The Monetary System

N.
Gregory Mankiw
Principles of
Macroeconomics Sixth Edition
16
The Monetary System
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Ron Cronovich
In this chapter,
look for the answers to these questions:
• What assets are considered “money”? What are
the functions of money? The types of money?
• What is the Federal Reserve?
• What role do banks play in the monetary
system? How do banks “create money”?
• How does the Federal Reserve control the
money supply?
2
What Money Is and Why It’s Important
 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.
3
The 3 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 of money
4
The 2 Kinds of Money
Commodity money:
takes the form of a commodity
with intrinsic value
Examples: gold coins,
cigarettes in POW camps
Fiat money:
money without intrinsic value,
used as money because of
govt decree
Example: the U.S. dollar
5
The Money Supply
 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
6
Measures of the U.S. Money Supply
 M1: currency, demand deposits,
traveler’s checks, and other checkable deposits.
M1 = $1.9 trillion (February 2011)
 M2: everything in M1 plus savings deposits,
small time deposits, money market mutual funds,
and a few minor categories.
M2 = $8.9 trillion (February 2011)
The distinction between M1 and M2

will often not matter when we talk about
“the money supply” in this course.
7
Case of India: Money Supply
 There are four measures of money supply in India which are
denoted by M1, M2, M3 and M4. This classification was
introduced by the Reserve Bank of India (RBI) in April 1977.
Prior to this till March 1968, the RBI published only one
measure of the money supply, M or defined as currency and
demand deposits with the public.
 From April 1968, the RBI also started publishing another
measure of the money supply which it called Aggregate
Monetary Resources (AMR). This included M1 plus time
deposits of banks held by the public.
 But since April 1977, the RBI has been publishing data on four
measures of the money supply which are discussed as under
8
Continue..
 M1. The first measure of money supply, M1 consists of:
 (i) Currency with the public which includes notes and coins of all
denominations in circulation excluding cash on hand with banks:
 (ii) Demand deposits with commercial and cooperative banks,
excluding inter-bank deposits; and
 (iii) ‘Other deposits’ with RBI which include current deposits of
foreign central banks, financial institutions and quasi-financial
institutions such as IDBI, IFCI, etc., other than of banks, IMF, IBRD,
etc. The RBI characterizes as narrow money.
9
Continue..
 M2. The second measure of money supply is M 2 which consists of
M1 plus post office savings bank deposits. Since savings bank deposits
of commercial and cooperative banks are included in the money supply,
it is essential to include post office savings bank deposits. The majority
of people in rural and urban India have preference for post office
deposits from the safety viewpoint than bank deposits.
 M3. The third measure of money supply in India is M 3, which consists of
M1, plus time deposits with commercial and cooperative banks,
excluding interbank time deposits. The RBI calls M 3 as broad money.
 M4. The fourth measure of money supply is M 4 which consists of M3 plus

total post office deposits comprising time deposits and demand deposits
as well. This is the broadest measure of money supply.
10
Continue..
 Of the four inter-related measures of money supply for which the
RBI publishes data, it is M3 which is of special significance. It is
M3 which is taken into account in formulating macroeconomic
objectives of the economy every year. Since M1 is narrow
money and includes only demand deposits of banks along-with
currency held by the public, it overlooks the importance of time
deposits in policy making. That is why, the RBI prefers M3 which
includes total deposits of banks and currency with the public in
credit budgeting for its credit policy.
11
Continue..
 It is on the estimates of increase in M3 that the effects of money
supply on prices and growth of national income are estimated.
In fact is an empirical measure of money supply in India, as is the
practice in developed countries. The Chakravarty Committee also
recommended the use of M3 for monetary targeting without any
reason.
12
Central Banks & Monetary Policy
 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.
13
The Structure of the Fed
The Federal Reserve System
consists of:
 Board of Governors
(7 members),
located in Washington, DC
 12 regional Fed banks,
located around the U.S. Ben S. Bernanke
 Federal Open Market Chair of FOMC,
Committee (FOMC), Feb 2006 – present
includes the Bd of Govs and
presidents of some of the regional Fed banks
The FOMC decides monetary policy.
14
Organizational Structure of RBI
15
Bank Reserves
 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
16
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%.
17
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
2. 100% reserve banking system:
banks hold 100% of deposits as reserves,
make no loans
3. Fractional reserve banking system
18
CASE 1: No banking system
Public holds the $100 as currency.
Money supply = $100.
19
CASE 2: 100% reserve banking system
Public deposits the $100 at First National Bank (FNB).
FNB holds FIRST NATIONAL BANK

100% of Assets Liabilities
deposit Reserves $100 Deposits $100
as reserves:
Loans $ 0
Money supply
= currency + deposits = $0 + $100 = $100
In a 100% reserve banking system,
banks do not affect size of money supply.
20
CASE 3: Fractional reserve banking system
Suppose R = 10%. FNB loans all but 10%
of the deposit:
FIRST NATIONAL BANK
Assets Liabilities
Reserves $100
10 Deposits $100
Loans $ 0 90
Depositors have $100 in deposits,

borrowers have $90 in currency.
Money supply = C + D = $90 + $100 = $190 (!!!)
21
How did the money supply suddenly grow?
When banks make loans, they create money.
The borrower gets
 $90 in currency—an asset counted in the
money supply
 $90 in new debt—a liability that does not have
an offsetting effect on the money supply
A fractional reserve banking system
creates money, but not wealth.
22
Borrower deposits the $90 at Second National Bank.
SECOND NATIONAL BANK

Initially, SNB’s
Assets Liabilities
T-account Reserves $ 90
9 Deposits $ 90
looks like this: Loans $ 0 81
If R = 10% for SNB, it will loan all but 10% of the

deposit.
23
SNB’s borrower deposits the $81 at Third National
Bank.
THIRD NATIONAL BANK
Initially, TNB’s
Assets Liabilities
T-account Reserves $ $8.10
81 Deposits $ 81
looks like this: Loans $ $72.90
0
If R = 10% for TNB, it will loan all but 10% of the

deposit.
24
The process continues, and money is created with
each new loan.
In this
$
100.00 example,
Original deposit = $ $100 of
FNB lending = 90.00 reserves
SNB lending = $ generates
TNB lending = 81.00 $1000 of
.. money.
. $
72.90
.. 25
.
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
26
Money Multiplier
In theory, we can predict the size of the money multiplier by knowing

the reserve ratio.
If you had a reserve ratio of 5%. You would expect a money

multiplier of 1/0.05 = 20
This is because if you have deposits of £1 million and a reserve ratio
of 5%. You can effectively lend out £20 million.
27
Suppose banks keep a reserve ratio of 10%.
Therefore, if someone deposits $100, the bank will keep $10 as reserves
and lend out $90.
However, because $90 has been lent out – other banks will see future
deposits of $90.
Therefore, the process of lending out deposits can start again.
Banks Deposits Money Lent out Reserves Total Deposits

Stage 1 100 90 10 100
Stage 2 90 81 9 190
Stage 3 81 72.9 8.1 271
28
29
ACTIVE LEARNING 1
Banks and the money supply
While cleaning your apartment, you look under the

sofa cushion and 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
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ACTIVE LEARNING 1
Answers
You deposit $50 in your checking account.

If banks hold no excess reserves, then
money multiplier = 1/R = 1/0.2 = 5
The maximum possible increase in deposits is
5 x $50 = $250
But money supply also includes currency,
which falls by $50.
Hence, max increase in money supply = $200.
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ACTIVE LEARNING 1
Answers
You deposit $50 in your checking account.

Answer: $200
B. What is the minimum amount that the
Answer: $0
If your bank makes no loans from your deposit,
currency falls by $50, deposits increase by $50,
money supply does not change.
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The Fed’s Tools of Monetary Control
 Earlier, we learned
money supply = money multiplier × bank reserves
 The Fed can change the money supply by

changing bank reserves or
changing the money multiplier.
33
How the Fed Influences Reserves
 Open-Market Operations (OMOs):
the purchase and sale of U.S. government bonds by the Fed.
 If the Fed buys a government bond from a bank, it pays by depositing
new reserves in that bank’s reserve account.
With more reserves, the bank can make more loans, increasing the
money supply.
 To increase the money supply, the Fed instructs its bond traders at the
New York Fed to buy bonds from the public in the nation’s bond markets.
The dollars the Fed pays for the bonds increase the number of dollars in
the economy.
 Some of these new dollars are held as currency, and some are deposited
in banks. Each new dollar held as currency increases the money supply
by exactly $1. Each new dollar deposited in a bank increases the money
supply by more than a dollar because it increases reserves and, thereby,
the amount of money that the banking system can create. 34
 To decrease bank reserves and the money supply, the Fed sells
government bonds.
 To reduce the money supply, the Fed does just the opposite: It sells
government bonds to the public in the nation’s bond markets. The
public pays for these bonds with its holdings of currency and bank
deposits, directly reducing the amount of money in circulation.
 In addition, as people make withdrawals from banks to buy these

bonds from the Fed, banks find themselves with a smaller quantity
of reserves. In response, banks reduce the amount of lending, and
the process of money creation reverses itself. Open-market
operations are easy to conduct.
35
 If the Fed buys a bond, the bank swaps its bond
for an equivalent amount in currency.
 The bond can’t be broken up and loaned out, but
the equivalent amount in currency can.
 Some of the currency is retained as reserves, the
rest is loaned out and expands according to the
money multiplier.
 This is how the Fed can increase the money
supply by swapping its cash for a bond held by a
bank.
36
 The Fed makes loans to banks, increasing their
reserves.
 Traditional method: adjusting the discount rate
—the interest rate on loans the Fed makes to
banks—to influence the amount of reserves
banks borrow
 New method: Term Auction Facility—the Fed
chooses the quantity of reserves it will loan, then
banks bid against each other for these loans.
 The more banks borrow, the more reserves they
have for funding new loans and increasing the
money supply. 37
How the Fed Influences the Reserve Ratio
 Recall: reserve ratio = reserves/deposits,
which inversely affects the money multiplier.
 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.
 Since 10/2008, the Fed has paid interest on
reserves banks keep in accounts at the Fed.
Raising this interest rate would increase the
reserve ratio and lower the money multiplier.
38
Problems Controlling the Money Supply
 If households hold more of their money as
currency, banks have fewer reserves,
make fewer loans, and money supply falls.
 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.
39
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 all
at once, hence banks may have to close.
40
 This can happen even if the bank is not bankrupt,
meaning that the assets are equal in value to the
liabilities. The problem is that many of the assets
are in illiquid form, such as loans that can’t be
called in instantaneously. These assets can’t be
converted to cash quickly enough to satisfy the
demand for withdrawals.
41
 Banks that fear runs 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.
42
 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.
43
Clicker question
Reducing R, the reserve requirement
A. Makes monetary policy more powerful and
reduces the likelihood of a bank run.
B. Makes monetary policy less powerful and
reduces the likelihood of a bank run.
C. Makes monetary policy less powerful and
increases the likelihood of a bank run.
D. Makes monetary policy more powerful and
increases the likelihood of a bank run.
44
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.
 Changes in the fed funds rate cause changes in
other rates and have a big impact on the economy.
45
The Fed Funds rate and other rates, 1970–2011
20 Fed Funds
Prime
3 Month T-Bill
15
Mortgage
(%)
10
0
1970 1975 1980 1985 1990 1995 2000 2005 2010
46
Monetary Policy and the Fed Funds Rate
The Federal
To raise fed funds
rf Funds market
rate, Fed sells Federal
funds rate
govt bonds (OMO). S2 S1
This removes 3.75%

reserves from the
banking system, 3.50%
reduces supply of
federal funds,
causes rf to rise. D1
F
F2 F1
Quantity of
federal funds
47
S U M MA RY
• Money serves three functions: medium of

exchange, unit of account, and store of value.
• There are two types of money: commodity
money has intrinsic value; fiat money does not.
• The U.S. uses fiat money, which includes
currency and various types of bank deposits.
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S U M MA RY
• In a fractional reserve banking system, banks

create money when they make loans. Bank
reserves have a multiplier effect on the money
supply.
• Because banks are highly leveraged, a small
change in the value of a bank’s assets causes a
large change in bank capital. To protect
depositors from bank insolvency, regulators
impose minimum capital requirements.
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S U M MA RY
• 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 recent years, the Fed has set monetary policy
by choosing a target for the federal funds rate.
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N.

 Without money, trade would require barter,

The distinction between M1 and M2

 M4. The fourth measure of money supply is M 4 which consists of M3 plus

 Banks’ liabilities include deposits,

FNB holds FIRST NATIONAL BANK

Depositors have $100 in deposits,

SECOND NATIONAL BANK

If R = 10% for SNB, it will loan all but 10% of the

If R = 10% for TNB, it will loan all but 10% of the

In theory, we can predict the size of the money multiplier by knowing

If you had a reserve ratio of 5%. You would expect a money

Banks Deposits Money Lent out Reserves Total Deposits

While cleaning your apartment, you look under the

You deposit $50 in your checking account.

You deposit $50 in your checking account.

 The Fed can change the money supply by

 In addition, as people make withdrawals from banks to buy these

This removes 3.75%

• Money serves three functions: medium of

• In a fractional reserve banking system, banks

• The Federal Reserve is the central bank of the

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