• What the main functions of money are and what makes something a good choice for money.
• How to explain the concept of fractionalreserve banking and the money multiplier.
• What role the central bank plays and what the Federal Reserve’s (Fed) dual mandate is.
• How the Fed conducts monetary policy.
• How monetary policy affects interest rates, the money supply, and the broader economy.
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11© 2014 by McGraw-Hill Education
Chapter 31
Money and the Monetary System
2© 2014 by McGraw-Hill Education
• What the main functions of money are and
what makes something a good choice for
money.
• How to explain the concept of fractional-
reserve banking and the money multiplier.
• What role the central bank plays and what the
Federal Reserve’s (Fed) dual mandate is.
• How the Fed conducts monetary policy.
• How monetary policy affects interest rates, the
money supply, and the broader economy.
What will you learn in this chapter?
3© 2014 by McGraw-Hill Education
• Money is the set of all assets that are regularly
used to directly purchase goods and services.
• Money serves three main functions:
1. Store of value: Money represents a certain amount of
purchasing power.
2. Medium of exchange: Money can be used to
purchase goods and services.
– A barter system is where people directly offer a
good or service for another good or service.
3. Unit of account: Money provides a standard unit of
comparison.
What is money? Functions of money
24© 2014 by McGraw-Hill Education
• There are two basic considerations that make
certain money better than others.
• Stability of value:
– Early versions of money generally took the form of a
physical material that was durable and had intrinsic
value.
– Money does not need intrinsic value to maintain
stability.
• Convenience:
– Technology has allowed for the development of more
convenient forms of money.
• For example, paper money is more convenient than gold
coins.
What makes for good money?
5© 2014 by McGraw-Hill Education
• Any form of money that can be legally
exchanged into a fixed amount of an
underlying commodity is commodity-backed
money.
– The most common underlying commodity is gold.
• Money created by rule, without any
commodity backing it, is fiat money.
– U.S. currency is backed only by the trust that the
government will keep the value of money relatively
constant.
Commodity-backed money versus fiat money
6© 2014 by McGraw-Hill Education
• Paper money made it possible for banks to
create money through a process called
fractional-reserve banking.
• The primary way that banks earn money is
through lending a fraction of deposited funds
and collecting interest on those loans.
– Demand deposits are funds held in bank accounts
that can be withdrawn by depositors at any time,
without advance notice.
Banks and the money-creation process
37© 2014 by McGraw-Hill Education
• Reserves refers to the money that banks keep
on hand.
• The reserve ratio is the ratio of the total
amount of demand deposits at the bank to the
amount kept as cash reserves.
– Required reserves is the amount that a bank is
legally required to keep on hand.
– Excess reserves is any additional amount that a
bank chooses to keep beyond the required
reserves.
Banks and the money-creation process
8© 2014 by McGraw-Hill Education
The money creation process occurs through banks repeatedly
accepting deposits and lending out a fraction of the deposits.
Banks and the money-creation process
Original deposit of
1,000 gold coins
Total deposits = 1,000 gold coins + 900 gold coins = 1,900 gold coins
Deposit of
900 more gold coins
100 gold coins
held on reserve
(10% of original deposit)
900 gold coins
loaned out
(90% of original deposit)
One
gold
coin
9© 2014 by McGraw-Hill Education
Assets Liabilities
The bank loans out 90%
of its new deposits
Assets Liabilities
The loan is deposited in
the bank
Assets Liabilities
Bank makes its first loan
Assets Liabilities
Original deposit
The above process increases money by $900.
Banks and the money-creation process
Loan: $900
Required
reserves: $100
Deposit: $1,000
Loan: $900
New cash
deposit: $900
Required
reserves: $100
Cash: $1,000 Deposit: $1,000
Deposit: $1,900 Loans: $1,710
Required
reserves: $190
Deposit: $1,900
A simple way to account for a bank’s transactions is by using
T-account formatting to record changes in banks assets and
liabilities.
410© 2014 by McGraw-Hill Education
A bank accepts a $1,000 deposit. If the bank has
a reserve ratio of 20% and loans out the rest,
find the change in assets and liabilities.
Active Learning: Money creation
Assets Liabilities
Loans: $2,000
Required
reserves
$500
Deposit: $2,500
11© 2014 by McGraw-Hill Education
• The money creation process continues with
repeated cycles of lending and depositing of
funds.
• The money multiplier is the ratio of money
created by the lending activities of the banking
system to the money created by the central bank:
Money multiplier =
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ୖୣୱୣ୰୴ୣ ୰ୟ୲୧୭
• In a fractional-reserve banking system, banks keep
less than 100% of their deposits on reserves.
Banks and the money-creation process
12© 2014 by McGraw-Hill Education
Use the money multiplier equation to fill in the
blanks in the following table.
Active Learning: The money multiplier
Situation Reserve ratio Money Multiplier
A 10%
B 5%
C 5
513© 2014 by McGraw-Hill Education
• The money supply is the amount of money
available in the economy.
– The money supply is managed by the Fed.
• The Fed classifies different types of money by
their liquidity.
– The monetary base includes cash and bank
reserves, sometime referred to as hard money.
– M1 includes cash plus checking account balances.
– M2 includes M1 plus savings accounts and other
financial instruments.
Measuring money
14© 2014 by McGraw-Hill Education
Hard money
M2
0
1
2
3
4
5
6
7
8
9
10
1984 1989 1994 1999 2004 2009
Trillions of U.S. dollars
Hard money, M1, and M2 over time • M1 indicates liquidity.
• M2 indicates savings.
• M2 is a measure of the
money multiplier when
compared to the
monetary base.
M1
Each measure provides a distinct understanding
of the financial system.
Measuring money
15© 2014 by McGraw-Hill Education
• The central bank is the institution responsible
for managing the nation’s money supply and
coordinating the banking system.
• In the U.S., the central bank is the Federal
Reserve, which has been mandated by Congress
to conduct monetary policy to perform two
essential functions:
1. Manage the money supply.
2. Act as a lender of last resort.
• Monetary policy refers to the actions made by
the central bank to manage the money supply.
Managing the money supply
616© 2014 by McGraw-Hill Education
The Federal Reserve System has a seven-member Board of Governors
and twelve regional banks that collectively act as the central bank of
the U.S.
Managing the money supply
San
Francisco
Dallas
Kansas
City
Chicago
St.
Louis
Atlanta
Richmond
Cleveland
Philadelphia
Boston
NewYork
Board of Governors,
ashington D.C.
Minneapolis
W
17© 2014 by McGraw-Hill Education
• In addition, five of the twelve regional bank
presidents serve on the Federal Open Market
Committee, or FOMC.
– Carries full responsibility for setting the overall
direction of monetary policy and guiding the money
supply.
• The Fed has a twin or dual mandate:
– Ensuring price stability: Enacting monetary policy that
meets the needs of the economy while keeping prices
constant over time.
– Maintaining full employment: Enacting monetary
policy that keeps the economy strong and stable.
Managing the money supply
18© 2014 by McGraw-Hill Education
• The Fed achieves these mandates by managing
the money supply through three main tools.
1. The reserve requirement is the amount of money
banks must hold in reserve.
2. The discount window is the lending facility that
allows banks to borrow reserves from the Fed.
• The discount rate is the interest rate charged by the Fed
for loans through the discount window.
3. Open-market operations are sales or purchases of
government bonds by the Fed to or from banks
on the open market.
Tools of monetary policy
719© 2014 by McGraw-Hill Education
• These transactions directly impact the money supply.
– Contractionary monetary policy is when money supply is
decreased to lower aggregate demand.
– Expansionary monetary policy is when money supply is
increased to raise aggregate demand.
• Open market operations also affect the inter-bank
lending market, the federal funds market.
– The federal funds rate is the interest rate at which banks
lend reserves to one another.
• The Fed affects the federal funds rate through
changes in the supply of reserves by conducting
contractionary and expansionary monetary policy.
Tools of monetary policy
20© 2014 by McGraw-Hill Education
• The liquidity-preference model
refers to the idea that the
quantity of money people
want to hold is a function of
the interest rate.
– This means the money demand
curve slopes downward.
– The Fed sets the money supply,
which means the money supply
curve is set by monetary policy.
The economic effects of monetary policy
Monetary
demand
Monetary supply
r*
Q*
Interest rate, r
Quantity of money
The liquidity-preference model
• Monetary policy primarily influences the economy through changes
in the interest rate.
• Changes in the interest rate, in turn, affect the appeal of borrowing
and lending, which can have significant impacts on the economy.
21© 2014 by McGraw-Hill Education
Interest rate, r
Quantity of money
MD
MS*
Shifts in the money supply curve
The liquidity-preference model explains how the
Fed’s actions can change interest rates.
The economic effects of monetary policy
Qe
MSc MSe
rc
Qc
r*
Q*
re
• Expansionary monetary
policy results in a higher
quantity of money and
lower interest rates.
• Contractionary monetary
policy results in a lower
quantity of money and
higher interest rates.
822© 2014 by McGraw-Hill Education
For each of the following situations, indicate the
effect (increase or decrease) on the money
supply and interest rate.
Active Learning: The money supply
Situation
Change in money
supply Change in interest rate
The Federal Reserve
conducts open-market
bond purchases.
The Federal Reserve sells
government bonds on the
open market.
23© 2014 by McGraw-Hill Education
Expansionary monetary policy
AD2
Interest rate, r
Quantity of money
Money
demand
MS1
Q1
r1
Expansionary monetary policy
Y2
P2
Price level
Real GDP
LRAS
AD1
Y1
SRAS
Expansionary monetary policy and the AD/AS model
P1
MS2
Q2
r2
• During a recession, expansionary
monetary policy decreases the interest
rate.
• Cheaper to borrow and less rewarding
to save money.
• The aggregate demand curve shifts out.
• Price and output increase.
24© 2014 by McGraw-Hill Education
Interest rate, r
Quantity of money
MD
MS1
Q1
Contractionary monetary policy
MS2
Q2
r2
Contractionary monetary policy
• During overheating, contractionary
monetary policy increases the interest
rate.
• More expensive to borrow and
encourages saving.
• The aggregate demand curve shifts in.
• Prices and output decrease.
r1
1
2
AD2
Contractionary monetary policy and the AD/AS model
Price level
Real GDP
LRAS
P
Y1
SRAS
AD1
P
Y2
925© 2014 by McGraw-Hill Education
• The Fed faces time lags
and imperfect
information.
– A few months can pass
before the Fed’s actions
make their impact.
– Mistiming of monetary
policy could make
economic conditions
worse.
The economic effects of monetary policy
Challenges Advantages
• The Fed does not have to
wait for politicians to come
to a policy consensus.
• The Fed is made up of
prominent economic
policy-makers.
– It is their job to make sure
they fully understand the
nuances of the overall
economy.
Analyzing the use of monetary policy shows how
policy can work in ideal cases, but it is rare for the
world to work so cleanly.
26© 2014 by McGraw-Hill Education
• One concern is how the lending market is affected
during times of expansionary monetary policy.
• That is, it may be that extra borrowing causes a
shortage of loanable funds, as the demand from
borrowers increases and the supply from savers
decreases.
• This leads to two very different models of the way
the world works:
1. The Federal Reserve determines the interest rate by
managing the supply and demand for money.
2. The market as a whole determines the interest rate
by the interaction of savers and borrowers.
Two interconnected markets
27© 2014 by McGraw-Hill Education
These two models are connected by the dynamics of the economy.
Two interconnected markets
Interest rate
Quantity of dollars
Market for loanable funds
Savings 2
Investment
Savings 1
r1
Q 1 Q 2
r2
MD
MS2
Interest rate
Quantity of dollars
Q 1
r1
MS1
Liquidity-preference model
r2
Q 2
• When the Fed acts to lower interest
rates, it spurs borrowing and increases
output in the economy.
• Some of this increase in output is saved.
• Shifts the supply of loanable funds outward
to equalize interest rates between models.
10
28© 2014 by McGraw-Hill Education
• The three main functions of money are a store
of value, a medium of exchange, and a unit of
account.
• Money needs to have stability of value to be
convenient.
• Banks create money by lending through the
fractional reserve banking.
• The money multiplier is the ratio of money
created by the lending activities to the money
created by the central bank.
Summary
29© 2014 by McGraw-Hill Education
• The Fed classifies different types of money by
their liquidity.
– M1 includes hard money plus checkable deposits.
– M2 includes M1 plus money in savings accounts
and CDs.
• The central bank maintains the money supply
and coordinates the banking system.
• The Federal Reserve has a dual mandate:
– Ensure price stability.
– Maintain full employment.
Summary
30© 2014 by McGraw-Hill Education
• Monetary policy includes changing the reserve
requirement, lending through the discount
window, and engaging in open-market
operations.
• The liquidity-preference model explains that
the demand for money is a function of the
interest rate.
• The Fed may want to engage in expansionary
or contractionary monetary policy depending
on the economic circumstances.
Summary