The Money Supply and The Federal Reserve System

1
CHAPTER 21
The Money Supply and the

Federal Reserve System
Prepared by: Fernando Quijano

and Yvonn Quijano
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
An Overview of Money
• Money is anything that is generally

accepted as a medium of exchange.
• Money is not income, and money is
not wealth. Money is:
• a means of payment,
• a store of value, and
• a unit of account.
© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair 2
• Money as a means of payment, or medium

of exchange, is more efficient than barter.
• Barter is the direct exchange of goods and
services for other goods and services.
• A barter system requires a double
coincidence of wants for trade to take
place. Money eliminates this problem.
• Money is a lubricant in the functioning of a
market economy.
• Money as a store of value refers to money as

an asset that can be used to transport
purchasing power from one time period to
another.
• Money is easily portable, and easily exchanged
for goods at all times. The liquidity property
of money makes money a good medium of
exchange as well as a store of value.
• Money also serves as a unit of account, or a

standard unit that provides a consistent way of
quoting prices.
• Commodity monies are items used as money
that also have intrinsic value in some other
use. Gold is one form of commodity money.
• Fiat, or token, money is money that is
intrinsically worthless.
• Legal tender is money that a government has
required to be accepted in settlement of debts.
Measuring the Supply of Money
in the United States
• The two most common measures of
money are M1 and M2.
• M1, or transactions money is money that
can be directly used for transactions. It
includes currency held outside banks, plus
demand deposits, plus traveler’s checks,
plus other checkable deposits
• M1 is a stock measure—it is measured at
a point in time—on a specific day. On
June 26, 2000, M1 was $1,103.3 billion.
Measuring the Supply of Money
in the United States
• M2, or broad money, includes near
monies, or close substitutes for
transactions money.
• M2 / M1 + savings accounts + money
market accounts + other near monies
• On June 26, 2000, M2 was $4,778.2

billion.
• The main advantage of looking at M2
instead of M1 is that M2 is sometimes
more stable.
The Private Banking System
• Most of the money in the United States

today is “bank money,” or money held
in checking accounts rather than
currency.
• Financial intermediaries are banks
and other financial institutions that act
as a link between those who have
money to lend and those who want to
borrow money.
How Banks Create Money
• To see how banks create money, consider

the origins of the modern banking system:
• Goldsmiths functioned as warehouses where
people stored gold for safekeeping.
• Upon receiving the gold, a goldsmith would
issue a receipt to the depositor. After a time,
these receipts themselves, rather than the gold
that they represented, began to be traded for
goods.
• At this point, all the receipts issued were
backed 100 percent by gold.
• Goldsmiths realized that people did not

come often to withdraw gold and, as a
result, they had a large stock of gold
continuously on hand. They could lend
out some of this gold without any fear of
running out.
• There were thus more claims than there
were ounces of gold.
• Knowing there were more receipts

outstanding than there were ounces of
gold, people might start to demand gold
for receipts.
• A run on a goldsmith (or a modern-day
bank) occurs when many people
present their claims at the same time.
The Modern Banking System
• A brief review of accounting:

Assets – liabilities / Net Worth, or
Assets / Liabilities + Net Worth
• A bank’s most important assets are its loans.
Other assets include cash on hand (or vault cash)
and deposits with the Fed.
• The Federal Reserve System (the Fed) is the
central bank of the United States.
• A bank’s liabilities are the promises to pay, or
IOUs, that it has issued. A bank’s most important
liabilities are its deposits.
T-Account for a Typical Bank
• The balance sheet of a bank must always

balance, so that the sum of assets
(reserves and loans) equals the sum of
liabilities (deposits and net worth).
T-Account for a Typical Bank (millions of dollars)
ASSETS LIABILITIES
Reserves 20 100 Deposits
Loans 90 10 Net worth
Total 110 110 Total
The Creation of Money
• Banks usually make loans up to the point

where they can no longer do so because
of the reserve requirement restriction (or
up to the point where their excess
reserves are zero).
excess reserves  actual reserves  required reserves
• When someone deposits $100, and the

bank deposits the $100 with the central
bank, it has $100 in reserves.
• If the required reserve ratio is 20%, the
bank has excess reserves of $80. With
$80 of excess reserves, the bank can lend
$400 and have up to $400 of additional
deposits. The $100 in reserves plus $400
in loans equal $500 in deposits.
Balance Sheets of a Bank in a Single-Bank Economy

Panel 1 Panel 2 Panel 3
ASSETS LIABILITIES ASSETS LIABILITIES ASSETS LIABILITIES
Reserves 0 0 Deposits Reserves 100 100 Deposits Reserves 100 500 Deposits
Loans 400
The Creation of Money: Balance Sheets of Three Banks
Panel 1 Panel 2 Panel 3
ASSETS LIABILITIES ASSETS LIABILITIES ASSETS LIABILITIES
Loans 80 Loans 80

Loans 64 Loans 64
Reserves 64 64 Deposits Reserves 64 115.20 Deposits Reserves 12.80 64 Deposits
Summary: Deposits
Bank 1 100
Bank 2 80
Bank 3 64
Bank 4 51.20
. .
. .
. .
Total 500.00
The Money Multiplier
• The money multiplier is the multiple by

which deposits can increase for every
dollar increase in reserves.
1
Money multiplier =
Required reserve ratio
• If the required reserve ratio is 10%, then

an increase in reserves of $1 could cause
an increase in deposits of $10 if there
were no leakage out of the system.
The Federal Reserve System
• The Federal Open Market Committee

(FOMC) sets goals regarding the money
supply and interest rates and directs the
operations of the Open Market Desk in
New York.
• The Open Market Desk is an office in the
New York Federal Reserve Bank from
which government securities are bought
and sold by the Fed.
Functions of the Fed
The Fed performs important functions for

banks including:
• Clearing interbank payments.

• Regulating the banking system.
• Assisting banks in a difficult financial
position.
• Managing exchange rates and the nation’s
foreign exchange reserves.
Functions of the Fed
The Fed performs important functions for

banks including:
• Control of mergers between banks.

• Examination of banks to ensure that they
are financially sound.
• Setting of reserve requirements for all
financial institutions.
• Lender of last resort.
The Fed’s Balance Sheet
Assets and Liabilities of the Federal Reserve System, April 30, 2000
(millions of dollars)
ASSETS LIABILITIES
Gold $ 11,048 $535,349 Federal Reserve notes (outstanding)

Loans to banks 25,145 Deposits:
U.S. Treasury 506,695 13,480 Bank reserves (from depository institutions)
securities 15,868 U.S. Treasury
All other assets 46,839 25,030 All other liabilities and net worth
Total $ 589,727 $589,727 Total
Source: Federal Reserve Bulletin, July 2000, Table 1.18.
The Fed’s Balance Sheet
• Although it is unrelated to the money

supply, the Fed’s gold counts as an asset
on its balance sheet.
• The largest of the Fed’s assets, by far,
consists of government securities
purchased over the years.
• A dollar bill is a liability, or IOU, of the Fed.
How the Fed Controls
the Money Supply
• The required reserve ratio establishes a link
between the reserves of the commercial
banks and the deposits (money) that
commercial banks are allowed to create.
• If the Fed wants to increase the money
supply, it creates more reserves, thereby
freeing banks to create additional deposits
by making more loans. If it wants to
decrease the money supply, it reduces
reserves.
How the Fed Controls
the Money Supply
A Decrease in the Required Reserve Ratio From 20 Percent to 12.5 Percent
Increases the Supply of Money (All Figures in Billions of Dollars)
PANEL 1: REQUIRED RESERVE RATIO = 20%
Federal Reserve Commercial Banks
Assets Liabilities Assets Liabilities
Government $200 $100 Reserves Reserves $100 $500 Deposits
securities $100 Currency Loans $400
Note: Money supply (M1) = Currency + Deposits = $600.
PANEL 2: REQUIRED RESERVE RATIO = 12.5%
Government $200 $100 Reserves Reserves $100 $800 Deposits
securities $100 Currency Loans $700 (+ $300)
(+ $300)
The Discount Rate
• Banks may borrow from the Fed. The

interest rate they pay the Fed is the
discount rate.
• Bank borrowing from the Fed leads to an
increase in the money supply. The higher
the discount rate, the higher the cost of
borrowing, and the less borrowing banks
will want to do.
The Discount Rate
The Effect On the Money Supply of Commercial Bank Borrowing from the Fed
(All Figures in Billions of Dollars)
PANEL 1: NO COMMERCIAL BANK BORROWING FROM THE FED
Securities $160 $80 Reserves Reserves $80 $400 Deposits
$80 Currency Loans $320
PANEL 2: COMMERCIAL BANK BORROWING $20 FROM THE FED
Securities $160 $100 Reserves Reserves $100 $500 Deposits
(+ $20) (+ $20) (+ $300)
Loans $20 $80 Currency Loans $420 $20 Amount owed
(+ $100) to Fed (+ $20)
The Discount Rate
• In practice, the Fed does not often use the

discount rate to control the money supply.
• The discount rate cannot be used to
control the money supply with great
precision, because its effects on banks’
demand for reserves are uncertain.
• Moral suasion is the pressure exerted by
the Fed on member banks to discourage
them from borrowing heavily from the Fed.
Open Market Operations
• Open market operations is the purchase

and sale by the Fed of government
securities in the open market; a tool used
to expand or contract the amount of
reserves in the system and thus the
money supply.
• Open market operations is by far the most
significant tool of the Fed for controlling
the supply of money.
The Mechanics of
Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the Differences
Between Those Panels and Panel 1.) (All Figures in Billions of Dollars)
PANEL 1
Federal Reserve Commercial Banks Jane Q. Public
Assets Liabilities Assets Liabilities Assets Liabilities
Securities $100 $20 Reserves Reserves $20 $100 Deposits Deposits $5 $0 Debts
$80 Currency Loans $80 $5 Net Worth
Note: Money supply (M1) = Currency + Deposits = $180. $80 Currency
PANEL 2
( $5) ( $5) ( $5) ( $5) ( $5)
$80 Currency Loans $80 Securities $5 $5 Net Worth
(+ $5)
PANEL 2
( $5) ( $5) ( $5) ( $25) ( $5)
$80 Currency Loans $60 Securities $5 $5 Net Worth
( $20) (+ $5)
• An open market purchase of securities by

the Fed results in an increase in reserves
and an increase in the supply of money by
an amount equal to the money multiplier
times the change in reserves.
• An open market sale of securities by the
Fed results in a decrease in reserves and
a decrease in the supply of money by an
amount equal to the money multiplier
times the change in reserves.
• Open market operations are the Fed’s

preferred means of controlling the money
supply because:
• they can be used with some precision,
• are extremely flexible, and
• are fairly predictable.
The Supply Curve for Money
• A vertical money
supply curve says
the Fed sets the
money supply
independent of the
interest rate.

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1

The Money Supply and the

Prepared by: Fernando Quijano

• Money is anything that is generally

• Money as a means of payment, or medium

• Money as a store of value refers to money as

• Money also serves as a unit of account, or a

• On June 26, 2000, M2 was $4,778.2

• Most of the money in the United States

• To see how banks create money, consider

• Goldsmiths realized that people did not

• Knowing there were more receipts

• A brief review of accounting:

• The balance sheet of a bank must always

Reserves 20 100 Deposits

Loans 90 10 Net worth

Total 110 110 Total

• Banks usually make loans up to the point

excess reserves  actual reserves  required reserves

• When someone deposits $100, and the

Balance Sheets of a Bank in a Single-Bank Economy

Reserves 80 80 Deposits Reserves 80 144 Deposits Reserves 16 80 Deposits

Reserves 64 64 Deposits Reserves 64 115.20 Deposits Reserves 12.80 64 Deposits

• The money multiplier is the multiple by

• If the required reserve ratio is 10%, then

• The Federal Open Market Committee

The Fed performs important functions for

• Clearing interbank payments.

The Fed performs important functions for

• Control of mergers between banks.

Gold $ 11,048 $535,349 Federal Reserve notes (outstanding)

• Although it is unrelated to the money

• Banks may borrow from the Fed. The

• In practice, the Fed does not often use the

• Open market operations is the purchase

• An open market purchase of securities by

• Open market operations are the Fed’s

• are extremely flexible, and

• are fairly predictable.

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