
Suppose R = 10%. FNB loans all but 10%
of the deposit:
FIRST NATIONAL BANK
Assets Liabilities
Req Res: ₺00
10 ₺ Deposits 100 ₺
Loans: ₺90 ₺
0

Money supply = 190 ₺ (!!!)

Depositors have 100 ₺ in deposits,
Borrowers have 90 ₺ in currency.
CH 29 THE MONETARY SYSTEM 13
Banks and the Money Supply: An Example 14

CASE 3: Fractional reserve banking system

How did the money supply suddenly grow?
When banks make loans, they create money.
The borrower gets:
• 90 ₺ in currency (an asset counted in the
money supply);
• 90 ₺ in new debt (a liability):

A fractional reserve banking system

creates money, but not wealth.

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 Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
Suppose borrower deposits the 90 ₺ at Second
National Bank (SNB).

Initially, SNB’s SECOND NATIONAL BANK

T-account Assets Liabilities
looks like this: Req Res: ₺ 990
₺ Deposits 90 ₺
Loans: 810 ₺

If R = 10% for SNB, it will loan all but 10% of the

deposit.

CH 29 THE MONETARY SYSTEM 15

 The Money Supply at this point:

• Demand deposits plus currency in circulation:

• Demand deposits:
• 100 ₺ in FNB;
• 90 ₺ in SNB;
• Currency in circulation:
• 81 ₺ loan made by SNB (in hands of borrower).
• Thus total money supply = 271 ₺

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CH 29 THE MONETARY SYSTEM
 Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
Next, suppose the borrower deposits the 81 ₺ at
Third National Bank (TNB).

Initially, TNB’s THIRD NATIONAL BANK

T-account Assets Liabilities
looks like this: Req Res: 8.10
$ 81₺ Deposits 81 ₺
Loans: $ 0₺
72.90

If R = 10% for TNB, it will loan all but 10% of the

deposit.

CH 29 THE MONETARY SYSTEM 17

What is the increase in the MS at this
point?

• Original deposit = 100.00 ₺ (= DD in FNB)

• FNB lending = 90.00 ₺ (= DD in SNB)
• SNB lending = 81.00 ₺ (= DD in Bank TNB)
• TNB lending = 72.90 ₺ (= currency in circulation):
At this point in the demand deposit expansion process:
Total money supply level equals demand deposits plus currency in
circulation = 343.90 ₺.
Thus, total increase in MS at this point = 243.90 ₺

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CH 29 THE MONETARY SYSTEM
The Demand Deposit Expansion has an upper limit

• Because each subsequent bank in the sytem receives

fewer and fewer deposits (because of the reserve
reqirements);
• And thus each subsequent bank in the system can
make lesser and lesser amounts of loans;
• The deposit expansion process come to a halt when
the initial increase in total reserves (100 ₺) has been
entirely converted into required reserves, throughout
the banking system;

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CH 29 THE MONETARY SYSTEM
The Demand Deposit Expansion has an upper limit

• The deposit expansion process come to a halt

when the initial increase in total reserves (100₺
in this example) has been entirely converted
into required reserves, throughout the banking
system;
• And thus excess reserves in the banking system
are 0 ₺, and banks can make no more loans;
• Thus the process comes to a halt.

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CH 29 THE MONETARY SYSTEM
The Demand Deposit Expansion has an upper limit

• The deposit expansion process come to a halt when

the initial increase in total reserves (100 ₺ in this
example) has been entirely converted into required
reserves, throughout the banking system;
• Question: How much Demand Deposits can be
supported by 100 ₺ of required reserves?
• Answer: 1000 ₺;
• Because 10% X 1000 ₺ = 100 ₺

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CH 29 THE MONETARY SYSTEM
 The Demand Deposit Expansion has an upper limit

• Question: How much Demand Deposits can be

supported by 100 ₺ of required reserves?
• Answer: 1000 ₺;
• Because 10% X 1000 ₺ = 100 ₺;
• Thus total maximum possible demand deposit
expansion (as a result of the initial increase in total
reserves of 100 ₺) is:
• 1000 ₺

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CH 29 THE MONETARY SYSTEM
 Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
The process continues, and money is created with
each new loan.

Original deposit = 100.00 ₺ In this

FNB lending = 90.00 ₺ example,
SNB lending = 81.00 ₺ 100 ₺ of
reserves
TNB lending = 72.90 ₺
.. .. generates
. . 1000 ₺ of
Thus, total maximum money.
possible money supply 1000.00 ₺
expansion =
CH 29 THE MONETARY SYSTEM 23
The Money Multiplier 24

• Money multiplier: the amount of money the banking system

generates with each dollar of reserves
• The money multiplier equals 1/R.
• In our example,
R = 10%
money multiplier = 1/R = 10
100 ₺ of reserves creates 1000 ₺ of money:

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Maximum demand deposit expansion

• Maximum demand deposit expansion:

• Equals the multiplier (1/R) X the initial change in total reserves:
• In our example: (1/0.10) X 100 ₺ =
• = (10) X 100 ₺ =
• = 1000 ₺ =
• = maximum possible demand deposit expansion.

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CH 29 THE MONETARY SYSTEM
Bank Reserves

• Total bank reserves = cash in the vault;

• Required reserves:
• = Require Reserve Ratio (R) X Demand Deposits;
• Excess reserves = Total bank reserves minus required reserves;
• Banks can lend out their excess reserves;
• Which can lead to demand deposit expansion.

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CH 29 THE MONETARY SYSTEM
The Central Bank’s 3 Tools of Monetary Control

1) Open-Market Operations (OMOs): the purchase

and sale of government bonds (Treasury bills) by the
nation’s Central Bank;
2) Reserve Requirements (RR): the % of deposits
banks are obligated to hold as reserves (i.e. Cash-in-
the-vault);
3) The Discount Rate: the interest rate on loans the
Central Bank makes to commercial banks.

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CH 29 THE MONETARY SYSTEM
The CB’s 3 Tools of Monetary Control 28

1) Open-Market Operations (OMOs): the purchase and sale of government

bonds (Treasury bills) by the nation’s Central Bank:

 To increase money supply, the CB buys government

bonds, paying with new cash.
…which are deposited in banks, increasing reserves
…which banks use to make loans, causing the
money supply to expand.
 To reduce money supply, the CB sells government
bonds, taking currency out of circulation, and the
process works in reverse.

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The CB’s 3 Tools of Monetary Control 29

1) Open-Market Operations (OMOs): the purchase and sale of government

bonds (Treasury bills) by the nation’s Central Bank:

 OMOs are easy to conduct, and are typically a CB’s

monetary policy tool of choice.
 In other words, OMOs are the main tool of monetary
policy by a Central Bank.

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The CB’s 3 Tools of Monetary Control 30

2. Reserve Requirements (RR):

affect how much money banks can create by making
loans:

 To increase money supply, the CB can reduce RR:

Banks make can then more loans from their pool of reserves, which increases
money multiplier and money supply (through deposit expansion).
 To reduce money supply, the CB can raise RR,
and the process works in reverse.
 Note: a CB rarely uses reserve requirements to control money supply:
Frequent changes would disrupt the commercial banking system.
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The CB’s 3 Tools of Monetary Control 31

3. The Discount Rate:

the interest rate on loans the CB makes to banks:
 When banks are running low on reserves,
they may borrow reserves from the CB.
 To increase money supply, the CB can lower discount rate, which
encourages commercial banks to borrow more reserves from the
CB;
 Banks can then make more loans, which increases the money supply
(through deposit expansion);
 To reduce money supply, the CB can raise discount rate, which leads
to fewer loans by banks and less deposit expansion.
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The CB’s 3 Tools of Monetary Control 32

3. The Discount Rate:

the interest rate on loans the CB makes to banks:
 The CB uses discount lending to provide extra
liquidity when financial institutions are in trouble,
e.g. after the 2008 global financial market crash.
 If no crisis, the CB rarely uses discount lending –
The CB is a “lender of last resort.”
 In other words, the Discount Rate is not a major
monetary policy tool.

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The Federal Funds Rate 33

• On any given day, commercial banks with insufficient reserves can

borrow from commercial banks with excess reserves.
• The interest rate on these loans is called the federal funds rate.
• The CB uses OMOs to target the fed funds rate.
• Because: Many interest rates are highly correlated, so changes in the fed
funds rate cause changes in other rates and have a big impact in the
economy.

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 Expansionary Monetary Policy and the Fed Funds Rate

To lower fed funds The Federal

Federal Funds market
rate, CB buys
funds rate
rf
govt bonds (OMO). S1 S2
This adds reserves to
the banking system,
increases supply of
federal funds, 3.50%
causes rf to fall. 3.25%

D1
F1 F2 F
Quantity of federal funds
CH 29 THE MONETARY SYSTEM 34
 Contractionary Monetary Policy and the Fed Funds Rate

To raise fed funds The Federal

Federalrf Funds market
rate, CB sells
funds rate
govt bonds (OMO). S2 S1
This removes
reserves from the 3.75%
banking system,
reduces supply of 3.50%
federal funds,
causes rf to rise.
D1
F
F2 F1
Quantity of federal
funds
CH 29 THE MONETARY SYSTEM 35