ECO121- MACROECONOMICS

CHAPTER 29: THE MONETARY SYSTEM

Taught by Que Anh Nguyen - FPT School of Business (FSB)

Original Slides by Ron Cronovich

Based on: N. Gregory Mankiw, Principles of Economics (6ed)

OBJECTIVES

1. What assets are considered “money”? What are the functions of money? The
types of money?

2. What is the Federal Reserve?

3. What role do banks play in the monetary system? How do banks “create money”?

4. How does the Federal Reserve control the money supply?

1. The Meaning of Money
▪ Without money, trade would require barter, the exchange of one good or service for another.
▪ Every transaction would require a double coincidence of wants – the unlikely occurrence that
two people each have a good the other wants.
▪ Most people would have to spend time searching for others to trade with – a huge waste of
resources.
▪ This searching is unnecessary with money, the set of assets that people regularly use to buy
g&s from other people.

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 1. The Meaning of Money
1.1. Functions of Money
Medium of exchange: an item
buyers give to sellers when they
want to purchase g&s
Unit of account: the
yardstick people use to post
prices and record debts
Store of value: an item people
can use to transfer purchasing
power from the present to the
future
→ liquidity: the ease with which
an asset can be converted into
the economy’s medium of
exchange. 3
1. The Meaning of Money
1.2. Kinds of Money

Commodity money:
takes the form of a commodity with intrinsic
value
Ex: gold coins
→ intrinsic value means that the item would
have value even if it were not used as money.

Fiat money
money without intrinsic value, used as
money because of govt decree
Ex: the U.S. dollar

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1. The Meaning of Money
1.3. Money in the U.S. Economy

▪ The money supply (or money stock): the quantity of money available in the
economy
▪ What assets should be considered part of the money supply? Two candidates:
▪ Currency: 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 by writing a check

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 1. The Meaning of Money
1.3. Money in the U.S. Economy

Measures of the U.S. Money Supply

▪ M1: currency, demand deposits, traveler’s checks, and other

checkable deposits.
M1 = $3.73 trillion (Jan 2019)
▪ M2: everything in M1 plus savings deposits, small time
deposits, money market mutual funds, and a few minor
categories.
M2 = $14.47 trillion (Jan 2019)

The distinction between M1 and M2

will usually not matter when we talk about
“the money supply” in this course.
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2. The Federal Reserve System
2.1. The Fed’s Organization

▪ Central bank: an institution that oversees the banking system and regulates the
money supply
▪ Monetary policy: the setting of the money supply by policymakers in the central bank
▪ Federal Reserve (Fed): the central bank of the U.S. Federal Reserve was created in
1913 after a series of bank failures in 1907

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2. The Federal Reserve System
2.1. The Fed’s Organization

The Federal Reserve System consists of:

▪ Board of Governors: 7 members, located in Washington, DC - 14-
year terms
→ Chair directs the Fed staff, presides over board meetings, and
testifies regularly about Fed policy in front of congressional committees
▪ 12 regional Fed banks, located around the U.S.
Jerome Powell
▪ Federal Open Market Committee (FOMC), Chair of FOMC,
includes the Bd of Govs and presidents of some of the regional Fed
Feb 2018 – present
banks. The FOMC decides monetary policy.
▪ Jobs of Fed: (1) regulate banks and ensure the health of the banking
system. (2) to control the quantity of money that is made available

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2. The Federal Reserve System
2.2. The Federal Open Market Committee

▪ All 12 regional presidents attend each FOMC meeting, but only five
get to vote.
▪ The president of the New York Fed always gets a vote
▪ The Fed has the power to increase or decrease the number of dollars
in the economy.
▪ Open-market operation: the purchase and sale of U.S. government
bonds
➢ If the FOMC decides to increase the money supply → the Fed
creates dollars and uses them to buy government bonds from the
public →  the money supply.
➢ If the FOMC decides to decrease the money supply → the Fed
sells government bonds to the public in the nation’s bond markets.
→  the money supply
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3. Banks and the Money Supply
3.1. The Simple Case of 100-Percent-Reserve Banking
Bank T-account

▪ T-account: a simplified accounting statement that shows a bank’s assets & liabilities.
▪ Example:
FIRST NATIONAL BANK
Assets Liabilities
Reserves $ 10 Deposits $100
Loans $ 90

▪ Banks’ liabilities include deposits, assets include loans & reserves.

▪ In this example, notice that R = $10/$100 = 10%.

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3. Banks and the Money Supply
3.1. The Simple Case of 100-Percent-Reserve Banking

Banks and the Money Supply: An Example

Suppose $100 of currency is in circulation.

To determine banks’ impact on money supply, we calculate the money supply in 3 different
cases:
1. No banking system → Public holds the $100 as currency. → Money supply = $100.
2. 100% reserve banking system: banks hold 100% of deposits as reserves, make no
loans
3. Fractional reserve banking system

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3. Banks and the Money Supply
3.1. The Simple Case of 100-Percent-Reserve Banking
CASE 2: 100% reserve banking system
▪ Public deposits the $100 at First National Bank (FNB).
▪ FNB is only a depository institution—that is, it accepts deposits and does not
make loans.
FIRST NATIONAL BANK
▪ FNB holds 100% of deposit as reserves:
Assets Liabilities
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. 12
3. Banks and the Money Supply
3.2. Money Creation with Fractional-Reserve Banking

Why not lend some of it out and earn a profit by charging interest on the loans?
Suppose R = 10%. FNB loans all but 10% of the deposit:

CASE 3: Fractional reserve banking system

FIRST NATIONAL BANK

Assets Liabilities
Reserves $10 Deposits $100
Loans $90

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3. Banks and the Money Supply
3.2. Money Creation with Fractional-Reserve Banking

▪ In a fractional reserve banking system, banks keep a fraction of deposits as

reserves and use the rest to make loans.
▪ The Fed establishes reserve requirements, regulations on the minimum
amount of reserves that banks must hold against deposits.
▪ Banks may hold more than this minimum amount if they choose.
▪ The reserve ratio, R
= fraction of deposits that banks hold as reserves
= total reserves as a percentage of total deposits

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3. Banks and the Money Supply
3.2. Money Creation with Fractional-Reserve Banking
Suppose R = 10%. FNB loans all but 10% of the deposit:
CASE 3: Fractional reserve banking system
FIRST NATIONAL BANK
Assets Liabilities
Reserves $10 Deposits $100
Loans $90

When banks make loans, they create money.

Money supply = $190 (!!!)
The borrower gets
➢ Depositors have $100 in deposits, ▪ $90 in currency (an asset counted in money supply)
➢ Borrowers have $90 in currency. ▪ $90 in new debt (a liability)

A fractional reserve banking system creates

money, but not wealth. 15
3. Banks and the Money Supply
3.3. The Money Multiplier

CASE 4: Fractional reserve banking system

Suppose the borrower from First National uses the $90 to buy something from
someone who then deposits the currency in Second National Bank. (SNB).
SECOND NATIONAL BANK
Initially, SNB’s T-account:
Assets Liabilities
Reserves $ 9 Deposits $ 90
Loans $ 81

If R = 10% for SNB, it will loan all but 10% of the deposit.
Money supply + $81
➢ Second National creates an additional $81 of money.
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3. Banks and the Money Supply
3.3. The Money Multiplier

CASE 4: Fractional reserve banking system

Suppose the borrower from Second National uses the $81 to buy something
from someone who then deposits the currency in Third National Bank. (TNB).
SECOND NATIONAL BANK
Initially, TNB’s T-account:
Assets Liabilities
Reserves $ 8.10 Deposits $ 81
Loans $72.90

If R = 10% for TNB, it will loan all but 10% of the deposit.
Money supply + $72.90
➢ Third National creates an additional $72.90 of money.
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3. Banks and the Money Supply
3.3. The Money Multiplier

CASE 4: Fractional reserve banking system

The process continues, and money is created with each new loan.

$ 100.00
Original deposit = In this example, $100
$ 90.00 = ( 0.9 $100.00)
FNB lending = of reserves generates
$ 81.00 = ( 0.9 $90.00) $1,000 of money.
SNB lending =
$ 72.90 = ( 0.9 $81.00)
TNB lending =
..
. ..
.
Total money supply = $1,000.00
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3. Banks and the Money Supply
3.3. The Money Multiplier
▪ 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
→ How the amount of money banks create depends on the reserve ratio.
→ If R = 1/20 (5%) → the banking system would have 20 times as much in
deposits as in reserves, implying a money multiplier of 20.

 the reserve ratio,  of each deposit banks loan out, and  the money multiplier.
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ACTIVE LEARNING 1 - Banks and the money supply

While cleaning your apartment, you look under the sofa cushion find a $50 bill (and
a half-eaten taco). You deposit the bill in your checking account.
The Fed’s reserve requirement is 20% 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?

20 20
ACTIVE LEARNING 1 - Banks and the money supply

You deposit $50 in your checking account.

A. What is the maximum amount that the
money supply could increase?
Answer: $200
B. What is the minimum amount that the money supply could increase?

Answer: $0
If your bank makes no loans from your deposit, currency falls by
$50, deposits increase by $50, money supply does not change.

22 22
3. Banks and the Money Supply
3.4. Bank Capital, Leverage, and the Financial Crisis of 2008–2009
▪ Leverage, the use of borrowed money to supplement existing funds for investment purposes.

The leverage ratio is $1,000/$50, or 20.

→ Of the $20 of assets, $19 are financed with borrowed money—either by taking in deposits or
issuing debt.

If bank’s assets ↑ by 5% → $1,000 of assets would now be worth $1,050 → the bank capital ↑
from $50 to $100 ($1050 − $950) → ↑ the owners’ equity by 100 percent.

If bank’s assets ↓ by 5% → $1,000 of assets would now be worth $950 → the bank capital ↓
from $50 to 0 ($950 − $950) → ↑ the owners’ equity by 100 percent.
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4. The Fed’s Tools of Monetary Control
4.1. How the Fed Influences the Quantity of Reserves

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

bonds by the Fed.
↑ money supply → Fed instructs its bond traders at the NY Fed to buy bonds → Fed
pays for the bonds with newly created dollars (currency/ deposited reserves of banks).
→ bank ↑ the money supply in the banking system by lending out.
↓ money supply → Fed sells government bonds to the public → The public pays for
these bonds with its currency and bank deposits → ↓ the amount of money in
circulation
➢ OMOs are easy to conduct, and are the Fed’s monetary policy tool of choice.

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4. The Fed’s Tools of Monetary Control
4.1. How the Fed Influences the Quantity of Reserves
2. Fed Lending to Banks
❑ When banks are running low on reserves, they borrow reserves from the Fed via Fed’s
discount window. The Discount Rate: the interest rate on loans the Fed makes to banks
▪ To ↑ money supply,
Fed ↓ discount rate → encourages banks to borrow more reserves from Fed.
→ Banks can then make more loans → ↑ money supply.
▪ To ↓ money supply, Fed can raise discount rate.

❑ From 2007-2010. Fed used Term Auction Facility, a quantity of funds it wanted to lend to
banks, and eligible banks then bid to borrow those funds.
❑ The Fed uses discount lending to provide extra liquidity when financial institutions are in
trouble, e.g. after the Oct. 1987 stock market crash.
If no crisis, Fed rarely uses discount lending – Fed is a “lender of last resort.”
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4. The Fed’s Tools of Monetary Control
4.2. How the Fed Influences the Reserve Ratio
1. Reserve Requirements (RR): the regulations that set the minimum amount of
reserves that banks must hold against their deposits.
affect how much money banks can create by making loans.
▪ ↑ money supply, Fed reduces RR.
Banks make more loans from each dollar of reserves, which increases money multiplier
and money supply.
▪ To ↓ money supply, Fed raises RR, and the process works in reverse.
Fed rarely uses reserve requirements to control money supply: Frequent changes
would disrupt banking.

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4. The Fed’s Tools of Monetary Control
4.2. How the Fed Influences the Reserve Ratio

2. Paying Interest on Reserves: In October 2008, however, the Fed began paying
interest on reserves, which affect how much money banks can create by making
loans.
▪ an increase in the interest rate on reserves will tend to increase the reserve ratio, lower
the money multiplier, and lower the money supply.

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4. The Fed’s Tools of Monetary Control
4.3. Problems Controlling the Money Supply

▪ Fed does not control the amount of money that households choose to hold
as deposits in banks. If households hold more of their money as currency, banks
have fewer reserves, make fewer loans, and money supply falls.
▪ Fed does not control the amount that bankers choose to lend. If banks hold
more reserves than required, they make fewer loans, and money supply falls.
▪ Yet, Fed can compensate for household and bank behavior to retain fairly precise
control over the money supply.

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4. The Fed’s Tools of Monetary Control
4.3. Problems Controlling the Money Supply

Bank Runs and the Money Supply

▪ A run on banks:
When people suspect their banks are in trouble, they may “run” to the bank to
withdraw their funds, holding more currency and less deposits.
▪ Under fractional-reserve banking, banks don’t have enough reserves to pay off
ALL depositors, hence banks may have to close.
▪ Also, banks may make fewer loans and hold more reserves to satisfy depositors.
▪ These events increase R, reverse the process of money creation, cause money
supply to fall.

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4. The Fed’s Tools of Monetary Control
4.3. Problems Controlling the Money Supply

Bank Runs and the Money Supply

▪ During 1929-1933, a wave of bank runs and bank closings caused money supply to
fall 28%.
▪ Many economists believe this contributed to the severity of the Great Depression.
▪ Since then, federal deposit insurance has helped prevent bank runs in the U.S.
▪ In the U.K., though, Northern Rock bank experienced a classic bank run in 2007 and
was eventually taken over by the British government.

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4. The Fed’s Tools of Monetary Control
4.4. The Federal Funds Rate

▪ On any given day, banks with insufficient reserves can borrow from banks with excess
reserves.
▪ The interest rate on these loans is the federal funds rate.
▪ The FOMC uses OMOs to target the fed funds rate.
▪ 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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4. The Fed’s Tools of Monetary Control
4.4. The Federal Funds Rate
The Federal Funds market
Federal rf
funds rate S2 S1

To raise fed funds rate, 3.75%

Fed sells govt bonds
(OMO). 3.50%
This removes reserves
from the banking system,
reduces supply of federal
funds, causes rf to rise. D1
F
F2 F1
Quantity of
federal funds
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4. The Fed’s Tools of Monetary Control
4.4. The Federal Funds Rate
The Federal Funds market
Federal rf
funds rate S2 S1

To raise fed funds rate, 3.75%

Fed sells govt bonds
(OMO). 3.50%
This removes reserves
from the banking system,
reduces supply of federal
funds, causes rf to rise. D1
F
F2 F1
Quantity of
federal funds
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4. The Fed’s Tools of Monetary Control

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SUMMARY

▪ Money includes currency and various types of bank deposits.

▪ The Federal Reserve is the central bank of the U.S., is responsible for
regulating the monetary system.
▪ The Fed controls the money supply mainly through open-market operations.
Purchasing govt bonds increases the money supply, selling govt bonds
decreases it.
▪ In a fractional reserve banking system, banks create money when they make
loans. Bank reserves have a multiplier effect on the money supply.

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Homework

HOMEWORK:
- Problem 2, 4, 6, 8, 12 pg. 647, 648;
(Mankiw 9th ed)

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Quick Quiz

P2- pg. 647 Explain whether each of the following events increases
or decreases the money supply.
a. The Fed buys bonds in open-market operations.
b. The Fed reduces the reserve requirement.
c. The Fed increases the interest rate it pays on reserves.
d. Citibank repays a loan it had previously taken from the Fed.
e. After a rash of pickpocketing, people decide to hold less currency.
f. Fearful of bank runs, bankers decide to hold more excess reserves.
g. The FOMC increases its target for the federal funds rate

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Quick Quiz

P4- pg. 647

Beleaguered State Bank (BSB) holds $250 million in deposits and maintains
a reserve ratio of 10 percent.
a. Show a T-account for BSB.
b. Now suppose that BSB’s largest depositor withdraws $10 million in
cash from her account and that BSB decides to restore its reserve ratio
by reducing the amount of loans outstanding. Show its new T-account.

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Quick Quiz
P4- pg. 647
Beleaguered State Bank
Assets Liabilities
Reserves $25 million Deposits $250 million
Loans $225 million

b. When BSB's largest depositor withdraws $10 million in cash and BSB reduces its loans
outstanding to maintain the same reserve ratio, its T-account is now:

Beleaguered State Bank

Assets Liabilities
Reserves $24 million Deposits $240 million
Loans $216 million

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