The Money Supply, Banking System,

and Monetary Policy

Chapters 17 & 18
Macroeconomics: Theories and Policies
ECON 219
S. Cunningham
What is Money?
Money is anything that is generally
acceptable to sellers in exchange for
goods and services.

A liquid asset is an asset that can

easily (i.e., quickly, cheaply,
conveniently) be exchanged for
goods and services.
What is Money?
Functions of Money
1) Medium of exchange
2) Unit of account
3) Store of value
M1 Money Supply
Money in the United States Today
consists of:
– Currency is the bills and coins that we
use.
– Deposits are also money because they
can be converted into currency and are
used to settle debts.
What is Money?—M1
 M1 is the narrowest and most liquid measure of
the money supply.
– It includes financial assets that are immediately
available for spending on goods and services.
 M1 includes:
– Currency
– Travelers’ Checks
– Demand Deposits (checking accounts)
– Other Checkable Deposits (interest-bearing checking)
 Demand Deposits and Checkable Deposits are
called transactions accounts—these are checking
accounts that can be drawn upon to make
payments.
U.S. Money Supply: M1
About Currency
 In 2003, currency was 52% of M1.
 U.S. currency today is not backed by gold
or silver.
– It is backed only by the confidence and trust of
the public.
– It is a fiduciary monetary system. (“Fiducia”
means “trust” in Latin.)
 Money backed by gold or silver (or
something else of value) is called
commodity money.
What is Money?—M2
 M2 adds to M1 less liquid assets that
can be converted to M1 assets
quickly and at low cost.
 Includes everything in M1
 Adds:
– Savings deposits
– Small denomination time deposits (CDs)
– Retail money market mutual funds
U.S. Money Supply: M2
U.S. Money Supply: M3
The Federal Reserve System
 The Federal Reserve System (“the Fed”)
serves as the central bank for the United
States.
 A central bank typically has the following
functions:
– It is the bankers’ bank: it accepts deposits
from and makes loans to commercial banks.
– It acts as banker for the federal government.
– It controls the money supply.
– Performs certain regulatory functions for the
financial industry.
Structure of the
Federal Reserve System

The primary elements in the Federal

Reserve System are:
1. The Board of Governors
2. The Regional Federal Reserve
District Banks (FRBs)
3. The Federal Open Market Committee
The Federal Reserve Banks

 12 District banks
 Nine directors
 The directors appoint the district
president who is approved by the
Board of Governors
The Federal Reserve System
The Board of Governors

 Seven members
 Appointed by the President
 Confirmed by the Senate
 Serve 14-year term
 Terms are staggered so that one comes
vacant every two years
 President appoints a member as Chairman
to serve a four-year term
Federal Open Market Committee (FOMC)

 Meets approximately every six weeks to

review the economy

 Made up of the following voting members:

• 7 members of the Board of Governors
• 5 of the FRB presidents (they rotate yearly)
= 12 FOMC members
Functions of the Fed (1)
 Banking Services and Supervision
– It supplies currency to banks through its 12 district
banks.
– It holds the reserves of banks in the district bank of
each bank.
– It processes and routes checks to banks through its
district banks and processing centers.
– It makes loans to banks—it is the “lender of last resort”,
the “banker’s bank”.
– It supervises and regulate banks, ensuring that they
operate in a sound and prudent manner.
– It is the banker for the U.S. government. It sells
government securities for the U.S. Treasury.
Functions of the Fed (2)
 Controlling the Money Supply
– The money supply is varied through the course
of the year to meet seasonal fluctuations in the
demand for money. This helps keep interest
rates less volatile.
• Example: 4th quarter holiday season creates an
increased demand for money to buy gifts.
– The Fed also changes the money supply to
achieve policy goals set by the FOMC.
Money Supply Growth Rates

Source: Monetary Trends

Federal Reserve Bank of St. Louis
Policy Goals of the Fed
 Ultimate Goal:
Economic growth with stable prices. This means greater
output (GDP) and a low, steady rate of inflation.
 Intermediate Targets:
– The Fed does not control output or the prices
directly. It does control the money supply.
– The Fed establishes target growth rates for the
money supply, which it believes are consistent
with its ultimate goals.
– The money supply growth rate becomes an
intermediate target, an objective used to
achieve some ultimate policy goal.
Fed Policy Linkages
The Federal Reserve System
The Fed’s Policy Tools
The three main policy tools are:
1) Open market operations
2) Discount rate
3) Reserve Requirements
Open Market Operations
 Open Market Operations (OMOs): the buying and
selling of government bonds by the Fed to
control bank reserves, the fed funds rate, and the
money supply.
 For example, if the FOMC wants to increase the
money supply, it gives a directive to the trading
desk at the FRB-NY to buy bonds.
 When the FRB-NY buys bonds, it writes checks
on itself, injecting new reserves into the banks of
the bond sellers.
 The increase in reserves result in an increase in
the money supply and a reduction in the fed
funds rate.
Operating Procedures
 FOMC Directive: The FOMC issues instructions to
the Federal Reserve Bank of NY to implement
monetary Policy for a six-week period.
 The FOMC directs the bond traders at the FRB-NY
to buy or sell government bonds to keep the
federal funds rate at a specific level.
– The federal funds rate (“fed funds rate”) is the interest
rate that banks charge when they lend excess reserves
to each other.
– The buying and selling of government bonds by the fed
to achieve policy objectives are called “open market
operations (OMO)”.
Discount Rate
 The discount rate (sometimes called the
“bank rate”) is the rate of interest a Fed
District Bank charges a bank in its district
when such a bank borrows from the Fed.
 When the Fed raises the discount rate, it
raises the cost of borrowing reserves,
reducing the amount of reserves
borrowed.
 Lower levels of reserves result in reduced
lending, and reduced money supply.
Reserve Requirement
 Legal reserves: the cash a bank holds in its vault
plus its deposits at the Fed.
 Reserves held by banks in excess of their reserve
requirements are called excess reserves.
 If the Fed lowers reserve requirements, banks will
hold excess reserves which they can then lend.
 Such lending triggers the expansion multiplier,
increasing the money supply.
 Similarly, the Fed may decrease the money
supply by raising reserve requirements.
How Banks Create Money
Reserves: Actual and Required
– The reserve ratio is the fraction of a bank’s
total deposits that are held in reserves.
– The required reserves ratio is the ratio of
reserves to deposits that banks are required,
by regulation, to hold. Required reserves are
those reserves which must be kept on hand or
on deposit with the Federal Reserve in order to
comply with the reserve requirements.
– Excess reserves are the cash reserves beyond
those required, which can be loaned.
How Banks Create Money

1
(Simple) Money Multiplier =
Reserve Requirement (ratio)
The Multiple Creation of Bank Deposits
Money Multiplier: Extended Model

 Ms = m x MB
 m = m(rr, C/D, ER/D)
where
 rr = reserves ratio
 C/D = currency to deposits ratio
 ER/D = excess reserves to deposits
ratio
How Money Supply Changes
affect GDP
Policymaking Process
 Independence from Political Process
– Congress could change things and
weaken this independence
 Humphrey-Hawkins Reports
 FOMC Meetings
– 8 times a year (every 6 weeks)
– Issue directives
Targeting Monetary Aggregates
r Ms

r2

r1
Md2

Md1
M
Targeting Interest Rates
r
Md2
Md1

r* Ms

M1 M2 M
Targeting A Monetary Aggregate
Ideal Case

r LM

r2

r1
IS2

IS1
Y* Y
Targeting A Monetary Aggregate
Less than Ideal Case (I)

LM
r

IS2

IS1

Y1 Y2 Y
Targeting A Monetary Aggregate
Less than Ideal Case (II)

LM
r

IS0

Y1 Y2 Y3 Y
Targeting the Interest Rate

r* LM

IS IS3
IS1 2
Y1 Y2 Y3 Y
Evolution of Policy
 1970-79: Targeting Fed Funds Rate
 1979-82: Targeting Monetary
Aggregates
 1982-2004: Mixed Approach
 Inflation Targeting?
– Time Inconsistency Problem