MACROECONOMICS I
The Monetary System
Lecture 6
March 18, 2022
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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?
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WHAT MONEY IS AND WHY IT’S IMPORTANT
Without money
 Trade would require barter: the exchange of 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 3 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
 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
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THE 2 KINDS OF MONEY
Commodity money:
 Takes the form of a commodity with intrinsic value
Examples: gold coins, cigarettes/ramen noodles
Fiat money:
 Money without intrinsic value, used as money
because of government decree
Example: the Czech Koruna, Euro, etc.
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THE MONEY SUPPLY
The money supply (or money stock):
 Quantity of money available in the economy
Currency:
 Paper bills and coins in the hands of the (nonbank)
public
Demand deposits:
 Balances in bank accounts that depositors can
access on demand by writing a check
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THE MONEY SUPPLY
M1 = $18.4 trillion (Feb 2021)
 Currency, demand deposits, traveler’s checks,
and other checkable deposits.
M2 =$19.7 trillion (Feb 2021)
 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. 7
CENTRAL BANKS & MONETARY POLICY
Central bank:
 Institution that oversees the banking system
and regulates the money supply
Monetary policy:
 Setting of the money supply by policymakers
in the central bank
Federal Reserve (Fed):
 The central bank of the U.S.
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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.
 Federal Open Market Committee (FOMC),
- includes the Board of Governors and
presidents of some of the regional Fed banks.
- The FOMC decides monetary policy. 9
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
The reserve ratio, R
= fraction of deposits that banks hold as reserves
= total reserves as a percentage of total deposits
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BANK T-ACCOUNT
T-account: a simplified accounting statement that shows a
bank’s assets & liabilities.
Banks’ liabilities include deposits,
Assets include loans & reserves.
Notice that R = $10/$100 = 10%. 11
FIRST NATIONAL BANK
Assets Liabilities
Reserves $ 10
Loans $ 90
Deposits $100
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
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BANKS AND THE MONEY SUPPLY: AN
EXAMPLE
Case 1: No banking system
Public holds the $100 as currency.
Money supply = $100.
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BANKS AND THE MONEY SUPPLY: AN
EXAMPLE
Case 2: 100% reserve banking system
Public deposits the $100 at First National Bank (FNB).
FNB holds
100% of
deposit
as reserves:
Money supply
= currency + deposits = $0 + $100 = $100
In a 100% reserve banking system, banks do not affect
size of money supply. 14
FIRST NATIONAL BANK
Assets Liabilities
Reserves $100
Loans $ 0
Deposits $100
FIRST NATIONAL BANK
Assets Liabilities
Reserves $100
Loans $ 0
Deposits $100
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Case 3: Fractional reserve banking system
Suppose R = 10%. FNB loans all but 10%
of the deposit:
Depositors have $100 in deposits, borrowers have
$90 in currency.
Money supply = C + D = $90 + $100 = $190 (!!!)
FIRST NATIONAL BANK
Assets Liabilities
Reserves $10
Loans $90
Deposits $100
16
Case 3: Fractional reserve banking system
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.
17
Case 3: Fractional reserve banking system
Borrower deposits the $90 at Second National
Bank.
Initially,
SNB’s
T-account
looks like this:
If R = 10% for SNB, it will loan all but 10% of the
deposit.
SECOND NATIONAL BANK
Assets Liabilities
Reserves $90
Loans $ 0
Deposits $90
SECOND NATIONAL BANK
Assets Liabilities
Reserves $ 9
Loans $81
Deposits $90
18
Case 3: Fractional reserve banking system
SNB’s borrower deposits the $81 at Third National
Bank.
Initially,
TNB’s
T-account
looks like this:
If R = 10% for TNB, it will loan all but 10% of the
deposit.
THIRD NATIONAL BANK
Assets Liabilities
Reserves $81
Loans $ 0
Deposits $81
THIRD NATIONAL BANK
Assets Liabilities
Reserves $ 8.10
Loans $72.90
Deposits $81
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Case 3: Fractional reserve banking system
The process continues, and money is created
with each new loan.
Original deposit = $100.00
FNB lending = $ 90.00
SNB lending = $ 81.00
TNB lending = $ 72.90
…
…
Total money supply = $1,000.00
In this example, $100 of reserves generates
$1,000 of money.
THE MONEY MULTIPLIER
Money multiplier = 1/R
 Amount of money the banking system
generates with each dollar of reserves
In our example, R = 10%
 Money multiplier = 1/R = 10
 $100 of reserves creates $1,000 of money
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21
ACTIVE LEARNING 1 BANKS AND THE MONEY SUPPLY
While cleaning your apartment, you look under
the sofa cushion and find a czk 5000 bill. You
deposit the bill in your checking account.
The CNB’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
money supply could increase?
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ACTIVE LEARNING 1 ANSWERS
You deposit czk 5000 in your checking account.
A. What is the maximum amount that the
money supply could increase?
If banks hold no excess reserves, then
money multiplier = 1/R = 1/0.2 = 5
The maximum possible increase in deposits is
5 x 5000 = czk25000
But money supply also includes currency, which falls
by czk 5000.
Hence, max increase in money supply = czk 20000.
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ACTIVE LEARNING 1 ANSWERS
You deposit czk 5000 in your checking account.
A. What is the maximum amount that the
money supply could increase?
Answer = czk 20000.
B. What is the minimum amount that the
money supply could increase?
Answer: czk 0
 If your bank makes no loans from your deposit,
currency falls by czk 5000, deposits increase by
czk 5000, money supply does not change.
A MORE REALISTIC BALANCE SHEET
Assets:
 Besides reserves and loans, banks also hold
securities.
Liabilities:
 Besides deposits, banks also obtain funds from
issuing debt and equity.
Bank capital:
 The resources a bank obtains by issuing equity
to its owners
 Also: bank assets minus bank liabilities 24
A MORE REALISTIC BALANCE SHEET
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
Leverage:
 The use of borrowed funds to supplement
existing funds for investment purposes
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A MORE REALISTIC BALANCE SHEET
Leverage ratio: ratio of assets to bank capital
In this example, the leverage ratio = $1000/$50 = 20
Interpretation: for every $20 in assets,
$ 1 is from the bank’s owners,
$19 is financed with borrowed money. 26
MORE REALISTIC NATIONAL BANK
Assets Liabilities
Reserves $ 200
Loans $ 700
Securities $ 100
Deposits $ 800
Debt $ 150
Capital $ 50
LEVERAGE AMPLIFIES PROFITS AND LOSSES
In our example, suppose bank assets appreciate
by 5%, from $1000 to $1050.
 This increases bank capital from $50 to $100,
doubling owners’ equity.
Instead, if bank assets decrease by 5%,
 Bank capital falls from $50 to $0.
If bank assets decrease more than 5%,
 Bank capital is negative and bank is insolvent.
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LEVERAGE AND THE FINANCIAL CRISIS
Financial crisis of 2008–2009
 Banks suffered losses on mortgage loans and
mortgage-backed securities due to widespread
defaults.
 Many banks became insolvent:
- In the U.S., 27 banks failed during 2000–2007,
-166 during 2008–2009.
 Many other banks found themselves with too little
capital, responded by reducing lending, causing a
credit crunch. 28
THE GOVERNMENT’S RESPONSE
To ease the credit crunch
 The Federal Reserve and U.S. Treasury injected
hundreds of billions of dollars’ worth of capital
into the banking system.
 This unusual policy temporarily made U.S.
taxpayers part-owners of many banks.
 The policy succeeded in recapitalizing the
banking system and helped restore lending to
normal levels in 2009.
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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
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HOW THE FED INFLUENCES RESERVES
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
loans, increasing the money supply
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HOW THE FED INFLUENCES RESERVES
The Fed makes loans to banks, increasing their
reserves
 Traditional method: adjusting the discount rate (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. 32
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.
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PROBLEMS 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
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THE FEDERAL FUNDS RATE
The federal funds rate
 Interest rate at which banks make overnight
loans to one another
- Lender – has excess reserves
- Borrower – needs reserves
 A change in federal funds rate
Cause changes in other rates and have a big
impact on the economy.
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THE FED FUNDS RATE AND OTHER RATES, 1970–2016
36
Fed. Funds
Mortgage
Prime
3 Month T-bill
37
MONETARY POLICY AND THE FED FUNDS RATE
To raise fed funds rate,
Fed sells
government bonds
(OMO).
This removes reserves
from the banking
system, reduces supply
of federal funds,
causes rf to rise.
rf
F
D1
S2
1.75%
F2
S1
F1
1.50%
The Federal
Funds market
Federal
funds rate
Quantity of federal funds
SUMMARY
• 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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SUMMARY
• 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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SUMMARY
• The Federal Reserve is the central bank of the U.S.
The Fed is responsible for regulating the monetary
system.
• The Fed controls the money supply mainly through
open-market operations.
- Purchasing government bonds increases the money
supply, selling government 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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