1. L6: The Money Supply & The Federal Reserve System
No.
Topic 1.
Barter System vs. Monetary System
Disadvantage(s) of BS
Functions of Money
Money Classification 2.
Banks and Money Creation
The Roles of a Central Bank (CB) - BNM
The Roles of CB towards Commercial Banks
The Roles of Commercial Banks towards Public
Money Creation
Multiplier 3.
Banks and Central Bank (CB)
Roles of Central Bank towards Banks
Money Supply Curve
How CB controls the Money Supply 4.
The Monetarist Transmission Mechanism
The Equation of Exchange
The Quantity Theory of Money

2. Weaknesses of Barter System leads to Monetary System
The Money Supply & The Federal Reserve System: Barter System vs. Monetary System
Weaknesses of Barter System leads to Monetary System
Barter is a way for participants to exchange goods and services directly in order to satisfy wants. However, the process requires too much time in order to exchange goods/services.
Need to have a coincidence of wants for both parties whom want to exchange goods/services.
Able to trade with small range of goods/services
Not suitable for a complex society like nowadays.

3. The Money Supply & The Federal Reserve System Concepts of Money
The use of money simplifies and therefore increases market transactions.
Money also can prevents wasting time that can be devoted to production, hence promoting economic growth by increasing a nation’s production possibilities.
It is a useful mechanism for transforming income in the present into future purchases.
Money is the most liquid form of wealth because it can be spent directly in the market place. It is immediately available to spend in exchange for goods/services without any additional expense.
The supply of money must be great enough to meet ordinary transaction needs. However, if it is too much in the market, it will become worthless.

4. The Money Supply & The Federal Reserve System Functions of Money
Three (3) Functions of Money
Medium of Exchange
It is a primary function of money and widely accepted in exchange goods/services.
A Unit of Account
A consistent way in quoting prices. A unit that can measure tax revenues collected and expenditure of a government..
E.g.: A price for one slice of pizza is RM10. Price for movie ticket is rM5. Therefore, one slice of pizza equals to 2 movie tickets.
A Store of Value
Money is an asset that can be used to transfer purchasing power from one time to another. In other words, it is the ability to hold value over time without spoiling it. It is as store of value in exchange for some item in the future.
Advantage(s):
Easily exchanged at all times and easily portable
Disadvantage:
The value of money falls when the prices of goods/services rise

5. The Money Supply & The Federal Reserve System: Money Classification
M1: Transactions Money
Beyond M2
M1, or transactions money Money that can be directly used for transactions.
There are no rules for deciding what is and is not money.
This poses problems for economists and those in charge of economic policy.
M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits
M2: Broad Money
M2, or broad money M1 plus savings accounts, money market accounts, and other near monies.
Near monies Close substitutes for transactions money, such as savings accounts and money market accounts.
M2 ≡ M1 + savings accounts + money market accounts + other near monies

6. The Roles of Bank Negara Malaysia (BNM)
The Money Supply & The Federal Reserve System: The Roles of Central Bank (CB) - BNM
The Roles of Bank Negara Malaysia (BNM)
To ensure financial system stability 
To develop financial system infrastructure
To build the nation's efficient and secured payment systems as well as the necessary institutions:
Securities Commission,
KLSE, now known as Bursa Malaysia
Credit Guarantee Corporation
To promotes financial inclusion, which has led to improved access to financial services for all economic sectors and segments of society, thereby supporting balanced economic growth.
As a banker and advisor to the Government:
advising on macroeconomic policies
managing the public debt.
Sole authority in issuing currency as well as managing the country's international reserves.
To ensure financial system stability and fostering a sound and progressive financial
sector.
To develop financial system infrastructure with major emphasis placed on building
the nation's efficient and secured payment systems as well as the necessary
institutions (including Securities Commission, KLSE, now known as Bursa Malaysia
and Credit Guarantee Corporation) which are important towards building a
comprehensive, robust and resilient financial system.
The Bank actively promotes financial inclusion, which has led to improved access to
financial services for all economic sectors and segments of society, thereby supporting
balanced economic growth.
A banker and adviser to the Government:
advising on macroeconomic policies
managing the public debt.
Sole authority in issuing currency as well as managing the country's
international reserves.

7. The Money Supply & The Federal Reserve System: The Roles of CB towards Commercial Banks
It is known that, CB has crucial role is to control the money supply.
The CB also performs several important functions for banks:
such as clearing interbank payments,
regulating the banking system,
assisting banks in a difficult financial position*
responsible for managing exchange rates and the nation’s foreign exchange reserves.
Often involved in inter country negotiations on international economic issues.
*Lender of last resort One of the functions of the CB: It provides funds to troubled banks that cannot find any other sources of funds.
To ensure financial system stability and fostering a sound and progressive financial
sector.
To develop financial system infrastructure with major emphasis placed on building
the nation's efficient and secured payment systems as well as the necessary
institutions (including Securities Commission, KLSE, now known as Bursa Malaysia
and Credit Guarantee Corporation) which are important towards building a
comprehensive, robust and resilient financial system.
The Bank actively promotes financial inclusion, which has led to improved access to
financial services for all economic sectors and segments of society, thereby supporting
balanced economic growth.
A banker and adviser to the Government:
advising on macroeconomic policies
managing the public debt.
Sole authority in issuing currency as well as managing the country's
international reserves.

8. The Money Supply & The Federal Reserve System: The Roles of Commercial Banks towards Public
Commercial Banks receive funds in various forms such as deposit in checking and saving accounts.
Basically, Com. Banks provides lending and saving services for the people.
From the money that have been deposited, the banks will lend the money to the borrower (public citizen). E.g.: Car loans, property loans, mortgages etc.
Commercial banks are a financial intermediaries – links between the lender and borrower

9. Assets − Liabilities ≡ Net Worth Assets ≡ Liabilities + Net Worth
The Money Supply & The Federal Reserve System: How Banks Creates Money?
The Modern Banking System: A Brief Review of Accounting
Assets − Liabilities ≡ Net Worth or
Assets ≡ Liabilities + Net Worth
Federal Reserve Bank (the Fed) The central bank of the United States.
Asset: Things that a firm owns that are worth something.
E.g.: building, furniture, cash, stocks, bonds, loans.
Reserves The deposits that a bank has at the Central bank plus its cash on the hand of the bank
Liabilities: what gives debts to the firms/banks. Something that bank owes.
E.g.: deposits from depositors.
Required reserve ratio The percentage of its total deposits that a bank must keep as reserves at the Central Bank.
Excess Reserve: The difference between a bank’s actual reserves and its required reserves.

10. The Money Supply & The Federal Reserve System: How banks creates Money?
The Money Multiplier
The multiple by which deposits can increase for every dollar increase in reserves; equal to 1 divided by the required reserve ratio.
The value of the multiplier depends on the required reserve ratio on deposits. A high required-reserve ratio lowers the value of the multiplier. A low required-reserve ratio raises the value of the multiplier.
An increase in bank reserves leads to a greater than one-for-one increase in the money supply.

11. The Money Supply & The Federal Reserve System: How banks creates Money?
Example: Money Creation and Multiplier
Assume that:
Reserve ratio is 10%, Bank A’s depositors is Sara who takes RM100,000.
All the transactions via electronic ..
Round
Bank
Increase in
current deposits
required reserves
in excess reserves
(RM) 1
Bank A
100,000
10,000
90,000 2
Bank B
9,000
81,000 3
Bank C
8,100
72,900 4
Bank D
7,290
65,610 5
Bank E
6,561
59,049 6
Bank F
5,905
53,144 7
Bank G
5,314
47,830 .
Total
All other banks
478,297
430,467
Total Increase
RM1,000,000
RM100,000
RM900,000

12. Actual money supply change initial change in excess reserves (ER)
The Money Supply & The Federal Reserve System: How banks creates Money?
Cont’d..
Therefore, referring to the example..
( 0.10)
Money Multiplier = 1 = 10
The actual change in the money supply is computed by the following formula:
Actual money supply change
initial change in excess reserves (ER)
money multiplier (MM) = x
Based on the example, the total actual money supply change is:
RM900,000 = RM90,000* x 10
*Note: Initial change in Excess Reserves = RM100,000 x 0.1 = RM90,000

13. The Money Supply & The Federal Reserve System: How CB controls money supply?
i, %
Shifts in the money supply:
Ms1: Ms supply curve shifts to the
right.
Ms2: Ms supply curve moves to the
left.
Ms2 Ms
Ms1
To ensure financial system stability and fostering a sound and progressive financial
sector.
To develop financial system infrastructure with major emphasis placed on building
the nation's efficient and secured payment systems as well as the necessary
institutions (including Securities Commission, KLSE, now known as Bursa Malaysia
and Credit Guarantee Corporation) which are important towards building a
comprehensive, robust and resilient financial system.
The Bank actively promotes financial inclusion, which has led to improved access to
financial services for all economic sectors and segments of society, thereby supporting
balanced economic growth.
A banker and adviser to the Government:
advising on macroeconomic policies
managing the public debt.
Sole authority in issuing currency as well as managing the country's
international reserves.
Q of Ms
If the CB’s money supply behavior is not influenced by the interest rate, the money supply curve is a vertical line.
Through its three tools, the CB is assumed to have the money supply be whatever value it wants.

14. Tools to Control The Money Supply
The Money Supply & The Federal Reserve System: How CB controls Money Supply?
In Malaysia, the main objective of the monetary policy is to promote the highest sustainable rate of output growth (domestic price and exchange rate stability).
How BNM ensure the stability?
BNM will maintain monetary stability by ensuring the growth of bank credit and Ms are adequate to assist the real growth in the economy without having any inflationary pressures.
Keyword(s): Money Supply, Control
Tools to Control The Money Supply
Changing the required reserve ratio.
Changing the discount rate.
Engaging in open market operations.

15. Changing the required reserve ratio
The Money Supply & The Federal Reserve System: How CB controls Money Supply?
Changing the required reserve ratio
Required Reserve Ratio (RRR) or Statutory Reserve Requirement (SRR)
It is for liquidity management. All financial institutions (i.e. commercial banks, merchant banks etc) are required to maintain balances of their Reserve Accounts equivalent to a certain proportion of their eligible liabilities.
Example:
If the CB wants to increase the Money Supply, it should reduce the required reserve ratio (RRR).
Assumptions:
Required Reserve Ratio decrease from 20%to 12.5%
Total Reserves for CB and Bank = RM100 mil
Initial deposit for Bank = RM500 mil
Initial loans for Bank = RM400 mil
Total Currency for CB = RM100 mil
All assets hold by the Central Bank are in govt. securities

16. The Money Supply & The Federal Reserve System: How CB controls Money Supply?
A Decrease in the RRR from 20% to 12.5% increases the Ms (Figures in RM mil)
Panel 1: Required Reserve Ratio = 20%
Federal Reserve
Commercial Banks
Assets
Liabilities
Government
200
100
Reserves
500
Deposits
securities
Currency
Loans
400
Money supply (M1) = Currency + Deposits = RM600.
Panel 2: Required Reserve Ratio = 12.5%
800
Loans (+ $300)
700
(+ $300)
Money supply (M1) = currency + deposits = RM900.

17. The Money Supply & The Federal Reserve System: How CB controls Money Supply?
When RRR = 20%
When RRR = 12.5%
( 0.2)
Money Multiplier = 1 = 5
( 0.125)
Money Multiplier = 1 = 8
Total deposit = Reserves x Multiplier
= RM100mil x 5
= RM500
Total deposit = Reserves x Multiplier
= RM100mil x 8
= RM800
Therefore, RM100mil reserves in commercial bank can support RM500mil in deposit
Therefore, RM100mil reserves in commercial bank can support RM800mil in deposit
● Money supply (M1) = Currency + Deposits
= RM100 + RM500
= RM600
● Money supply (M1) = Currency + Deposits
= RM100 + RM800
= RM900
Conclusion
A Decrease in the RRR from 20% to 12.5% increases the Ms from RM600 mil to RM900 mil

18. Changing the discount rate
The Money Supply & The Federal Reserve System: How CB controls Money Supply?
Changing the discount rate
Banks may borrow from CB. The interest rate they had to pay to CB is called discount rate.
If CB wants to increase Ms, thus CB shall reduce the discount rate. This will cause the cost of borrowing is cheaper and banks tend to borrow in a large amount.
Hence, reserves as well as deposits for the bank will increase. More loans can be given to public citizens to encourage consumptions. Economic activity will expand – leads to economic growth.
Example:
If CB wants to increase money supply, thus CB will lower down the discount rate for Banks to borrow.
Assumptions:
Total Loan from Central Bank = RM20 mil
Reserve Ratio = 20%
Total Reserves for CB and Bank = RM80 mil
Initial deposit for Bank = RM400 mil
Initial loans for Bank = RM320 mil
Total Currency for CB = RM80 mil
All assets hold by the Central Bank are in govt. securities = RM160 mil

19. (All Figures in RM millions)
The Money Supply & The Federal Reserve System: How CB controls Money Supply?
The Effect on the Money Supply of Commercial Bank Borrowing from the Fed
(All Figures in RM millions)
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.

20. The Money Supply & The Federal Reserve System: How CB controls Money Supply?
Before Bank decide to borrow RM20 mil from
CB;
After Bank borrowed RM20 mil from CB;
Total reserve will be additional RM20 mil, therefore;
New Total Reserve = RM80 mil + RM20 mil
= RM100 mil
Thus,
New Total Deposit = RM100 mil + RM400 mil
= RM500 mil
Hence; RM100 mil reserves in commercial bank can support RM500 mil in deposit
RM80 mil reserves in commercial bank can support RM400 mil in deposit
● Initial Ms (M1) = Currency + Deposits
= RM80 + RM400
= RM480 mil
● New Ms (M1) = Currency + Deposits
= RM80 + RM500
= RM580 mil
Conclusion
The effect on the money supply of the Bank borrowing from the CB increases the Ms from RM480 mil to RM580 mil

21. The Money Supply & The Federal Reserve System: How CB controls Money Supply?
Before Bank decide to borrow RM20 mil from
CB;
After Bank borrowed RM20 mil from CB;
Total reserve will be additional RM20 mil, therefore;
New Total Reserve = RM80 mil + RM20 mil
= RM100 mil
Thus,
New Total Deposit = RM100 mil + RM400 mil
= RM500 mil
Hence; RM100 mil reserves in commercial bank can support RM500 mil in deposit
RM80 mil reserves in commercial bank can support RM400 mil in deposit
● Initial Ms (M1) = Currency + Deposits
= RM80 + RM400
= RM480 mil
● New Ms (M1) = Currency + Deposits
= RM80 + RM500
= RM580 mil
Conclusion
The effect on the money supply of the Bank borrowing from the CB increases the Ms from RM480 mil to RM580 mil

22. The Money Supply & The Federal Reserve System: How CB controls Money Supply?
Engaging in open market operations (OMO)
This is the most significant tools for controlling the Ms
The purchase and sale by the CB 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.
How OMO works to change the Ms?
■ An open market purchase of securities by the CB 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 CB 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.

23. The Money Supply & The Federal Reserve System: How CB controls Money Supply?
Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the Differences between Those Panels and Panel 1. All Figures in RM mil)
Panel 1
Federal Reserve
Commercial Banks
Jane Q. Public
Assets
Liabilities
Securities
100 20
Reserves
Deposits 5
Debts 80
Currency
Loans
Net Worth
Note: Money supply (M1) = Currency + Deposits = RM180.
Panel 2
Securities (- 5) 95 15
Reserves (- 5)
Deposits (- 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 = RM155.

24. The Money Supply & The Federal Reserve System: The Monetarist Transmission Mechanism
Theory of Monetarism
Change in Monetary Policy  Change in Money Supply  Change in AD curve  Change in P, real GDP and Employment
The Quantity Theory of Money
The Quantity Theory was first developed by Irving Fisher in the inter-war years, and is a basic theoretical explanation for the link between money and the general price level.
The theory also known as the Fisher Identity or The Equation of Exchange.  This is an identity which relates total aggregate demand to the total value of output (GDP).

25. The Equation of Exchange
The Money Supply & The Federal Reserve System: The Monetarist Transmission Mechanism
The Equation of Exchange
MV = PQ
Where;
M is the Money Supply (M1)
V is the velocity of circulation of money
P is the general price level
Y is the real value of national output (i.e. real GDP)
In words, Money supply (M) multiplied by the velocity of circulation (V) = the value of national output (price level (P) x volume of transactions (Y))

26. The Money Supply & The Federal Reserve System: The Equation of Exchange - Velocity
V = PQ/M
Velocity: The number of times that a unit of currency (E.g. : RM20 note) is used in a given period of time when used as a medium of exchange to buy goods and services.
Velocity of circulation can be calculated by dividing the money value of national output by the money supply.
Assume the RM20 travels from hand to hand 5 times. This means the velocity of the money is 5, therefore;
MV = PQ
Velocity:
E.g.: Assume that you have only one of a RM20 note. Suppose you spend the money on a pizza at Pizza Hut. The owner’s of the Pizza Hut puts your RM20 note in his pocket, and later on he decided to buy an economics book as he loves Economic so much. The cost of the Economic book is exactly RM20. At this point, with a single RM20 note has been financed RM40 worth of total spending.
RM20 x 5 = RM100
The equation of exchange is an identity that express the value of what people spend is equal to, or exchanged for what they buy.; GDP nominal reflects to what the people buy. (P x Q).
Recall that, nominal GDP = average selling price (P) multiplied by the quantity of actual output of final g/services (Q). In other words, RM100 is the total amount spending.

27. The Quantity Theory of Money
The Money Supply & The Federal Reserve System: The Quantity Theory of Money
If MV changed, what happen to P and/or Q? Does P increases/decreases or Q increases/decreases or both increases/decreases ?
The Quantity Theory of Money
MV = PQ
V constant because people’s habits of holding a certain quantity of money, therefore the number of times RM spent are slow to change.
Q constant because the economist believed in price and wage flexibility. Hence, the economy would automatically adjust to long-run full employment output (Q)
Velocity:
E.g.: Assume that you have only one of a RM20 note. Suppose you spend the money on a pizza at Pizza Hut. The owner’s of the Pizza Hut puts your RM20 note in his pocket, and later on he decided to buy an economics book as he loves Economic so much. The cost of the Economic book is exactly RM20. At this point, with a single RM20 note has been financed RM40 worth of total spending.
Since V and Q are constant, thus The Quantity Theory of Money states that changes in Ms are directly related to changes in price level – relates to monetary policy.
Thus, we can say that if the M doubled-up, the level of P also will doubled-up, while the Q remains constant.