The Money Supply and

the Federal Reserve

System
 An Overview of Money

• Money is anything that

is generally accepted as
a medium of exchange.
• Money is not income, and money is not
wealth. Money is:
• a means of payment,
• a store of value, and
• a unit of account.

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 What is Money?
• As a medium of exchange, or means of
payment, money is generally accepted by
buyers and sellers as payment for goods and
services.
• Barter is the direct exchange of goods and
services for other goods and services.
• A barter system requires a double coincidence
of wants for trade to take place. Money
eliminates this problem.

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Which field of economic theory does not require that we know
anything about money?
a. Microeconomics.
b. Macroeconomics.
c. Neither microeconomic nor macroeconomic theory requires
that we know anything about money.
d. None of the above. Both microeconomic and
macroeconomic theory require that we know quite a bit about
money.

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Which field of economic theory does not require that we know
anything about money?
a. Microeconomics.
b. Macroeconomics.
c. Neither microeconomic nor macroeconomic theory requires
that we know anything about money.
d. None of the above. Both microeconomic and
macroeconomic theory require that we know quite a bit about
money.

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 What is Money?

• As a store of value, money

serves as an asset that can be
used to transport purchasing
power from one time period
to another.

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 What is Money?

• Money is easily
portable, and easily
exchanged for goods at
all times.
• The liquidity property
of money makes money
a good medium of
exchange as well as a
store of value.
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 What is Money?

• As a unit of account, money

is a standard that provides a
consistent way of quoting
prices.

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Which of the following refers to the liquidity property of money?
a. The fact that money makes a good medium of exchange.
b. The fact that money is portable and comes in convenient
denominations.
c. The fact that money is readily accepted and thus easily
exchanged for goods.
d. All of the above.

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Which of the following refers to the liquidity property of money?
a. The fact that money makes a good medium of exchange.
b. The fact that money is portable and comes in convenient
denominations.
c. The fact that money is readily accepted and thus easily
exchanged for goods.
d. All of the above.

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Commodity and Fiat Monies
Kinds of money are generally
divided into two groups:
• Commodity monies are items used
as money that also have intrinsic
value in some other use. Gold is
one form of commodity money.
• Fiat, or token, money is money
that is intrinsically worthless.
However, money all over the
world is mostly fiat.

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Commodity and Fiat Monies

• Legal tender is money that a

government has required to
be accepted in settlement of
debts.
• Currency debasement is the
decrease in the value of
money that occurs when its
supply is increased rapidly.
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 Measuring the Supply of
Money in the United States
• M1, or transactions money is
money that can be directly
used for transactions.
M1  currency held outside
banks + demand deposits +
traveler’s checks + other
checkable deposits
• M1 is a stock measure—it is
measured at a point in time—
on a specific day.
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 Measuring the Supply of
Money in the United States
• M2, or broad money,
includes near monies, or
close substitutes for
transactions money.
M2  M1 + savings accounts +
money market accounts + other
near monies
• The main advantage of
looking at M2 instead of M1
is that M2 is sometimes more
stable.
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When you transfer $1,000 from your checking account to your
savings account, this transaction will:
a. Decrease both M1 and M2.
b. Decrease M1 and increase M2.
c. M1 will remain the same and M2 will increase.
d. M2 will remain the same and M1 will decrease.

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When you transfer $1,000 from your checking account to your
savings account, this transaction will:
a. Decrease both M1 and M2.
b. Decrease M1 and increase M2.
c. M1 will remain the same and M2 will increase.
d. M2 will remain the same and M1 will decrease.

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The Private Banking System

• Financial
intermediaries are
banks and other
financial institutions
that act as a link
between those who
have money to lend
and those who want
to borrow money.

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 How Banks Create Money
• A Historical Perspective: Goldsmiths
– Goldsmiths functioned as warehouses where people
stored gold for safekeeping.
– Upon receiving the gold, a goldsmith would issue a
receipt to the depositor. After a time, these receipts
themselves began to be traded for goods, and were
backed 100 percent by gold.
– Then, Goldsmiths realized that they could lend out
some of this gold without any fear of running out.
Now there were more claims than there were
ounces of gold.

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How Banks Create Money

• A run on a goldsmith (or a

modern-day bank) occurs
when many people present
their claims at the same time.

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 The Modern Banking System
• A brief review of accounting:
Assets – liabilities  Net Worth, or
Assets  Liabilities + Net Worth
• A bank’s most important assets are its loans. Other assets
include cash on hand (or vault cash) and deposits with the
Fed.
• A bank’s liabilities are its debts—what it owes. Deposits are
debts owed to the bank’s depositors.

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The Modern Banking System
• The Federal Reserve System (the Fed) is the central
bank of the United States.
• Banks are legally required to hold a certain
minimum percentage of their deposit liabilities as
reserves.

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The Modern Banking System

• Reserves are the deposits that a

bank has at the central bank plus
its cash on hand.
• The required reserve ratio is the
percentage of its total deposits
that a bank must keep as reserves
at the central bank.

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T-Account for a Typical Bank
• The balance sheet of a bank must always
balance, so that the sum of assets (reserves
and loans) equals the sum of liabilities
(deposits and net worth).
T-Account for a Typical Bank (millions of dollars)
ASSETS LIABILITIES

Reserves 20 100 Deposits

Loans 90 10 Net worth

Total 110 110 Total

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On the T-account of a bank:
a. Reserves are on the liability side.
b. Deposits are an important liability.
c. Assets plus net worth equal liabilities.
d. Assets are usually greater than liabilities plus net worth.

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On the T-account of a bank:
a. Reserves are on the liability side.
b. Deposits are an important liability.
c. Assets plus net worth equal liabilities.
d. Assets are usually greater than liabilities plus net worth.

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 The Creation of Money

• A bank’s required amount of

reserves = rrr x total deposits in the
bank
• Banks usually make loans up to the
point where they can no longer do
so because of the reserve
requirement restriction (or up to
the point where their excess
e x c e s s r ereserves
s e r v e s  are
a c t uzero).
a l re s e rv e s  re q u ire d re s e rv e s
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How Banks Create Money
The Money Multiplier

An increase in bank reserves leads to a greater than

one-for-one increase in the money supply. Economists
call the relationship between the final change in
deposits and the change in reserves that caused this
change the money multiplier.

money multiplier The multiple by which deposits can

increase for every dollar increase in reserves; equal to
1 divided by the required reserve ratio.

1
money multiplier 
required reserve ratio

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Assuming there are no leakages out of the
banking system, a money multiplier
equal to 10 means that:
a. The reserve ratio equals 10.
b. An additional $10 of reserves create one
dollar of deposits.
c. Each additional dollar of deposits
creates $10 of reserves.
d. Each additional dollar of reserves
creates $10 of additional deposits.

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Assuming there are no leakages out of the
banking system, a money multiplier
equal to 10 means that:
a. The reserve ratio equals 10.
b. An additional $10 of reserves create one
dollar of deposits.
c. Each additional dollar of deposits
creates $10 of reserves.
d. Each additional dollar of reserves
creates $10 of additional deposits.

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 The Creation of Money
• When someone deposits $100 in a bank, and the bank deposits
the $100 with the central bank, the bank has $100 in total
reserves.
• If the required reserve ratio is 20%, the bank has excess reserves
of $80. With $80 of excess reserves, the bank can have up to $400
of additional deposits. The $100 in reserves plus $400 in loans
equal $500 in deposits.

Balance Sheets of a Bank in a Single-Bank Economy

In Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400.

Panel 1 Panel 2 Panel 3

ASSETS LIABILITIES ASSETS LIABILITIES ASSETS LIABILITIES
Reserves 0 0 Deposits Reserves 100 100 Deposits Reserves 100 500 Deposits
Loans 400

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Functions of the Federal Reserve

The Fed performs important functions

for banks including:
• Clearing interbank payments.
• Regulating the banking system.
• Assisting banks in a difficult financial
position.
• Managing exchange rates and the
nation’s foreign exchange reserves.
• Control of mergers between banks.

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Functions of the Federal Reserve

The Fed performs important functions

for banks including:
• Examination of banks to ensure that
they are financially sound.
• Setting of reserve requirements for all
financial institutions.
• Lender of last resort: The Fed provides
funds to troubled banks that cannot
find any other sources of funds.

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 How the Federal Reserve
Controls the Money Supply
• Three tools are available to the Fed
for changing the money supply:
1. changing the required reserve ratio;
2. changing the discount rate; and
3. engaging in open market
operations.

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The Required Reserve Ratio
• The required reserve ratio establishes a link
between the reserves of the commercial banks
and the deposits (money) that commercial
banks are allowed to create.
• If the Fed wants to increase the money supply,
the Fed can decrease the required reserve
ratio, which allows the bank to create more
deposits by making loans.

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How the Federal Reserve Controls the Money Supply
The Required Reserve Ratio

TABLE 25.2 A Decrease in the Required Reserve Ratio from 20 Percent to 12.5 Percent
Increases the Supply of Money (All Figures in Billions of Dollars)
Panel 1: Required Reserve Ratio = 20%
Federal Reserve Commercial Banks
Assets Liabilities Assets Liabilities

Government $200 $100 Reserves Reserves $100 $500 Deposits

securities $100 Currency Loans $400

Note: Money supply (M1) = Currency + Deposits = $600.

Panel 2: Required Reserve Ratio = 12.5%
Federal Reserve Commercial Banks
Assets Liabilities Assets Liabilities

Government $200 $100 Reserves Reserves $100 $800 Deposits

securities $100 Currency Loans $700 (+ $300)
(+ $300)

Note: Money supply (M1) = currency + deposits = $900.

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How the Federal Reserve Controls the Money Supply
The Required Reserve Ratio

Decreases in the required reserve ratio allow

banks to have more deposits with the existing
volume of reserves. As banks create more
deposits by making loans, the supply of money
(currency + deposits) increases. The reverse is
also true: If the Fed wants to restrict the
supply of money, it can raise the required
reserve ratio, in which case banks will find
that they have insufficient reserves and must
therefore reduce their deposits by “calling in”
some of their loans. The result is a decrease in
the money supply.

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 The Discount Rate

• The discount rate is the interest

rate that banks pay to the Fed to
borrow from it.
• Bank borrowing from the Fed leads
to an increase in the money supply.
The higher the discount rate, the
higher the cost of borrowing, and
the less borrowing banks will want
to do.
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• Assume that there is only one bank in the
country and the required reserve ratio is 20%.
• The initial position of the bank and the Fed
appear in Panel 1, where the money supply
(currency + deposits) is $480.

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How the Federal Reserve Controls the Money Supply
The Discount Rate

TABLE 25.3 The Effect on the Money Supply of Commercial Bank Borrowing from the Fed
(All Figures in Billions of Dollars)
Panel 1: No Commercial Bank Borrowing from the Fed
Federal Reserve Commercial Banks
Assets Liabilities Assets Liabilities

Securities $160 $80 Reserves Reserves $80 $400 Deposits

$80 Currency Loans $320

Note: Money supply (M1) = currency + deposits = $480.

Panel 2: Commercial Bank Borrowing $20 from the Fed

Federal Reserve Commercial Banks
Assets Liabilities Assets Liabilities

Securities $160 $100 Reserves Reserves $100 $500 Deposits

(+ $20) (+ $20) (+ $300)
Loans $20 $80 Currency Loans $420 $20 Amount owed to
(+ $100) Fed (+ $20)

Note: Money supply (M1) = currency + deposits = $580.

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• In panel 2, bank has borrowed $20 from Fed.
By using this $20 as a reserve, the bank can
increase the loans by $100, from $320 to
$420. (Remember, rrr = 20% gives a money
multiplier of 5; having excess reserves of $20
allows the bank to create additional $20 x 5,
or $100, in deposits. The money supply has
thus increased from $480 to $580.

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 The Discount Rate
• Therefore, bank borrowing from Fed leads to
an increase in the money supply.
• The Fed can influence bank borrowing, and
thus the money supply, through the discount
rate: the higher the discount rate, the higher
the cost of borrowing, and the less borrowing
banks will want to do.
• Moral suasion is the pressure that was exerted
in the past by the central bank on member
banks to discourage them from borrowing
heavily.

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 Open Market Operations

• Open market operations is the

purchase and sale by the central bank
of government securities in the open
market; a tool used to expand or
contract the amount of reserves in
the system and thus the money
supply.
• Open market operations is by far the
most significant tool of the CB for
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The preferred tool of the Federal Reserve for
conducting monetary policy involves:
a. Changes in the reserve requirement.
b. Changes in the discount rate.
c. Open market operations.
d. Government spending and taxation.

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The preferred tool of the Federal Reserve for
conducting monetary policy involves:
a. Changes in the reserve requirement.
b. Changes in the discount rate.
c. Open market operations.
d. Government spending and taxation.

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Open Market Operations

• An open market purchase of

securities by the CB results in
an increase in reserves and
an increase in the supply of
money by an amount equal
to the money multiplier times
the change in reserves.

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Open Market Operations

• An open market sale of

securities by the CB results in
a decrease in reserves and a
decrease in the supply of
money by an amount equal
to the money multiplier times
the change in reserves.

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If the Fed wants to increase the money supply, it will:
a. Increase the discount rate.
b. Increase the reserve requirement.
c. Buy government securities in the open market.
d. Print money.
e. Sell gold.

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If the Fed wants to increase the money supply, it will:
a. Increase the discount rate.
b. Increase the reserve requirement.
c. Buy government securities in the open market.
d. Print money.
e. Sell gold.

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How the Federal Reserve Controls the Money Supply
The Supply Curve for Money

If the Fed’s money

supply behavior is
not influenced by
the interest rate, the
money supply curve
is a vertical line.
Through open
market operations,
the Fed can have the
money supply be
whatever value it
wants.
 FIGURE 25.5 The Supply of Money
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