Chapter 15

The Monetary System

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 The Meaning of Money

 Money is the set of

assets in the economy
that people regularly use
to buy goods and
services from other
people.

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 Three Functions of Money
 Medium of Exchange: anything that
is readily acceptable as payment.
 Unit of Account: serves as a unit of
account to help us compare the
relative values of goods.
 Store of Value: a way to keep some of
our wealth in a readily spendable form
for future needs.
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 The Two Types of Money
 Commodity Money: something that
performs the function of money and
has alternative, nonmonetary uses.
– Examples: Gold, silver, cigarettes
 Fiat Money: something that serves
as money but has no other important
uses.
– Examples: Coins, currency, check
deposits
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 Money in the U.S. Economy
 Money Stock is the quantity of money
circulating in the economy.
 Different ways of measuring the money
stock in the economy:
– M1
– M2

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 Measurement of Money

 The most familiar

form of money used

M1
includes:
– Coins
– Currency
– Check Deposits
– Travelers Checks

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 Measurement of Money
 A broader measure of
money than M1, includes:
– M1 +

M2
– Savings Deposits +
– Small Time Deposits +
– Money Market Mutual
Funds +
– and other minor
categories
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 Where is All The Currency?
 In 1996 there was about $380 billion of
U.S. currency outstanding ($1,900 in
currency per person).
 Location of outstanding currency may
include:
– Currency held abroad
– Currency held by illegal entities
– Currency held in businesses for transac-tion
purposes
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 Quick Quiz!

 List and
describe the
three functions
of money.

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 The Federal Reserve
 The Federal Reserve (“Fed”) serves as
the nation’s central bank, which is
designed to oversee the banking system
and regulate the quantity of money in the
economy.
 The “Fed” is a privately owned
institution, authorized in 1914 by
Congress to ensure the health of the
nation’s banking system.
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 The Fed’s Organization
 The Fed is run by its Board of
Governors.
– Seven members appointed by the
President of the United States.
– The Chairman of the Board is the most
important position: presiding, directing,
and testifying about Fed policy. She/He is
appointed by the President.

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 The Fed’s Organization

 The Federal Reserve System is made

up of the Federal Reserve Board in
Washington, D.C. and twelve regional
Federal Reserve Banks.
 Monetary policy is made by the Federal
Open-Market Committee.

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 Three Primary Functions of the Fed
 Regulate the private banking
industry to make sure banks follow
federal laws intended to promote safe
and sound banking practices.
 Act as a banker’s bank, making
loans to other banks and as a lender
of last resort.
 Control of the supply of money i.e.
Monetary Policy.
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 Money Supply Changes by the Fed
 Open-Market Operations: The primary
way in which the Fed changes the
money supply done through the
purchase and sale of U.S. government
bonds with newly printed money.
– 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.

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 Quick Quiz!

 How does the

Fed increase the
supply of money
in the economy?

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 Banks and The Money Supply
 The behavior of banks can influence
the quantity of demand deposits in the
economy and therefore, the money
supply.
 Fractional Reserve Banking System:
The practice of holding a fraction of
money deposited as reserves and
lending out the rest.
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 Fractional Reserve Banking
 Deposits into a bank are recorded as
both assets and liabilities. Deposits that
have been received but not lent out are
called reserves.
 The supply of money in the economy is
affected by the amount of deposits that
are kept in the bank as reserves and the
amount that is lent out. Loans become
an asset to the bank.
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 Bank “T-Account” Example
First National Bank
Assets Liabilities

Reserves Deposits
$10.00 $100.00

Loans
$90.00
Total Assets Total Liabilities
$100.00 $100.00

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 Bank “T-Account” Example
First National Bank A “T-Account”
Assets Liabilities illustrates the
financial position
Reserves Deposits
$10.00 $100.00
of a bank that
accepts deposits,
Loans keeps a portion as
$90.00
reserves and lends
Total Assets Total Liabilities out the rest.
$100.00 $100.00

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 Money Creation with
Fractional-Reserve Banking
 When a bank makes a loan (from it’s
reserves) the money supply increases.
When banks hold only a fraction of
deposits in reserve, banks create
money.
 The creation of money through loans
does not create any wealth, but allows
banks to charge interest several times
on the same bit of wealth.
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 The Money Multiplier
 When one bank loans money, that
money is generally deposited into
another or the same bank thus
creating more deposits and more
reserves to be lent out.
 The Money Multiplier is the amount of
money that the banking system
generates with each dollar of reserves.
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 The Money Multiplier
First National Bank
Assets Liabilities

Reserves Deposits
$10.00 $100.00

Loans
$90.00

Total Assets Total Liabilities

$100.00 $100.00

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 The Money Multiplier
First National Bank Second National Bank
Assets Liabilities Assets Liabilities

Reserves Deposits Reserves Deposits

$10.00 $100.00 $9.00 $90.00

Loans Loans
$90.00 $81.00

Total Assets Total Liabilities Total Assets Total Liabilities

$100.00 $100.00 $90.00 $90.00

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 The Money Multiplier
First National Bank Second National Bank
Assets Liabilities Assets Liabilities

Reserves Deposits Reserves Deposits

$10.00 $100.00 $9.00 $90.00

Loans Loans
$90.00 $81.00

Total Assets Total Liabilities Total Assets Total Liabilities

$100.00 $100.00 $90.00 $90.00

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 The Money Multiplier
First National Bank Second National Bank
Assets Liabilities Assets Liabilities

Reserves Deposits Reserves Deposits

Total Money Supply = $190.00!
$10.00 $100.00 $9.00 $90.00

Loans Loans
$90.00 $81.00

Total Assets Total Liabilities Total Assets Total Liabilities

$100.00 $100.00 $90.00 $90.00

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 What determines the size of the money
multiplier?
 The money multiplier
is the reciprocal of the
reserve ratio.
– With a reserve
requirement (R) of 20%
M =1
or 1/5 . . .
– The multiplier will be 5.

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R
 Tools of Monetary Control
The Fed has three instruments of
monetary control:
 Open-Market Operations:
– Buying and selling bonds.
 Changing the Reserve Ratio:
– Increasing or decreasing the ratio.
 Changing the Discount Rate:
– The interest rate the Fed charges other
banks for loans.
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 Problems in Controlling the Money
Supply
Two problems that the Fed must
“wrestle” 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.
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