The Monetary System: Money, Banking, and the Federal Reserve

The Monetary System

What is Money and Why It’s Important

Money is a fundamental component of modern economies, facilitating the exchange of goods and services. Without money, economies would rely on barter, which is inefficient due to the need for a double coincidence of wants.

• Barter System: Direct exchange of goods and services without a medium of exchange. Requires both parties to want what the other offers.

• Double Coincidence of Wants: The unlikely situation where two people each have a good or service that the other desires.

• Money: The set of assets regularly used to buy goods and services from others, eliminating the inefficiencies of barter.

The Three Functions of Money

Money serves three primary functions in an economy:

• Medium of Exchange: An item that buyers give to sellers when purchasing goods and services.

• Unit of Account: The standard measure used to post prices and record debts.

• Store of Value: An asset that can be used to transfer purchasing power from the present to the future.

• Wealth: The total of all stores of value owned by an individual or entity.

• Liquidity: The ease with which an asset can be converted into the economy’s medium of exchange (money).

The Two Kinds of Money

Money can be classified based on its intrinsic value:

• Commodity Money: Money that takes the form of a commodity with intrinsic value (e.g., gold coins, cigarettes, ramen noodles in prison).

• Fiat Money: Money without intrinsic value, used as money because of government decree (e.g., US dollar).

The Money Supply

Definition and Components

The money supply (or money stock) is the total quantity of money available in the economy. It includes various assets, primarily:

• Currency: Paper bills and coins held by the non-bank public.

• Demand Deposits: Balances in bank accounts that depositors can access on demand by writing a check.

Measures of the US Money Supply

The US money supply is measured using two main aggregates:

• M1: Includes currency, demand deposits, savings deposits, and other checkable deposits.

• M2: Includes everything in M1 plus small time deposits, retail money market funds, and a few minor categories.

Central Banks and Monetary Policy

The Role of Central Banks

Central banks oversee the banking system and regulate the money supply. In the United States, the central bank is the Federal Reserve (Fed).

• Central Bank: Institution that manages a country’s currency, money supply, and interest rates.

• Monetary Policy: The process by which the central bank manages the money supply to achieve macroeconomic objectives.

• Federal Reserve (Fed): The central bank of the United States.

The Structure of the Federal Reserve

• Board of Governors: Central governing body of the Fed.

• 12 Regional Federal Reserve Banks: Serve different regions of the US.

• Federal Open Market Committee (FOMC): Makes key decisions about interest rates and the growth of the US money supply.

Bank Reserves and the Banking System

Fractional Reserve Banking

Banks operate on a fractional reserve system, keeping only a fraction of deposits as reserves and lending out the rest.

• Reserve Requirements: Regulations on the minimum amount of reserves banks must hold against deposits, set by the Fed.

• Reserve Ratio (R): The fraction of deposits that banks hold as reserves.

Formula:

$R = \frac{\text{Reserves}}{\text{Deposits}}$

Bank T-Account

A T-account is a simplified accounting statement showing a bank’s assets and liabilities.

• Assets: Loans and reserves.

• Liabilities: Deposits.

Banks and the Money Supply: Examples

The impact of banks on the money supply can be illustrated with three cases:

1. No Banking System: Public holds all currency; money supply equals the amount of currency.

2. 100% Reserve Banking System: Banks hold all deposits as reserves; money supply equals currency plus deposits, but banks do not create money.

3. Fractional Reserve Banking System: Banks hold a fraction of deposits as reserves and lend out the rest, creating new money.

Example: Suppose $100 is deposited in a bank with a reserve ratio of 10% ($R = 0.10$):

• Depositors have $100 in deposits; borrowers have $90 in currency.

• Money supply = $90 + $100 = $190$.

• Banks create money by making loans, but do not create wealth (the borrower also has a new liability).

The Money Multiplier

Definition and Calculation

The money multiplier measures how much the money supply increases with each dollar of reserves.

• Money Multiplier Formula:

$\text{Money Multiplier} = \frac{1}{R}$

• For $R = 0.10$, the money multiplier is 10.

• $100 of reserves can create $1,000 of money in the banking system.

The Fed’s Tools of Monetary Control

How the Fed Influences the Money Supply

The Fed can change the money supply by altering bank reserves or the money multiplier.

• Money Supply Formula:

$\text{Money Supply} = \text{Money Multiplier} \times \text{Bank Reserves}$

• Open-Market Operations (OMOs): The Fed buys or sells US government bonds to change bank reserves.

• Discount Rate: The interest rate on loans the Fed makes to banks; lowering the rate encourages banks to borrow more reserves.

• Standing Repo Facility: Allows banks to swap reserves for collateral, increasing reserves temporarily.

• Reserve Requirements: Changing the required reserve ratio alters the money multiplier.

• Interest on Reserves: Since 2008, the Fed pays interest on reserves held at the Fed; raising this rate encourages banks to hold more reserves, reducing the money multiplier.

Problems Controlling the Money Supply

Several factors can complicate the Fed’s control over the money supply:

• If households hold more money as currency, banks have fewer reserves to lend, reducing the money supply.

• If banks choose to hold excess reserves, they make fewer loans, also reducing the money supply.

• The Fed can adjust its policies to compensate for these behaviors, maintaining fairly precise control over the money supply.

Summary Table: Types of Money and Money Supply Measures

Type of Money	Description	Examples
Commodity Money	Has intrinsic value	Gold coins, cigarettes
Fiat Money	No intrinsic value; value by government decree	US dollar, Euro

Money Supply Measure	Components
M1	Currency, demand deposits, savings deposits, other checkable deposits
M2	Everything in M1, plus small time deposits, retail money market funds, minor categories

Additional info: The notes have been expanded with definitions, formulas, and examples for clarity and completeness. The summary tables are inferred for study purposes.