Chapter 7: The Monetary System

Purpose of The Monetary System: The monetary system allows for the exchange of goods
and services through the use of money, which facilitates trade in the economy.
Money: The set of assets in an economy that people regularly use to buy goods and services
from other people.
- Without money, society would rely on barter, where goods and services are traded directly,
which is less efficient.
Types of Money:
- Commodity Money: Money that takes the form of a commodity with intrinsic value
- Fiat Money: Money without intrinsic value that is used as money by government decree.
- Cryptocurrencies: A new kind of money existing only electronically.
The Importance of Liquidity
- Liquidity: The ease with which an asset can be converted into the economy’s medium of
exchange.
- It refers to how quickly and easily an asset can be turned into cash, the most liquid form of
asset because it is universally accepted.
The Role of Government:
- Governments declare fiat money as legal tender, meaning it must be accepted as payment.
- The acceptance of fiat money is based not just on government decree but also on social
conventions and the shared belief in its value.
Functions of Money
- Medium Of Exchange: An item that buyers give to sellers when they want to purchase
goods and services.
- Unit Of Account: The yardstick people use to post prices and record debts.
- Store of Value: Money can hold purchasing power over time. An item that people can use
to transfer purchasing power from the present to the future.

Money in the U.S. Economy

- Currency: The paper bills and coins in the hands of the public.
- Demand Deposits: Balances in bank accounts that depositors can access on demand by
writing a check.
- Two key measures of the U.S. money stock are M1 and M2
- M1: represents the most liquid components of the money supply, including physical
currency (coins and paper money) in circulation, demand deposits (checking accounts), and
other checkable deposits.
- They are often used for day-to-day spending.
- M1 is considered a narrow measure of the money supply because it includes only the most
liquid forms of money.
- M2: It includes all the components of M1 and currency, demand deposits, and other
checkable deposits, M2 includes savings deposits, time deposits (certificates of deposit), and
money market mutual funds held by individuals.

1. Fiat money is
a. a type of money with intrinsic value. b. a type of money set by government decree.
c. any asset used as the medium of exchange.
d. any asset used as the unit of account.
2. the money stock includes all of the following except
a. metal coins. b. paper currency.
c. lines of credit accessible with credit cards.
d. bank balances accessible with debit cards.
The Fed’s Organization
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.
Money Supply: The quantity of money available in the economy
Monetary Policy: The setting of the money supply by policymakers in the central bank
- The Federal Reserve, often called the Fed, is the central bank of the United States.
- It is responsible for regulating the banking system and controlling the quantity of money in
the economy.
- It monitors banks' financial conditions, facilitates transactions, and can lend to banks as a
"lender of last resort" to maintain system stability.
- The Federal Reserve System includes the Federal Reserve Board in Washington, D.C., and
12 regional Federal Reserve Banks across major cities.
- The Fed's primary functions are to regulate banks to ensure the banking system's health and
to control the money supply, constituting its monetary policy.

3. Which of the following is Not true about the Federal reserve?

a. it was established by the U.S. constitution.
b. it regulates the banking system.
c. it lends to banks.
d. it conducts open-market operations.
4. if the Fed wants to increase the money supply, it can
a. raise income tax rates.
b. reduce income tax rates.
c. buy bonds in open-market operations.
d. sell bonds in open-market operations.

The Simple Case of 100% Reserve Banking

Reserves: Deposits that banks have received but have not loaned out.
- Initially, imagine a world without banks where currency is the only money, a total of $100.
- Then, someone established the First National Bank, which only accepts deposits but doesn't
lend money, known as 100% reserve banking.
- Before the bank's existence, the money supply was $100 in currency.
- After the bank opens and people deposit their currency, the money supply becomes $100 in
demand deposits, with no currency in circulation.
- In a 100% reserve banking system, banks do not affect the money supply since all deposits
are held as reserves and not lent out.
Money Creation with Fractional Reserve Banking

- Fractional-Reserve Banking: A banking system in which banks hold only a fraction of

deposits as reserves.
- Reserve Ratio: The fraction of deposits that banks hold as reserves.
- Bankers at First National Bank decide not to keep all deposits as reserves but to lend some
out to earn interest, moving to fractional reserve banking.
- The reserve ratio, a fraction of deposits kept as reserves, is influenced by government
regulations (reserve requirements)
- Assuming a reserve ratio of 10%, First National Bank keeps 10% of its deposits in reserve
and lends out the rest.
- With $100 in deposits and a 10% reserve ratio, the bank’s T-account shows $10 in reserves
and $90 in loans, while still having $100 in liabilities (deposits).
- Before lending, the money supply is $100 (all in deposits). After lending $90, the money
supply increases to $190, as depositors still have $100 in demand deposits and borrowers
now hold $90 in currency.
- Fractional reserve banking creates more money but not more wealth, as it increases
liquidity (more medium of exchange available) without increasing the overall wealth of the
economy.
- Loans create simultaneous assets for the bank and liabilities for borrowers, meaning while
there’s more money in circulation, the overall wealth remains unchanged.
The Money Multiplier
- The amount of money the banking system generates with each dollar of reserves
- The process of money creation continues as money deposited in one bank is lent out and
then deposited in another bank, creating more money with each cycle of deposit and lending.
- Example: A borrower from First National Bank deposits $90 in Second National Bank,
which also has a reserve ratio of 10%. Second National keeps $9 in reserve, and lends out
$81, creating additional money.
- This process repeats, with each bank creating more money by lending out the majority of
deposits while keeping a fraction as reserves.
- Eventually, this process leads to a significant increase in the total money supply. For
instance, an initial deposit of $100 can lead to a total money supply of $1,000 through
repeated lending and deposits.
- The money multiplier is the amount of money the banking system generates with each
dollar of reserves. It is determined by the reciprocal of the reserve ratio.
- If the reserve ratio is 1/10 (or 10%), the money multiplier is 10, meaning each dollar of
reserves generates $10 of money.
- The money multiplier formula (1/R) shows how banks create money based on the reserve
ratio. A lower reserve ratio results in a higher money multiplier, allowing more money to be
created.
- The reserve ratio directly influences how much money can be created by the banking
system. Higher reserve ratios mean banks lend out less of each deposit, resulting in a smaller
money multiplier.
- In 100% reserve banking, where all deposits are kept as reserves, the reserve ratio is 1, the
money multiplier is also 1, and banks do not create additional money through lending.
- Money Multiplier = 1 / Required Reserve Ratio

Bank Capital, Leverage, and the Financial Crisis of 2008–2009

Bank Capital: The resources a bank’s owners have put into the institution
- Banks not only accept deposits but also get financial resources from issuing equity (bank
capital) and debt.
- A realistic bank balance sheet includes assets like reserves, loans, and securities, and
liabilities such as deposits, debt, and capital (owners' equity).
- Bank capital is the resources a bank gets from its owners. It uses these for various
investments to generate profit.
- Leverage is crucial for banks as it involves using borrowed money for investment,
amplifying both potential gains and risks.
- A leverage ratio shows the total assets relative to bank capital. For instance, a ratio of 20
means for every dollar of capital, the bank has $20 of assets.
- If the bank’s assets increase in value, leverage can significantly amplify the owners’ equity.
However if assets decrease in value, it can lead to dramatic losses or even bankruptcy.
- Banks are required to hold a certain amount of capital, especially if holding risky assets, to
ensure they can pay off depositors.
- Capital requirements aim to prevent banks from becoming bankrupt and to ensure they can
meet their obligations without relying on government insurance funds.
- The financial crisis of 2008-2009 highlighted the dangers of insufficient bank capital.
Many banks suffered losses, leading to a credit crunch and economic downturn.
- To stabilize the banking system, the U.S. Treasury and Fed injected public funds to
increase bank capital, making taxpayers temporary part owners of many banks. This aimed
to normalize bank lending and economic activity.
Leverage: The use of borrowed money to supplement existing funds for purposes of
investment
Leverage Ratio: The ratio of assets to bank capital
Capital Requirement: A government regulation specifying a minimum amount of bank
capital.

5. Isabella takes $100 of currency from her wallet and deposits it into her checking
account. if the bank adds the entire $100 to reserves, the money supply _________, but
if the bank lends out some of the $100, the money supply _________.
a. increases; increases even more
b. increases; increases by less
c. is unchanged; increases
d. decreases; decreases by less
6. if the reserve ratio is ¼ and the central bank increases the quantity of reserves in the
banking system by $120, the money supply increases by
a. $90.
b. $150.
c. $160.
d. $480.
7. a bank has capital of $200 and a leverage ratio of 5. if the value of the bank’s assets
declines by 10 percent, then its capital will be reduced to
a. $100.
b. $150.
c. $180.
d. $185.
The Fed’s Tools of Monetary Control
The Fed's tools for influencing the money supply fall into two categories:
- Tools that influence the quantity of reserves in the banking system.
- Tools that affect the reserve ratio and, consequently, the money multiplier.

How the Fed Influences the Quantity of Reserves

- The Federal Reserve (Fed) can modify the money supply by altering the amount of reserves
banks hold.
- The Fed changes reserves through two main methods:
- Open market operations: Buying or selling government bonds.
- Lending to banks: Direct loans to banks.
Open Market Operations: To increase the money supply, the Fed buys government bonds,
adding new dollars to the economy. These dollars boost bank reserves and the overall money
supply when deposited.
To reduce the money supply, the Fed sells government bonds. This pulls money out of
circulation and lowers bank reserves, leading to less money creation.
Open-Market Operations: The purchase and sale of U.S. government bonds by the Fed.
Discount Rate: The interest rate on the loans that the Fed makes to banks.
Reserve Requirements: Regulations on the minimum number of reserves that banks must
hold against deposits.
Federal Funds Rate: The interest rate at which banks make overnight loans to one another.
8. Which of the following actions by the Fed would tend to increase the money supply?
a. an open-market sale of government bonds
b. a decrease in reserve requirements
c. an increase in the interest rate paid on reserves
d. an increase in the discount rate on Fed lending
9. if the Fed raises the interest rate it pays on reserves, it will _________ the money
supply by increasing _________.
a. decrease; the money multiplier
b. decrease; excess reserves
c. increase; the money multiplier
d. increase; excess reserves

10. in a system of fractional-reserve banking, even without any action by the central
bank, the money supply declines if households choose to hold _________ currency or if
banks choose to hold _________ excess reserves.
a. more; more
b. more; less
c. less; more
d. less; less
Questions For review
1. Which of the following are considered money in the U.S. economy? Which are not?
Explain your answers by discussing each of the three functions of money.
a. a U.S. penny
b. a Mexican peso
c. a Picasso painting
d. a plastic credit card
2. Explain whether each of the following events increases or decreases the money
supply.
a. The Fed buys bonds in open-market operations.
- The Fed buys bonds: Increases money supply by injecting money into banks.
b. The Fed reduces the reserve requirement.
- The Fed reduces reserve requirements: Increases money supply by allowing banks to lend
more
c. The Fed increases the interest rate it pays on reserves.
- The Fed increases interest on reserves: Decreases money supply as banks prefer to hold
reserves.
d. Citibank repays a loan it had previously taken from the Fed.
- Citibank repays Fed loan: Decreases money supply by removing money from circulation.
e. After a rash of pickpocketing, people decide to hold less currency.
- People hold less currency: Increases money supply as more funds are deposited into banks.

f. Fearful of bank runs, bankers decide to hold more excess reserves.

- Bankers hold more reserves: Decreases money supply by limiting loan creation.
g. The FOMC increases its target for the federal funds rate.
- FOMC raises federal funds rate: Decreases money supply by making borrowing more
expensive.
3. Your uncle repays a $100 loan from Tenth National Bank (TNB) by writing a $100
check from his TNB checking account. Use T-accounts to show the effect of this
transaction on your uncle and on TNB. Has your uncle’s wealth changed? Explain.
- Your Uncle's T-account:

- TNB's T-account:

Explanation:
Your Uncle's T-account:
- Assets: Your uncle's assets decrease by $100 because he uses $100 from his assets to repay
the loan.
- Liabilities + Net Worth: Your uncle's liabilities decrease by $100 as he repays the loan,
which also reduces his net worth by $100.
TNB's T-account:
- Assets: TNB's assets increase by $100 because your uncle's repayment adds $100 to TNB's
reserves.
- Liabilities + Net Worth: TNB's liabilities increase by $100 as the repayment reduces your
uncle's checking deposit, which is a liability of the bank.

4. Beleaguered State Bank (BSB) holds $250 million in deposits and maintains a reserve
ratio of 10 percent.
a. Show a T-account for BSB.
- T-account for Beleaguered State Bank (BSB) before the withdrawal:

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.
- T-account for BSB after the withdrawal and reducing loans to restore the reserve ratio:

c. Explain what effect BSB’s action will have on other banks.

- When BSB reduces its loans to restore its reserve ratio, it effectively decreases the number
of reserves available to other banks in the system. This reduction in available reserves might
lead to a decrease in lending capacity for other banks and could potentially tighten liquidity
conditions in the broader banking system.
d. Why might it be difficult for BSB to take the action described in part (b)? Discuss another
way for BSB to return to its original reserve ratio.
Challenges: It might be difficult for BSB to quickly reduce its loans to restore its reserve
ratio, especially if there's limited demand for borrowing or if the bank's loan portfolio
consists of long-term loans that cannot be easily called in or adjusted.
Alternative approach: Instead of reducing loans, BSB could raise additional funds through
other means, such as attracting new deposits or borrowing from other financial institutions.
By increasing its liabilities (deposits or borrowings), BSB could bolster its reserves without
necessarily reducing its loan portfolio. For example, the bank could offer promotional rates
to attract new deposits or issue short-term debt securities to raise funds. This approach
allows BSB to maintain its lending activities while restoring its reserve ratio.

5. You take $100 you had kept under your mattress and deposit it in your bank
account. If this $100 stays in the banking system as reserves and if banks hold reserves
equal to 10 percent of deposits, by how much does the total amount of deposits in the
banking system increase? By how much does the money supply increase?
A-) Increase in Deposits:
- Since banks hold reserves equal to 10 percent of deposits, your initial $100 deposit
increases the reserves by $100. However, since banks are required to hold only 10 percent of
deposits as reserves, they can lend out the remaining 90 percent.
- Therefore, the increase in deposits is calculated as the reciprocal of the reserve ratio:
- Increase in Deposits = Initial Deposit / Reserve Ratio
= $100 / 0.10
= $1000
So, the total amount of deposits in the banking system increases by $1000.
B-) Increase in the Money Supply:
- The increase in the money supply can be calculated using the money multiplier, which is
the reciprocal of the reserve requirement ratio.
- Money Multiplier = 1 / Reserve Ratio
= 1 / 0.10 = 10
- The increase in the money supply is given by:
- Increase in Money Supply = Initial Deposit × Money Multiplier
= $100 × 10 = $1000
So, the money supply increases by $1000.
Therefore, when you deposit $100 into your bank account and it stays in the banking system
as reserves, the total amount of deposits in the banking system increases by $1000, and the
money supply also increases by $1000.

6. Happy Bank starts with $200 in bank capital. It then accepts $800 in deposits. It
keeps 12.5 percent (1/8th) of deposits in reserve. It uses the rest of its assets to make
bank loans.
a. Show the balance sheet of Happy Bank.

b. What is Happy Bank’s leverage ratio?

- The leverage ratio is calculated as the ratio of total assets to bank capital:
- Leverage Ratio = Total Assets / Bank Capital
= $800 / $200 = 4
- Happy Bank's leverage ratio is 4.
c. Suppose that 10 percent of the borrowers from Happy Bank default and that these bank
loans become worthless. Show the bank’s new balance sheet.
- Since 10 percent of the loans ($700 * 10% = $70) become worthless due to default, the
bank's assets decline by $70.

d. By what percentage do the bank’s total assets decline? By what percentage does the
bank’s capital decline? Which change is larger? Why?
- Percentage Decline = ≈ 8.75%
- The bank's total assets decline by approximately 8.75%.
Percentage decline in bank's capital: Since the bank's capital remains unchanged after the
default, the percentage decline in bank's capital is 0%.

7. The Fed conducts a $10 million open-market purchase of government bonds. If the
required reserve ratio is 10 percent, what are the largest and smallest possible increases
in the money supply that could result? Explain.
a-) Largest Possible Increase in the Money Supply:
- In this scenario, banks lend out the maximum amount allowed by the required reserve ratio,
which is the reciprocal of the reserve ratio.
- Money Multiplier = 1 / Required Reserve Ratio
- 1 / 0.10 = 10
- Therefore, the largest possible increase in the money supply is:
- Largest Increase = Initial Change in Reserves × Money Multiplier
- $10 million × 10 = $100 million

b-) Smallest Possible Increase in the Money Supply:

- In this scenario, banks hold onto the entire $10 million as excess reserves, and none of it is
lent out. Therefore, the money multiplier is 1, as no additional money is created through
lending.
- Money Multiplier = 1 / Required Reserve Ratio
- Therefore, the smallest possible increase in the money supply is:
- Smallest Increase=Initial Change in Reserves × Money Multiplier

- The largest possible increase in the money supply, with a 10% required reserve ratio, could
be up to $100 million, utilizing the full potential of the money multiplier effect. The smallest
possible increase would be exactly $10 million if banks choose not to lend out any of the
new reserves.
8. Assume that the reserve requirement is 5 percent. All other things being equal, will
the money supply expand more if the Fed buys $2,000 worth of bonds or if someone
deposits in a bank $2,000 that she had been hiding in her cookie jar? If one of these
actions creates more money than the other, how much more does it create? Support
your thinking.
- Given that the reserve requirement is 5 percent, or 0.05, we can calculate the money
multiplier as:
- Money Multiplier = 1 / Required Reserve Ratio = 1 / 0.05 = 20
- This means that for every $1 increase in reserves, the money supply could potentially
increase by up to $20.
a-) Fed Buying $2,000 Worth of Bonds:
- When the Fed buys $2,000 worth of bonds from the public, it injects $2,000 in reserves into
the banking system. Using the money multiplier, the potential increase in the money supply
is:
- Potential Increase = Initial Change in Reserves × Money Multiplier
- $2,000 × 20 = $40,000
b-) Someone Depositing $2,000 into a Bank:
- When someone deposits $2,000 into a bank, this $2,000 becomes part of the bank's
reserves. The potential increase in the money supply is the same calculation:
- Potential Increase=Initial Change in Reserves × Money Multiplier
= $2,000 × 20 = $40,000
- Both actions have the same potential to expand the money supply by up to $40,000.
- Neither creates more money than the other; the effect on the money supply is identical in
both scenarios.
- Therefore, all other things being equal, both the Fed buying $2,000 worth of bonds and
someone depositing $2,000 into a bank would lead to the same expansion of the money
supply, increasing it by $40,000.
9. Suppose that the reserve requirement for checking deposits is 10 percent and that
banks do not hold any excess reserves.
a. If the Fed sells $1 million of government bonds, what is the effect on the economy’s
reserves and money supply?
b. Now suppose that the Fed lowers the reserve requirement to 5 percent but that banks
choose to hold another 5 percent of deposits as excess reserves. Why might banks do so?
What is the overall change in the money multiplier and the money supply as a result of these
actions?

10. Assume that the banking system has total reserves of $100 billion. Assume also that
required reserves are 10 percent of checking deposits and that banks hold no excess
reserves and households hold no currency.
a. What is the money multiplier? What is the money supply?
b. If the Fed now raises required reserves to 20 percent of deposits, what are the change in
reserves and the change in the money supply?
11. Assume that the reserve requirement is 20 percent. Also assume that banks do not
hold excess reserves and that the public does not hold any cash. The Fed decides that it
wants to expand the money supply by $40 million.
a. If the Fed is using open-market operations, will it buy or sell bonds?
b. What quantity of bonds does the Fed need to buy or sell to accomplish the goal? Explain
your reasoning.
12. The economy of Elmendyn contains 2,000 $1 bills.
a. If people hold all money as currency, what is the quantity of money?
b. If people hold all money as demand deposits and banks maintain 100 percent reserves,
what is the quantity of money?
c. If people hold equal amounts of currency and demand deposits and banks maintain 100
percent reserves, what is the quantity of money?
d. If people hold all money as demand deposits and banks maintain a reserve ratio of 10
percent, what is the quantity of money?
e. If people hold equal amounts of currency and demand deposits and banks maintain a
reserve ratio of 10 percent, what is the quantity of money?
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a. Holding all money as currency: Quantity of money is $2,000.
b. All as demand deposits with 100% reserves: Quantity remains $2,000, no money creation
via lending.
c. Equal currency and deposits with 100% reserves: Total quantity is $2,000.
d. All as demand deposits with 10% reserve ratio: Quantity of money increases to $20,000
due to lending.
e. Equal currency and deposits with 10% reserve ratio: Quantity of money is $11,000,
considering the currency outside the banking system and the effect of the money multiplier
on deposits.