1. The Money Supply and the Federal Reserve System

2. 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.

3. What is Money?
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.
As a medium of exchange, or means of payment, money is generally accepted by buyers and sellers as payment for goods and services.

4. What is Money?
As a store of value, money serves as an asset that can be used to transport purchasing power from one time period to another.

5. What is Money?
As a unit of account, money is a standard that provides a consistent way of quoting prices.

6. What is Money?
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.

7. Commodity and Fiat Monies
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.

8. Commodity and Fiat Monies
Legal tender is money that a government has required to be accepted in settlement of debts.
Currency debasement is the decrease in the value of money that occurs when its supply is increased rapidly.

9. Measuring the Supply of Money in the United States
M1, or transactions money is money that can be directly used for transactions.
M1  currency held outside banks + demand deposits + traveler’s checks + other checkable deposits
M1 is a stock measure—it is measured at a point in time—on a specific day.

10. 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
The main advantage of looking at M2 instead of M1 is that M2 is sometimes more stable.

11. The Private Banking System
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.

12. How Banks Create Money A Historical Perspective: Goldsmiths
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 began to be traded for goods, and were backed 100 percent by gold.
Then, Goldsmiths realized that they could lend out some of this gold without any fear of running out. Now there were more claims than there were ounces of gold.

13. How Banks Create Money
A run on a goldsmith (or a modern-day bank) occurs when many people present their claims at the same time.

14. 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.
A bank’s liabilities are its debts—what it owes. Deposits are debts owed to the bank’s depositors.

15. The Modern Banking System
The Federal Reserve System (the Fed) is the central bank of the United States.

16. The Modern Banking System
Reserves are the deposits that a bank has at the Federal Reserve bank plus its cash on hand.
The required reserve ratio is the percentage of its total deposits that a bank must keep as reserves at the Federal Reserve.

17. 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

18. 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).

19. The Creation of Money
When someone deposits $100 in a bank, and the bank deposits the $100 with the central bank, the bank has $100 in total reserves.
Balance Sheets of a Bank in a Single-Bank Economy
In Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400.
Panel 1
Panel 2
Panel 3
ASSETS
LIABILITIES
Reserves 0
0 Deposits
Reserves 100
100 Deposits
500 Deposits
Loans 400

20. The Creation of Money
If the required reserve ratio is 20%, the bank has excess reserves of $80. With $80 of excess reserves, the bank can 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
In Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400.
Panel 1
Panel 2
Panel 3
ASSETS
LIABILITIES
Reserves 0
0 Deposits
Reserves 100
100 Deposits
500 Deposits
Loans 400

21. The Creation of Money The Creation of Money When There Are Many Banks
Panel 1
Panel 2
Panel 3
ASSETS
LIABILITIES
Reserves 100
100 Deposits
Reserves 100 Loans 80
180 Deposits
Reserves 20 Loans 80
Reserves 80
80 Deposits
Reserves 80 Loans 64
144 Deposits
Reserves 16 Loans 64
Reserves 64
64 Deposits
Deposits
Reserves 12.80
.00
500
Total
. . .
.20 51
Bank 4 64
Bank 3 80
Bank 2
100
Bank 1
Deposits
Summary:

22. The Money Multiplier
.00
500
Total
. . .
.20 51
Bank 4 64
Bank 3 80
Bank 2
100
Bank 1
Deposits
Summary:
The money multiplier is the multiple by which deposits can increase for every dollar increase in reserves.
In the example above, the required reserve ratio is 20%. Each dollar increase in reserves could cause an increase in deposits of $5 when there is no leakage out of the system. An additional $100 of reserves result in additional deposits of $500.

23. The Federal Reserve System

24. The Federal Reserve System

25. 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.

26. Functions of the Federal Reserve
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.
Control of mergers between banks.

27. Functions of the Federal Reserve
The Fed performs important functions for banks including:
Examination of banks to ensure that they are financially sound.
Setting of reserve requirements for all financial institutions.
Lender of last resort: The Fed provides funds to troubled banks that cannot find any other sources of funds.

28. The Federal Reserve Balance Sheet
Assets and Liabilities of the Federal Reserve System, June 30, 2003 (millions of dollars)
ASSETS
LIABILITIES
Gold $
11,045
$593,031
Federal Reserve notes (outstanding)
Loans to banks
36,538
Deposits:
U.S. Treasury securities
550,314
20,359
Bank reserves (from depository institutions)
6,219
U.S. Treasury
All other assets
46,268
24,556
All other liabilities and net worth
Total
644,165
$644,165
Source: Federal Reserve Bulletin, August 2003, Table 1.18.

29. The Federal Reserve 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.

30. How the Federal Reserve Controls the Money Supply
Three tools are available to the Fed for changing the money supply:
changing the required reserve ratio;
changing the discount rate; and
engaging in open market operations.

31. The Required Reserve Ratio
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, the Fed can decrease the required reserve ratio, which allows the bank to create more deposits by making loans.

32. The Required Reserve Ratio
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
Government
$200
$100
Reserves
$500
Deposits
securities
Currency
Loans
$400
Note: Money supply (M1) = Currency + Deposits = $600.
PANEL 2: REQUIRED RESERVE RATIO = 12.5%
$800
Loans (+ $300)
$700
(+ $300)
Note: Money supply (M1) = Currency + Deposits = $900.

33. The Discount Rate
The discount rate is the interest rate that banks pay to the Fed to borrow from it.
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.

34. 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
Federal Reserve
Commercial Banks
Assets
Liabilities
Securities
$160
$80
Reserves
$400
Deposits
Currency
Loans
$320
Note: Money supply (M1) = Currency + Deposits = $480.
PANEL 2: COMMERCIAL BANK BORROWING $20 FROM THE FED
$100
Reserves (+ $20)
$500
Deposits (+ $300)
$20
Loans (+ $100)
$420
Amount owed to Fed (+ $20)
Note: Money supply (M1) = Currency + Deposits = $580.

35. The Discount Rate
Moral suasion is the pressure that was exerted in the past by the Fed on member banks to discourage them from borrowing heavily.
On January 9, 2003, the Fed announced a new procedure that sets the discount rate above the rate that banks pay to borrow in the private market. It is thus clear that the Fed is not using the discount rate as a tool to try to change the money supply on a regular basis.

36. 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.

37. The Mechanics of Open Market Operations
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
Securities
$100
$20
Reserves
Deposits $5 $0
Debts
$80
Currency
Loans
Net Worth
Note: Money supply (M1) = Currency + Deposits = $180.
PANEL 2
Securities (- $5)
$95
$15
Reserves (- $5)
Deposits (- $5)
Securities (+ $5)
Note: Money supply (M1) = Currency + Deposits = $175.
PANEL 3
$75
Deposits (- $25)
Loans (- $20)
$60
Note: Money supply (M1) = Currency + Deposits = $155.

38. Open Market Operations
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.

39. Open Market Operations
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.

40. Open Market Operations
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.

41. The Supply Curve for Money
Through open market operations, the Fed can have the money supply be whatever value it wants.

42. Review Terms and Concepts
barter
commodity monies
currency debasement
discount rate
excess reserves
Federal Open Market Committee (FOMC)
Federal Reserve System (the Fed)
fiat, or token, money
financial intermediaries
legal tender
lender of last resort
liquidity property of money
M1, or transactions money
M2, or broad money
medium of exchange, or means of payment
money multiplier
near monies
Open Market Desk
open market operations
required reserve ratio
reserves
run on a bank
store of value
unit of account