Ch 29 The Monetary System

N.
GREGORY MANKIW NINTH EDITION
PRINCIPLES OF
ECONOMICS
CHAPTER
The Monetary System

29
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V. Andreea Chiritescu
Eastern Illinois University
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IN THIS CHAPTER
• What assets are considered “money”?
What are the functions of money?
The types of money?
• What is the Federal Reserve System?
• What role do banks play in the monetary
system? How do banks “create
money”?
• How does the Federal Reserve control the
money supply?
2
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The Meaning of Money – 1
• Barter
– Exchange one good or service for another
– Requires a double coincidence of wants:
unlikely occurrence that two people
each have a good the other wants.
– Waste of resources: people spend time
searching for others to trade with
• Using money
– Solves those problems
3
The Meaning of Money – 2
• Money
– The set of assets in an economy that
people regularly use to buy goods
and services from other people
• Money has three functions:
– Medium of exchange, a unit of account,
and a store of value.
– Distinguish money from other assets
4
The Functions of Money
1. Medium of exchange
– Item that buyers give to sellers when they
want to purchase goods and services
2. Unit of account
– Yardstick people use to post prices and
record debts
3. Store of value
– Item that people can use to transfer
purchasing power from the present to the
future
5
Store of Value
• Transfer purchasing power from the present
to the future
– Hold money or nonmonetary assets
• Wealth
– The total of all stores of value, including both
money and nonmonetary assets
• Liquidity
– The ease with which an asset can be converted
into the economy’s medium of exchange
6
The Kinds of Money
• Commodity money:
– Money that takes the form of a commodity
with intrinsic value
• The item would have value even if it were not
used as money
• Gold coins, cigarettes in POW camps
• Fiat money:
– Money without intrinsic value, used as
money because of government
decree
• The U.S. dollar
7
Money in the U.S. Economy
• Money stock:
– The quantity of money circulating in the
economy
• Currency:
– 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
8
The Money Stock
• M1 = $3.8 trillion (July 2019)
– Currency, demand deposits, traveler’s
checks, and other checkable deposits.
• M2 =$14.9 trillion (July 2019)
– Everything in M1 plus savings deposits, small
time deposits, money market mutual funds,
and a few minor categories.
The distinction between M1 and M2 will often
not matter when we talk about “the money
supply” in this course.
9
Active Learning 1: Calculating M1 and M2
Suppose the entire economy has:
• $150 dollars kept in coffee cans and wallets
• $300 in saving accounts
• $200 in credit card limits
• $20 in traveler’s checks
• $350 in checking accounts
• $400 in money market mutual funds
Calculate M1 and M2.
10
Active Learning 1: Answers, M1 and M2
• M1 = Currency + Demand deposits + Traveler’s
checks + Other checkable deposits.
M1 = 150 + 350 + 20 + 0 = $520
• M2 = M1 + Savings deposits + Small time
deposits + Money market mutual funds + A few
minor categories.
M2 = 520 + 300 + 0 + 400 + 0 =
$1,220
11
The Federal Reserve System
• Federal Reserve (Fed)
– The central bank of the United States
• Central bank
– An institution designed to oversee the
banking system and regulate the quantity
of money in the economy
12
The Fed’s Organization
• The Federal Reserve System consists of:
– Board of Governors
• 7 members, 14-year terms, located in
Washington, DC
• Jerome Powell, Chair of the Fed, appointed in
2018
– 12 regional Federal Reserve Banks
located around the U.S.
13
The Fed’s Jobs
1. Regulate banks and ensure the health of
the banking system
– Monitors each bank’s financial condition
– Facilitates bank transactions (clearing
checks)
– A bank’s bank: makes loans to banks;
lender of last resort
2. Monetary policy by FOMC
– Control the money supply: quantity of
money available in the economy
14
The Federal Open Market Committee, FOMC
• FOMC:
– All 7 members of the Board of Governor
– And 5 of the 12 regional bank presidents
• All 12 regional presidents attend each FOMC
meeting, but only 5 get to vote
– Open-market operations, OMO:
• Buy U.S. government bonds to increase the
money supply
• Sell U. S. government bonds to decrease the
money supply
15
Bank Reserves
• 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
• The reserve ratio, R
=fraction of deposits that banks hold as reserves
=total reserves as a percentage of total deposits
16
The T-Account
• T-account: a simplified accounting
statement that shows a bank’s assets and
liabilities.
FIRST NATIONAL BANK
Assets Liabilities
Reserves $ 10 Deposits $100
Loans $ 90
• Banks’ liabilities include deposits

• Assets include loans and reserves.
• Notice that R = $10/$100 = 10%
17
EXAMPLE 1: Changes in money supply
Suppose $1,000 of currency is in circulation.
To determine banks’ impact on money supply,
we calculate the money supply in 3 different
cases:
A. No banking system
B. 100% reserve banking system (banks hold
100% of deposits as reserves, make no loans)
C. Fractional reserve banking system, R = 20%
18
EXAMPLE 1: Solution, A
A. No banking system
• Public holds the $1,000 as currency.

• Money supply = $1,000.
19
EXAMPLE 1: Solution, B
B: 100% reserve banking system. Public deposits
the $1,000 at First National Bank (FNB).
FIRST NATIONAL BANK
Assets Liabilities
Reserves $1,000 Deposits $1,000
Loans $ 0
• FNB holds 100% of deposit as reserves

• Money supply = currency + deposits = $0 +
$1,000 = $1,000
In a 100% reserve banking system, banks do not
affect size of money supply.
20
EXAMPLE 1: Solution, C – 1
C: Fractional reserve banking system, R = 20%
FNB loans all but 20% of the deposit to Isabella:
FIRST NATIONAL BANK
Assets Liabilities
Reserves $200 Deposits $1,000
Loans $800
• Depositors have $1,000 in deposits, Isabella

(the borrower) has $800 in currency.
Money supply = currency + deposits = $800 +
$1,000 = $1,800 (!!!)
21
Changes in Money Supply
How did the money supply suddenly grow?
• When banks make loans, they create money.
• Isabella (the borrower) gets:
• $800 in currency—an asset counted in the
money supply
• $800 in new debt (loans)—a liability that does
not have an offsetting effect on the money
supply
A fractional reserve banking system creates
money, but not wealth.
22
C: Fractional reserve banking system
• Isabella deposits the $800 at Second National
Bank. So, SNB’s T-account looks like this:
• If R = 20% for SNB, it will loan all but 20% of
the deposit to Kerem, and it’s T-account will
change to:
SECOND NATIONAL BANK
Assets
Assets Liabilities
Liabilities
Reserves
Reserves $160
$800 Deposits $800
Loans
Loans $ 0
$640
23
• Kerem (SNB’s borrower) deposits the $640 at
Third National Bank. So, TNB’s T-account
looks like this:
• If R = 20% for TNB, it will loan all but 20% of
the deposit to Dalia, and it’s T-account will
change to:
THIRD NATIONAL
THIRD NATIONAL BANK
BANK
Assets
Assets Liabilities
Liabilities
Reserves $128
Reserves $640 Deposits
Deposits $640
$640
Loans
Loans $512
$0
24
The process continues, and money is created
with each new loan.
Original deposit = $1,000.00
FNB lending = $ 800.00
SNB lending = $ 640.00
TNB lending = $ 512.00
………………………………………………………….
Total money supply = $5,000.00

In this example, $1,000 of reserves generates
$5,000 of money.
25
The Money Multiplier
• Money multiplier = 1/R
– Amount of money the banking system
generates with each dollar of
reserves
– Is the reciprocal of the reserve ratio
• The higher the reserve ratio
– The smaller the money multiplier because
the less of each deposit banks loan
out
26
Active Learning 2: Banks and the money supply
While cleaning his apartment, Hakeem finds a
$50 bill under the couch. He deposits the bill
in his checking account at Chase Bank.
The Fed’s reserve requirement is 10% 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?
C. How would your answers to A and B
change if
R = 5%?
27
Active Learning 1: Answers, A
R = 10%. Hakeem deposits $50 in his
checking account.
A. Maximum increase in money
supply?
• If banks hold no excess reserves, then
money multiplier = 1/R = 1/0.1 =
10
• The maximum possible increase in deposits is
10 x $50 = $500
• But money supply also includes currency,
which falls by $50.
• Hence, max increase in money supply =
28
Active Learning 1: Answers, B
R = 10%. Hakeem deposits $50 in his
checking account.
B. Minimum increase in the money
supply?
Answer: $0
– If Chase Bank makes no loans from Hakeem’s
deposit, currency falls by $50, deposits increase
by $50, money supply does not change.
– When banks hold all deposits in reserve, banks
do not influence the supply of money.
29
Active Learning 1: Answers, C
R = 5%. Hakeem deposits $50 in his checking
account.
C. Maximum and minimum increase in money
supply if R = 5%?
• Money multiplier increases to 20
• If banks hold no excess reserves, the max
increase in money supply is new deposits (20 x
$50) – currency ($50) = $950.
• If banks keep all deposits in reserve, the change in
money supply is $0, regardless of R.
30
A More Realistic Balance Sheet
• Assets: Reserves, loans, securities (stocks
and bonds)
• Liabilities: Deposits, debt, and equity.
• Bank capital (owner’s equity):
– The resources a bank obtains by issuing equity
to its owners
– Equals bank assets minus bank liabilities
• Leverage:
– The use of borrowed funds to supplement
existing funds for investment
purposes
31
EXAMPLE 2A: A More Realistic Balance Sheet
MORE REALISTIC NATIONAL BANK
Assets Liabilities
Reserves $ 400 Deposits $ 1,500
Loans $ 1,000 Debt $ 400
Securities $ 600 Capital $ 100
• Leverage ratio = $2,000/$100 = 20

• So, for every $20 in assets,
$ 1 is from the bank’s owners,
$19 is financed with borrowed
money.
32
EXAMPLE 2B: Appreciation or depreciation
• If bank assets appreciate by 5%, from $2,000 to
$2,100.
– Bank capital increases from $100 to $200,
doubling owners’ equity.
• If bank assets decrease by 5%, from $2,000
to
$1,900
– Bank capital falls from $100 to $0.
• If bank assets decrease more than 5%, bank
capital is negative and bank is insolvent.
33
Capital Requirement
• Capital requirement:
– A government regulation that specifies a
minimum amount of capital,
– Intended to ensure banks will be able to pay off
depositors and debts
• Financial crisis of 2008–2009
– Banks find themselves with too little capital to
satisfy capital requirements
– Credit crunch: the shortage of capital induced
the banks to reduce lending
34
The Fed’s Tools of Monetary Control
• Fractional-reserve banking
– Banks create money
– The Fed’s control of the money supply is
indirect
money supply = money multiplier × bank
reserves
• The Fed can change the money supply
by
– Changing quantity of reserves
– Changing the reserve ration and money
35
Open-Market Operations
• Open-Market Operations (OMOs):
– The purchase and sale of U.S.
government bonds by the
Fed.
• To increase bank reserves and the money
supply:
– The Fed buys a government bond from a
bank
• Pays by depositing new reserves in that
bank’s reserve account.
• With more reserves, the bank can make more
36
Fed Lending to Banks
• Banks borrow from Fed’s discount window
– Paying an interest rate called the discount rate
– Increasing reserves in the banking system, and
increasing the money supply
– If the Fed lowers the discount rate: encourages
banks to borrow more, increasing the
quantity of reserves and the money supply
• Term Auction Facility (2007-2010)
– Fed sets a quantity of reserves it will loan, then
banks bid against each other for these
loans.)
37
Fed Helps Financial Institutions in Trouble
• The Fed lends to banks
– Not only to control the money supply but also to
help financial institutions when they are in
trouble
– 2008 and 2009, a fall in housing prices
throughout the U.S.
• Sharp rise in mortgage defaults and many
financial institutions holding those mortgages
ran into trouble
• The Fed provided many billions of dollars in
loans to financial institutions in distress.
38
How the Fed Influences the Reserve Ratio
• The Fed sets reserve requirements:
– Regulations on the minimum amount of
reserves banks must hold against deposits.
– Reducing reserve requirements would lower the
reserve ratio and increase the money
multiplier.
• Paying interest on reserves, since Oct.
2008
– When banks hold reserves at the Fed
– Raising this interest rate would increase the
reserve ratio, lower the money
multiplier, and lower the money supply
39
Problems in Controlling the Money Supply
• The Fed does not control:
– The amount of money that households
choose to hold as deposits in
banks
– The amount that bankers choose to
lend
• Yet, the Fed can compensate for household
and bank behavior to retain fairly precise
control over the money supply.
40
Bank Runs and the Money Supply
• A run on banks:
– If people suspect their banks are in trouble,
they “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: 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
41
Bank Runs and the Money Supply
• 2007, bank run in the U.K.
– Northern Rock bank - was eventually taken
over by the British government.
• 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, FDIC
– Helped prevent bank runs in the U.S.
– A more stable banking system
42
The Federal Funds Rate
• The federal funds rate
– Interest rate at which banks make overnight loans
to other banks
– The lender has excess reserves and the borrower
needs reserves
• Decisions by the FOMC
– To change the target for the federal funds rate are
also decisions to change the money supply
• A decrease in the target for federal funds rate
– Means an expansion in the money supply
43
The Fed funds rate and other rates, 1969–2019
44
EXAMPLE 3: Monetary policy
To raise fed funds Federal Federal Funds market
rate, Fed sells funds
government bonds rate, rf
(OMO). S2 S1
• This removes 1.75%
reserves from the
1.50%
banking system,
reduces supply of
federal funds,
• causes rf to D1
F
rise. F F
2 1
Quantity of federal funds
45
THINK-PAIR-SHARE
Suppose you are a personal friend of the
chair of the Board of Governors of the Federal
Reserve System (Jerome Powell, 2019). He
comes over to your house for lunch and
notices your couch. He is so struck by the
beauty of your couch that he simply must
have it for his office. He buys it from you for
$1,000 and, since it is for his office, he
pays you with a check drawn on the
Federal Reserve Bank of New York.
46
THINK-PAIR-SHARE
A. Are there more dollars in the economy
than before? Why or why not?
B. Why do you suppose that the Fed doesn’t
buy and sell couches, real estate, and
so on instead of government bonds
when they desire to change the money
supply?
C. If the Fed doesn’t want the money supply
to rise when it purchases new
furniture, what might it do to offset the
purchase?
47
CHAPTER IN A NUTSHELL
• Money: assets that people regularly use to
buy goods and services. Three functions:
medium of exchange, unit of account, and
store of value.
• Commodity money has intrinsic value. Fiat
money, such as paper dollars, is money
without intrinsic value.
• Money in the U.S. economy: currency and
bank deposits, such as checking accounts.
48
• The Federal Reserve, the central bank of the
United States, is responsible for regulating
the U.S. monetary system.
• The Fed chair is appointed by the president
and confirmed by Congress every 4 years.
• The chair is the head of the Federal Open
Market Committee, which meets about every
6 weeks to consider changes in monetary
policy.
49
• Bank depositors provide resources to banks by
depositing their funds into bank accounts.
These deposits are part of a bank’s liabilities.
• Bank owners also provide resources (called
bank capital) for the bank. Because of leverage
(the use of borrowed funds for investment), a
small change in the value of a bank’s assets can
lead to a large change in the value of the bank’s
capital.
• To protect depositors, bank regulators require
banks to hold a certain minimum amount of
capital.
50
• The Fed controls the money supply:
– Open-market operations: The purchase of
government bonds increases the money supply,
and the sale of government bonds decreases
the money supply.
– Can expand the money supply by decreasing
the discount rate, increasing its lending to
banks, lowering reserve requirements, or
decreasing the interest rate on reserves.
51
• When individuals deposit money in banks and
banks loan out some of these deposits, the
quantity of money in the economy increases.
• Because the banking system influences the money
supply in this way, the Fed’s control of the money
supply is imperfect.
• The Fed has in recent years set monetary policy
by choosing a target for the federal funds rate, a
short-term interest rate at which banks make loans
to one another. As the Fed pursues its target, it
adjusts the money supply.
52

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N.

GREGORY MANKIW NINTH EDITION

The Monetary System

• Banks’ liabilities include deposits

• Public holds the $1,000 as currency.

• FNB holds 100% of deposit as reserves

• Depositors have $1,000 in deposits, Isabella

Total money supply = $5,000.00

• Leverage ratio = $2,000/$100 = 20

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