1. What Counts as Money Money has several useful functions
Provides a unit of account
Standardized way of measuring value of things that are traded
Serves as store of value
One of several ways in which households can hold their wealth
Yet credit cards are not considered money, even though you can use them to buy things
Why is this?
A more formal definition of money helps to answer questions like this
Money is an asset that is widely accepted as a means of payment
Only assets—things of value that people own—can be considered as money
The right to borrow is not an asset - that is why credit limit on your credit card, or your ability to go into a bank and borrow funds, is not considered money
Only things that are widely acceptable as a means of payment are regarded as money
Other assets—such as stocks and bonds or even gold bars—cannot generally be used to pay for goods and services
They fail the acceptability test

2. Measuring the Money Supply
Amount of money in circulation can affect macroeconomy
Money Supply
Total amount of money held by the public
In practice, measuring money supply is not as straightforward as it might seem
Governments have decided best way to deal with them is to have different measures of the money supply
In effect, alternative ways of defining what is and what is not money
Each measure includes a selection of assets that are widely acceptable as a means of payment and are relatively liquid
An asset is considered liquid if it can be converted to cash quickly and at little cost
An illiquid asset can be converted to cash only after a delay, or at considerable cost

3. Assets and Their Liquidity
Most liquid asset is cash in the hands of the public
Next in line are asset categories of about equal liquidity
Demand deposits
Checking accounts held by households and business firms at commercial banks
Other checkable deposits
Catchall category for several types of checking accounts that work very much like demand deposits - includes automatic transfers from saving account
Travelers checks
Specially printed checks that you can buy from banks or other private companies, like American Express – can be easily spent at almost any hotel or store
Savings-type accounts
At banks and other financial institutions
Are less liquid than checking-type accounts, since they do not allow you to write checks

4. Assets and Their Liquidity
Next on the list are deposits in retail money market mutual funds – which use customer deposits to buy a variety of financial assets- depositors can withdraw their money by writing checks.
Time deposits (sometimes called certificates of deposit, or CDs)
Require you to keep your money in the bank for a specified period of time (usually six months or longer)
Impose an interest penalty if you withdraw early

5. Figure 1: Monetary Assets and Their Liquidity (May 23, 2005)
Savings
Type
Accounts
($3,512 billion)
Demand
Deposits
($332 billion) +
Other
Checkable
($324 billion)
Travelers
Checks
($8 billion)
Large
Time
Deposits
($1189 billion)
Money
Market
Mutual
Funds
($700 billion)
Small
Time
Deposits
($886 billion)
Cash in the
Hands of the
Public
($706 billion)
More Liquid
Less Liquid

6. M1 And M2 Standard measure of money stock is M1
Sum of the first four assets in our list
M1 = cash in the hands of the public + demand deposits + other checking account deposits + travelers checks
When economists or government officials speak about “money supply,” they usually mean M1
Another common measure of money supply, M2, adds some other types of assets to M1
M2 = M1 + savings-type accounts + retail MMMF balances + small denomination time deposits
Other official measures of money supply besides M1 and M2 that add in assets that are less liquid than those in M2
M1 and M2 have been most popular, and most commonly watched, definitions

7. M1 And M2
Important to understand that M1 and M2 money stock measures exclude many things that people use regularly as a means of payment
Technological advances—now and in the future—will continue trend toward new and more varied ways to make payments
For rest of our discussion, we will assume money supply consists of just two components
Cash in the hands of the public and demand deposits
That is Money supply = Cash in the hands of public + demand deposits
You will see later that our definition of the money supply corresponds closely to liquid assets that our national monetary authority—the Federal Reserve—can control

8. The Banking System: Financial Intermediaries
What are banks?
Financial intermediaries—business firms that specialize in
Assembling loanable funds from households and firms whose revenues exceed their expenditures
Channeling those funds to households and firms (and sometimes the government) whose expenditures exceed revenues
An intermediary helps to solve problems by combining a large number of small savers’ funds into custom-designed packages
Then lending them to larger borrowers
Intermediaries must earn a profit for providing brokering services
By charging a higher interest rate on funds they lend than rate they pay to depositors

9. The Banking System: Financial Intermediaries
United States boasts a wide variety of financial intermediaries, including
Commercial banks
Savings and loan associations
Mutual savings banks
Credit unions
Insurance companies
Some government agencies
There are four types of financial intermediaries- depository institutions- that accept deposits from the general public and lend the deposits to borrowers
Savings and Loan associations – obtain funds through their customers’ time, saving and checkable deposits and use them primarily to make mortgage loans

10. Mutual savings banks – accept deposits (shares) and use them primarily to make mortgage loans (differ from S&L because they are owned by their depositors rather than outside investors)
Credit unions – specialize in working with particular group of people, acquire funds through their member deposit – make consumer and mortgage loans
Commercial banks – largest group of depository institutions, obtain funds mainly by accepting checkable deposits, saving deposits and the time deposits - make business, mortgage and consumer loans

11. Commercial Banks
A commercial bank (or just “bank” for short) is a private corporation that provides services to the public
Owned by its stockholders
For our purposes, most important service is to provide checking accounts
Enables bank’s customers to pay bills and make purchases without holding large amounts of cash that could be lost or stolen
Every year, US households and businesses write trillions of dollars’ worth of checks to pay their bills
Banks provide checking account services in order to earn a profit
Where does a bank’s profit come from ??? Only by charging check-printing fees and ATM-using fee??-
NO……then what is the most important source of profit? What about interest rate differentials??

12. A Bank’s Balance Sheet
A balance sheet is a two-column list that provides information about financial condition of a bank at a particular point in time
In one column, bank’s assets are listed
Everything of value that it owns
On the other side, the bank’s liabilities are listed
Amounts bank owes
Bond
A promise to pay back borrowed funds, issued by a corporation or government agency
Loan
An agreement to pay back borrowed funds, signed by a household or noncorporate business –examples?
Next come two categories that might seem curious
“Vault cash” – coin and currency that bank has stored in its vault
“Account with the Federal Reserve” – banks maintain their own accounts with the Fed reserve – they add and subtract to these accounts when they make transaction with other banks
Neither vault cash nor accounts with the Fed pay interest
Then why does the bank hold them?

13. Commercial Bank’s Balance Sheet
Assets
Liabilities and Net Worth
Property and buildings
$5 million
Demand deposit liabilities
$100 million
Government and corporate bonds
$25 million
Net Worth
Loans
$65 million `
Cash in vault
$2 million
In accounts with the Federal Reserve
$8 million
Total Assets
$105 million
Total Liabilities plus Net Worth

14. The Federal Reserve System
Every large nation controls its money supply with a central bank
A nation’s principal monetary authority
Most developed countries established central banks long ago
England’s central bank—Bank of England—was created in 1694
France established Banque de France in 1800
United States established Federal Reserve System in 1913
U.S. waited such a long time to establish a central authority because of
Suspicion of central authority that has always been part of U.S. politics and culture
Large size and extreme diversity of our country
Fear that a powerful central bank might be dominated by the interests of one region to the detriment of others

15. The Federal Reserve System
Our central bank is different in form from its European counterparts
One major difference is indicated in the very name of the institution
Does not have the word “central” or “bank” anywhere in its title
Another difference is the way the system is organized
Another interesting feature of Federal Reserve System is its peculiar status within government
Strictly speaking, it is not even a part of any branch of government
Both President and Congress exert some influence on Fed through their appointments of key officials

16. Figure 2: The Geography of the Federal Reserve System
District boundaries
State boundaries
Reserve Bank cities
Board of Governors of the Federal Reserve System
Dallas
Boston
New York
Washington
San Francisco
Kansas City
Atlanta 12 9 10 11 8 6 5 7 4 3 2 1
St. Louis
Chicago
Richmond
Cleveland
Minneapolis
Philadelphia
Note: Both Alaska and Hawaii are in the Twelfth District

17. Figure 3: The Structure of the Federal Reserve System
Senate confirms
Chair of Board of Governors
12 Federal Reserve
District Banks
Lend reserves
Clear checks
Provide currency
3,500 Member Banks
Elect 6 directors
of each
Federal Reserve
Bank
Appoints 3 directors of each Federal Reserve Bank
President appoints
Federal Open Market
Committee
(7 Governors + 5 Reserve
Bank Presidents)
Conducts open market operations to control the money supply
Board of Governors
(7 members, including chair)
Supervises and regulates member banks
Supervises 12 Federal Reserve District Banks
Sets reserve requirements and approves discount rate

18. The Structure of the Fed
Board of Governors
Consists of seven members who are appointed by President and confirmed by Senate for a 14-year term
In order to keep any President or Congress from having too much influence over Fed
Four-year term of the chair is not coterminous with four-year term of the President
Each of 12 Federal Reserve Banks is supervised by nine directors
Three of whom are appointed by Board of Governors
Other six are elected by private commercial banks—the official stockholders of the system
Directors of each Federal Reserve Bank choose a president of that bank, who manages its day-to-day operations
Only about 3,500 of the 8,000 or so commercial banks in United States are members of Federal Reserve System
But they include all national banks and state banks
All of the largest banks in United States are nationally chartered banks and therefore member banks as well

19. The Federal Open Market Committee
Federal Open Market Committee (FOMC)
A committee of Federal Reserve officials that establishes U.S. monetary policy
Most economists regard FOMC as most important part of Fed
Consists of all 7 governors of Fed, along with 5 of the 12 district bank presidents
Not even President of United States knows details behind the decisions, or what FOMC actually discussed at its meeting, until summary of meeting is finally released
Committee exerts control over nation’s money supply by buying and selling bonds in public (“open”) bond market

20. The Functions of the Federal Reserve
Federal Reserve, as overseer of the nation’s monetary system, has a variety of important responsibilities including
Supervising and regulating banks
Acting as a “bank for banks”
Issuing paper currency
Check clearing
Controlling money supply

21. The Fed and the Money Supply
Suppose Fed wants to change nation’s money supply
It buys or sells government bonds to bond dealers, banks, or other financial institutions
Actions are called open market operations
We’ll make two special assumptions to keep our analysis of open market operations simple for now
Households and business are satisfied holding the amount of cash they are currently holding
Any additional funds they might acquire are deposited in their checking accounts
Any decrease in their funds comes from their checking accounts
Banks never hold reserves in excess of those legally required by law

22. How the Fed Increases the Money Supply
To increase money supply, Fed will buy government bonds
Called an open market purchase
Suppose Fed buys $1,000 bond from Lehman Brothers, which deposits the total into its checking account
Two important things have happened
Fed has injected reserve into banking system
Money supply has increased
Demand deposits have increased by $1,000 and demand deposits are part of money supply
Lehman Brothers’ bank now has excess reserves
Reserves in excess of required reserves
If required reserve ratio is 10% bank has excess reserves of $900 to lend
Demand deposits increase each time a bank lends out excess reserves

23. The Demand Deposit Multiplier
How much will demand deposits increase in total?
Each bank creates less in demand deposits than the bank before
In each round, a bank lent 90% of deposit it received
Whatever the injection of reserves, demand deposits will increase by a factor of 10, so we can write
ΔDD = 10 x reserve injection
Demand deposit multiplier is number by which we must multiply injection of reserves to get total change in demand deposits
Size of demand deposit multiplier depends on value of required reserve ratio set by Fed

24. Cumulative Increases in Demand Deposits After a $1,000 Cash Deposit
Round
Additional Demand Deposits Created by Each Bank
Additional Demand Deposits Created by All Banks
Bank 1
$1,000
Bank 2
$900
$1,900
Bank 3
$810
$2,710
Bank 4
$729
$3,439
Bank 5
$656
$4,095
Bank 6
$590
$4,685 …
Bank 10
$387
$6,511
Bank 20
$135
$8,784
Bank 50
very close to zero
very close to $10,000

25. The Demand Deposit Multiplier
For any value of required reserve ratio (RRR), formula for demand deposit multiplier is 1/RRR
Using general formula for demand deposit multiplier, can restate what happens when Fed injects reserves into banking system as follows
ΔDD = (1 / RRR) x ΔReserves
Since we’ve been assuming that the amount of cash in the hands of the public (the other component of the money supply) does not change, we can also write
ΔMoney Supply = (1 / RRR) x ΔReserves

26. The Fed’s Influence on the Banking System as a Whole
Can also look at what happened to total demand deposits and money supply from another perspective
Where did additional $1,000 in reserves end up?
In the end, additional $1,000 in reserves will be distributed among different banks in system as required reserves
After an injection of reserves, demand deposit multiplier stops working—and the money supply stops increasing—only when all reserves injected are being held by banks as required reserves
In the end, total reserves in system have increased by $1,000
Amount of open market purchase

27. How the Fed Decreases the Money Supply
Just as Fed can increase money supply by purchasing government bonds
Can also decrease money supply by selling government bonds
An open market sale
Process of calling in loans will involve many banks
Each time a bank calls in a loan, demand deposits are destroyed
Total decline in demand deposits will be a multiple of initial withdrawal of reserves
Keeping in mind that a withdrawal of reserves is a negative change in reserves
Can still use our demand deposit multiplier—1/(RRR)—and our general formula
ΔDD = (1/RRR) x ΔReserves

28. Some Important Provisos About the Demand Deposit Multiplier
Although process of money creation and destruction as we’ve described it illustrates the basic ideas, formula for demand deposit multiplier—1/RRR—is oversimplified
In reality, multiplier is likely to be smaller than formula suggests, for two reasons
We’ve assumed that as money supply changes, public does not change its holdings of cash
We’ve assumed that banks will always lend out all of their excess reserves

29. Other Tools for Controlling the Money Supply
While other tools can affect the money supply, open market operations have two advantages over them
Precision and secrecy
This is why open market operations remain Fed’s primary means of changing money supply
Fed’s ability to conduct its policies in secret—and its independent status in general—is controversial
In recent years, because Fed has been so successful in guiding economy, controversy has largely subsided

30. Other Tools for Controlling the Money Supply
There are two other tools Fed can use to increase or decrease money supply
Changes in required reserve ratio
Changes in discount rate
Changes in either required reserve ratio or discount rate could set off the process of deposit creation or deposit destruction in much the same way outlined in this chapter
In reality, neither of these policy tools is used very often
Why are these other tools used so seldom?
Partly because they can have unpredictable effects

31. Using the Theory: Bank Failures and Banking Panics
A bank failure occurs when a bank cannot meet its obligations to those who have claims on the bank
Includes those who have lent money to the bank, as well as those who deposited their money there
Historically, many bank failures have occurred when depositors began to worry about a bank’s financial health
Run on the bank
An attempt by many of a bank’s depositors to withdraw their funds
Ironically, a bank can fail even if it is in good financial health, with more than enough assets to cover its liabilities
Just because people think bank is in trouble
Banking panic occurs when many banks fail simultaneously

32. Using the Theory: Bank Failures and Banking Panics
Banking panics can cause serious problems for the nation
Hardship suffered by people who lose their accounts when their bank fails
Even when banks do not fail, withdrawal of cash decreases banking system’s reserves
Money supply can decrease suddenly and severely, causing a serious recession
Banking panic of 1907 convinced Congress to establish Federal Reserve System
But creation of Fed did not, in itself, solve problem
Great Depression is a good example of this problem
Officials of Federal Reserve System, not quite grasping seriousness of the problem, stood by and let it happen

33. Using the Theory: Bank Failures and Banking Panics
For five-year period ending in Dec 2004, a total of 29 banks failed—an average of about 6 per year
Why the dramatic improvement?
Federal Reserve learned an important lesson from Great Depression
It now stands ready to inject reserves into system more quickly in a crisis
In 1933 Congress created Federal Deposit Insurance Corporation (FDIC) to reimburse those who lose their deposits
FDIC has had a major impact on the psychology of banking public
FDIC protection for bank accounts has not been costless
To many observers, experience of late 1980s and early 1990s was a reminder of the need for a sound insurance system and close monitoring of banking system

34. Figure 4: Bank Failures in the United States, 1921-2004
2,500
2,000
1,500
1,000
500
1920
1930
1940
1950
1960
1970
1980
1990
2000
3,000
3,500
4,000
2004
Number of Bank Failures