Chapter 14: Money, Banks, and the Federal
Reserve System
Yulei Luo
SEF of HKU
March 28, 2016
Learning Objectives
1. De…ne money and discuss its four functions.
2. Discuss the de…nitions of the money supply.
3. Explain how banks create money.
4. Discuss the three policy tools the central bank uses to manage
the money supply.
5. Explain the quantity theory of money and use it to explain
how high rates of in‡ation occur.
What Is Money and Why Do We Need It?
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Money: Economists consider money to be any asset that
people are generally willing to accept in exchange for goods
and services, or for payment of debts.
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Asset: Anything of value owned by a person or a …rm.
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Suppose you were living before the invention of money. If you
wanted to trade, you would have to barter, trading goods and
services directly for other goods and services.
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Shortcoming: requiring a double coincidence of wants. For a
barter trade to take place bw. two people, each person must
want what the other one has.
Hence, the problem of BE provides an incentive to identify a
product that most people will accept in exchange for what
they have to trade.
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(Conti.) Eventually, societies started using commodity money.
Commodity money: A good used as money; also has value
independent of its use as money. E.g., silver, gold, and
deerskin.
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Historically, once a good became widely accepted as money,
people who didn’t have an immediate use for it would be
willing to accept it.
Trading G&S is much easier once money becomes available:
people only need to sell what they have for money and then
use the money to buy what they want.
By making exchange easier, money allows people to specialize
and become more productive while pursuing their comparative
advantage.
The Functions of Money
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Anything used as money— whether a deerskin, a seashell,
cigarettes, or a dollar bill— should ful…ll the following four
functions:
1. Medium of exchange (MOE): Money serves as a MOE when
sellers are willing to accept it in exchange for G&S. An
economy is more e¢ cient when a single good is recognized as
a MOE.
2. Unit of account: Instead of having to quote the price of a
single good in terms of many other goods, each good has a
single price. This function of money gives buyers and sellers a
unit of account, a way of measuring value in terms of money.
E.g., in U.S., every good has a price in terms of dollars.
3. Store of value: Money allows value to be stored easily: If you
do not use all your accumulated dollars to buy G&Ss today,
you can hold the rest to use in the future. Note that money is
not the only store of value.
4. Standard of deferred payment (SDP): Money can serve as a
SDP in borrowing and lending. Money can facilitate exchange
over time by providing a store of value and a standard of
deferred payments.
What Can Serve as Money?
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Five criteria make a good suitable to use as a medium of
exchange:
1. The good must be acceptable to (that is, usable by) most
people.
2. It should be of standardized quality so that any two units are
identical.
3. It should be durable so that value is not lost by spoilage.
4. It should be valuable relative to its weight so that amounts
large enough to be useful in trade can be easily transported.
5. The medium of exchange should be divisible because di¤erent
goods are valued di¤erently.
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Dollar bills meet all these criteria.
Commodity Money
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Commodity money (CM) meets the criteria for a medium of
exchange.
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But CM has a signi…cant problem: its value depends on it
purity. Unless traders trust each other completely, they needed
to check the weight and purity of the metal at each trade.
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It is ine¢ cient to use commodity good (transportation costs
and risk, etc.). To get around this problem, private
institutions or governments began to store gold and issue
paper certi…cates that could be redeemed for gold.
Fiat Money
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It can be ine¢ cient for an economy to rely on only gold or
other precious metals for its money supply.
Money, such as paper currency, that is authorized by a central
bank or governmental body and that doesn’t have to be
exchanged by the central bank for gold or some other
commodity money.
Federal Reserve System: The central bank of the US. A U.S.
dollar bill is actually a Federal Reserve Note, issued by the FR.
Federal Reserve currency is legal tender in the US, which
means the federal government requires that it be accepted in
payment of debts and requires that cash or checks
denominated in dollars be used in payment of taxes.
HHs and …rms have con…dence that if they accept paper
dollars in exchange for G&Ss, the dollars will not lose much
value during the time they hold them.
Hong Kong Monetary Authority: The central bank of Hong
Kong.
How Do We Measure Money Today?
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Economists have developed several di¤erent de…nitions of the
money supply (MS). Each de…nition includes a di¤erent group
of assets and is based on how liquid the assets are.
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The most narrow measure of money is cash. Broader
measures include other assets that can be easily converted
into cash, such as checking account or saving account.
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M1: The narrowest de…nition of the MS.
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Currency: All the paper money and coins that are in circulation
– meaning what is not held by banks or the government.
The value of all checking account balances at banks.
The value of traveler’s checks. (ignore it in our discussion of
the money supply as it is too small.)
Checking account deposits (CAD) are used much more often
than currency to make payments. More than 80% of all
expenditures on G&S are made with checks rather than with
currency.
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M2: A broader de…nition of the money supply: M1 plus
savings account balances, small-denomination time deposits
(such as CoD), balances in money market deposit accounts in
banks, and non-institutional money market fund shares.
Small-denomination time deposits are similar to savings
accounts, but the deposits are for a …xed period of
time— usually from six months to several years— and
withdrawals before that time are subject to a penalty.
Money market mutual funds invest in very short-term bonds,
such as U.S. Treasury bills.
In the following discussion, we will use the M1 de…nition of
the MS because it corresponds most closely to money as a
medium of exchange.
There are two key points about the MS to keep in mind:
1. The money supply consists of both currency and checking
account deposits.
2. Because balances in checking account deposits are included in
the MS, banks play an important role in the process by which
the MS increases and decreases.
U.S. Money Supply, July 2013
How much money is there
in America? This is harder
to answer than it first
appears, because you
have to decide what to
count as “money”.
M1 is the narrowest
definition of the money
supply: the sum of
currency in circulation,
checking account deposits
in banks, and holdings of
Figure 14.1 Measuring the money
supply, July 2013
traveler’s checks.
There is a relatively large amount of U.S. currency, because people
in other countries sometimes hold and use U.S. dollars instead of
their own currency.
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U.S. Money Supply, July 2013—continued
Figure 14.1
Measuring the money
supply, July 2013
M2 is a broader definition of the money supply: it includes M1, plus
savings account balances, small-denomination time deposits,
balances in money market deposit accounts, and non-institutional
money market fund shares.
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Making
the
Connection
Are Bitcoins Money?
When we think of money, we typically think
of currency issued by a government.
• But currency is only a small part of the
money supply.
Over the last decade or so, consumers have
come to trust forms of e-money such as
PayPal.
Bitcoins are a new form of e-money, owned not by a government or
firm, but a product of a decentralized system of linked computers.
• Bitcoins can be traded for other currencies on web sites.
• Some web sites accept Bitcoins as a form of payment.
Should Bitcoins be included in a measure of the money supply?
• For now, they are not; if they grow popular, maybe they should be.
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Two examples
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The De…nitions of M1 and M2. Suppose you decide to
withdraw $2, 000 from your checking account and use the
money to buy a bank certi…cate of deposit (CoD). How this
will a¤ect M1 and M2? Answers: Reduce M1 by $2000 but
leaves M2 unchanged.
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What About Credit Cards and Debit Cards? They are not
included in the de…nitions of the money supply. When you buy
G&S with a credit card, you are in e¤ect taking out a loan
from the bank issuing the card. Only when you pay your bill
at the end of the moth from your checking account is the
transaction complete. With a debit card, the funds to make
the purchase are taken directly from your checking account.
In either case, the cards themselves do not represent money.
Bank Balance Sheets
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The key assets on a bank’s balance sheet are its reserves,
loans, and holdings of securities, such as U.S. treasury bills.
Reserves: Deposits that a bank keeps as cash in its vault or on
deposit with the Federal Reserve.
Required reserves: Reserves that a bank is legally required to
hold, based on its checking account deposits.
Required reserve ratio: The minimum fraction of deposits
banks are required by law to keep as reserves.
Excess reserves: Reserves that banks hold over and above the
legal requirement.
Banks make consumer loans to households and commercial
loans to businesses. A loan is an asset to a bank because it
represents a promise by the person taking it out to make
certain speci…ed payments to the bank.
Deposits include checking accounts, savings accounts, and
certi…cates of deposit, and are liabilities to banks because they
are owed to the households or …rms that have deposited the
funds.
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Fractional reserve banking system: A banking system in which
banks keep less than 100% of deposits as reserves.
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Bank run A situation in which many depositors simultaneously
decide to withdraw money from a bank.
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Bank panic A situation in which many banks experience runs
at the same time.
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A central bank, like the Federal Reserve in the US, can help
stop a bank panic by acting as a lender of last resort. In
acting as a lender of last resort, a central bank makes loans to
banks that cannot borrow funds elsewhere.
Bank Balance Sheets
Figure 14.2
Balance sheet of a typical large bank
On a balance sheet, a firm’s assets are listed on the left, and its
liabilities (and stockholders’ equity, or net worth) are listed on the
right. The left and right sides must add to the same amount.
• Banks use money deposited with them to make loans and buy
securities (investments).
• Their largest liabilities are their deposit accounts: money they owe
to their depositors.
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Bank Balance Sheets
Figure 14.2
Balance sheet of a typical large bank
Reserves are deposits that a bank keeps as cash in its vault or on
deposit with the Federal Reserve.
• Notice that the bank does not keep enough deposits on hand to
cover all of its deposits. This is how the bank makes a profit:
lending out or investing money deposited with it.
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Money Creation at Bank of America
A T-account is a stripped-down version of a balance sheet, showing
only how a transaction changes a bank’s balance sheet.
When you deposit $1,000 in currency at Bank of America, its reserves
increase by $1,000 and so do its deposits:
The currency component of the money supply decreases by the
$1,000, since that $1,000 is no longer in circulation; but the checking
deposits component increases by $1,000. So there is no net change
in the money supply—yet.
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T-Accounts
But Bank of America needs to
make a profit; so it keeps 10%
of the deposit as reserves, and
lends out the rest, creating a
$900 checking account deposit.
The $900 initially appears in a BoA checking account but will soon be
spent; and Bank of America will transfer $900 in currency to the bank
at which the $900 check is deposited.
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When Will it End?
Each “round”, the additional checking account deposits get smaller
and smaller.
• Every round, 10% of the deposits are kept as reserves. This allows
us to tell by how much the checking deposits will eventually
increase: the $1,000 in currency will become the 10% required
reserves for all of the checking deposits, so a total of $10,000 in
checking deposits can be created.
Bank
Increase In Checking Account Deposits
Bank of America
$1,000
PNC
+ 900
(= 0.9 × $1,000)
Third Bank
+ 810
(= 0.9 × $900)
Fourth Bank
+ 729
(= 0.9 × $810)
•
+•
•
+•
•
+•
Total change in checking account deposits
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= $10,000
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Simple Deposit Multiplier
An alternative way to find out how much money the original $1,000 in
currency will create is to add up all of the checking account deposits.
$1,000 + [0.9 × $1,000] + [(0.9 × 0.9) × $1,000] + [(0.9 × 0.9 × 0.9) × $1,000] + …
= $1,000 + [0.9 × $1,000] + [0.92 × $1,000] + [0.93 × $1,000] + …
= $1,000 (1 + 0.9 + 0.92 + 0.93 + …)
The expression in the parentheses can be rewritten as:
1
1
= 10
=
1 − 0.9
0.10
So the total increase in deposits is $1,000(10) = $10,000.
• The “10” here is the simple deposit multiplier: the ratio of the
amount of deposits created by banks to the amount of new
reserves.
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General Form for the Simple Deposit Multiplier
In general, we can write the simple deposit multiplier as:
Simple deposit multiplier =
1
RR
So with a 10% required reserve ratio (RR), the simple deposit multiplier
is 10.
• With a 20% required reserve ratio, the simple deposit multiplier is 5.
Then:
Change in checking account deposits = Change in bank reserves ×
1
RR
For example, $100,000 in new deposit, with a 10% required
reserve ratio, results in:
1
0.10
= $100,000 × 10 = $1,000,000
Change in checking account deposits = $100,000 ×
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Real-World Deposit Multiplier
With a 10% required reserve ratio, the simple deposit multiplier tells
us that a currency deposit will be multiplied 10 times.
• But in reality, we do not observe this: currency deposits only end
up being multiplied about 2.5 times, during “normal” periods.
Why this difference?
• Banks may not lend out as much as we predict, either because
they want to keep excess reserves, or they cannot find creditworthy borrowers.
• Consumers keep some currency out of the bank; that currency
cannot be used as required reserves.
Note: during the recession of 2007-2009, research suggests that the
real-world multiplier fell to close to 1.
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How the Federal Reserve Manages the Money Supply?
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Monetary policy: The actions the Federal Reserve takes to
manage the money supply (MS) and interest rates to pursue
economic objectives.
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To manage the MS, the Fed uses three monetary policy tools:
1. Open market operations
2. Discount policy
3. Reserve requirements
The Federal Reserve System
Figure 14.3
The Federal Reserve system
In 1913, Congress divided the country into 12 Federal Reserve
districts, each of which provides services to banks in the district.
But the real power of the Fed lies in Washington, DC, with the Board
of Governors.
• In 2013, the chair of the Board of Governors was Ben Bernanke.
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The Federal Reserve System—continued
Figure 14.3
The Federal Reserve system
The Fed is also responsible for managing the money supply.
The Federal Open Market Committee (FOMC) conducts America’s
monetary policy: the actions the Federal Reserve takes to manage
the money supply and interest rates to pursue macroeconomic
policy objectives.
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Open Market Operations
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Federal Open Market Committee (FOMC) The Federal
Reserve committee responsible for OMOs and managing the
MS in the U.S.. It meets eight times per year to discuss
monetary policy.
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Open market operations: The buying and selling of Treasury
securities by the Federal Reserve in order to control the MS.
Note that the US treasury borrows money by selling bills,
note, and bonds.
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To increase (decrease) MS, the FOMC directs the trading
desk, located in the New York Fed, to buy (sell) US treasury
securities from the public. When the sellers (buyers) deposit
(withdraw) the funds in (from) their banks, the reserve of
banks will rise (decline). This will start the process of
increasing (decreasing) loans and checking account deposits
that increases (decrease) MS.
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(Conti.) Three reasons why the Fed conducts MP principally
through OMO:
1. The Fed initiate OMO, it completely controls their volume.
2. The Fed can make both large and small OMO.
3. The Fed can implement its OMO quickly.
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The main way the Fed increases the MS is not by printing
more paper money but buying Treasury securities.
Open Market Operations in Action
The Fed has three monetary policy tools at its disposal:
Open market operations (most common)
Suppose the Fed engages in an open market purchase of $10 million.
• The banking system’s T-account reflects an increase in reserves,
and a corresponding decrease in assets due to its debt to the Fed.
• The banking system’s reserves are liabilities for the Fed, but it
gains assets equal to the debt owed to it by the banking system.
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Discount Policy
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Discount loans Loans the Federal Reserve makes to banks.
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Discount rate The interest rate the Federal Reserve charges
on discount loans.
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When a bank receives a loan from the Fed, its reserves
increase by the amount of the loan. By lowering the DR, the
Fed can encourage banks to take additional loans and thereby
increase their reserves. As a result, MS will increase.
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Note that in practice, this policy is used to help banks that
experience temporary problems with deposit withdrawals,
rather than to use them to increase or decrease MS.
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In response to the bank failures that were occurring at the
onset of the Great Depression, Congress established the
Federal Deposit Insurance Corporation (FDIC) in 1934 to
insure deposits in most banks up to a limit, which is currently
$250,000 per deposit.
Reserve Requirements
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When the Fed reduces the RR ratio, it converts required
reserves into excess reserves.
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This policy is not conducted frequently because frequent
adjustments would be disruptive and costly for banks.
Putting It All Together: Decisions of the Nonbank Public,
Banks, and the Fed
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The nonbank public and banks also a¤ect MS in practice.
The public decide how much money to deposit in banks and
banks decide how much to reserve and how to loan out.
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The Fed sta¤ monitors information on banks’reserves and
deposits every week, and the Fed can respond quickly to shifts
in behavior by depositors or banks. It can therefore steer the
MS close to the desired level.
The Rise and Effects of the Shadow Banking System
The banks we have been discussing so far are commercial banks,
whose primary role is to accept funds from depositors and make
loans to borrowers.
In the last 20 years, two important developments have occurred in the
financial system:
1. Banks have begun to resell many of their loans rather than keep
them until they are paid off.
2. Financial firms other than commercial banks have become
sources of credit to businesses.
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Securitization Comes to Banking
A security is a financial asset—such as a stock or a bond—that can
be bought and sold in a financial market.
• Traditionally, when a bank made a loan like a residential mortgage
loan, it would “keep” the loan and collect payments until the loan
was paid off.
In the 1970s, secondary markets developed for securitized loans,
allowing them to be traded, much like stocks and bonds.
Securitization: The process of transforming loans or other financial
assets into securities.
(a) Securitizing a loan
(b) The flow of payments on a securitized loan
Figure 14.4
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The process of securitization
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The Shadow Banking System
The 1990s and 2000s brought increasing important of non-bank
financial firms, including:
• Investment banks: banks that do not typically accept deposits from
or make loans to households; they provide investment advice, and
engage also engage in creating and trading securities such as
mortgage-backed securities.
• Money market mutual funds: funds that sell shares to investors and
use the money to buy short-term Treasury bills and commercial
paper (loans to corporations).
• Hedge funds: funds that raise money from wealthy investors and
make “sophisticated” (often non-standard) investments.
By raising funds from investors and providing them directly or
indirectly to firms and households, these firms have become a
“shadow banking system”.
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How Does the Money Supply Affect Prices?
Beginning in the 16th century, Spain sent gold and silver from Mexico
and Peru back to Europe.
• These metals were minted into coins, increasing the money
supply.
Prices in Europe rose steadily during those years.
• This helped people to make the connection between the amount of
money in circulation and the price level.
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Connecting Money and Prices: The Quantity Equation
In the early 20th century, Irving Fisher formalized the relationship
between money and prices as the quantity equation:
Money supply
𝑀𝑀 × 𝑉𝑉 = 𝑃𝑃 × 𝑌𝑌
real output
velocity of moneyprice level
Velocity of money: the average number of times each dollar in the
money supply is used to purchase goods and services included in
GDP.
Rewriting this equation by dividing through by M, we obtain:
𝑃𝑃 × 𝑌𝑌
𝑉𝑉 =
𝑀𝑀
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Calculating the Velocity of Money
Measuring:
• The money supply (M) with M1,
• The price level (P) with the GDP deflator, and
• The level of real output (Y) with real GDP,
We obtain the following value for velocity (V):
We can always calculate V. But will we always get the same answer?
The quantity theory of money asserts that, subject to measurement
error, we will:
Quantity theory of money: A theory about the connection between
money and prices that assumes that the velocity of money is
constant.
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The Quantity Theory Explanation of Inflation
When variables are multiplied together in an equation, we can form
the same equation with their growth ratesaddedtogether.
So the quantity equation:
generates:
𝑀𝑀 × 𝑉𝑉 = 𝑃𝑃 × 𝑌𝑌
Growth rate of the money supply + Growth rate of velocity
= Growth rate of the price level or the inflation rate
+ Growth rate of real output
Rearranging this to make the inflation rate the subject, and assuming
that the velocity of money is constant, we obtain:
Inflation rate = Growth rate of the money supply − Growth rate of real output
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The Inflation Rate According to the Quantity Theory
Inflation rate = Growth rate of the money supply − Growth rate of real output
This equation provides the following predictions:
1. If the money supply grows faster than real GDP, there will be
inflation.
2. If the money supply grows slower than real GDP, there will be
deflation (a decline in the price level).
3. If the money supply grows at the same rate as real GDP, there
will be neither inflation nor deflation: the price level will be stable.
Is velocity truly constant from year to year? The answer is no.
• But the quantity theory of money can still provide insight:
• In the long run, inflation results from the money supply growing at
a faster rate than real GDP.
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How Accurate Are Estimates of Inflation from the QTM?
Real GDP growth has
been relatively
consistent over time.
So based on the
quantity theory of money
(QTM), there should be
a predictable, positive
relationship between the
annual rates of inflation
and growth rates of the
money supply.
There is a positive
relationship, but not the
consistent relationship
(a) Inflation and money supply growth in the
United States, 1870s-2000s
implied by a constant
velocity of money.
Figure 14.5a The relationship between money growth and
inflation over time and around the world
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Accuracy of the QTM—continued
We see a similar
story when we
compare average
rates of inflation and
growth rates of the
money supply across
different countries.
Although the
relationship is not
entirely predictable,
countries with higher
growth in the money
supply do have
higher rates of
inflation.
(b) Inflation and money supply growth in 56
countries, 1995-2011
Figure 14.5b
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The relationship between money growth and
inflation over time and around the world
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