The Monetary System: Structure, Functions, and Policy Tools

The Monetary System

What Money Is and Why It's Important

Money is a fundamental component of modern economies, facilitating trade and economic activity by eliminating the inefficiencies of barter systems.

• Barter requires a double coincidence of wants, meaning both parties must have what the other desires, making transactions difficult and inefficient.

• Money serves as a universally accepted medium, reducing the time and resources spent searching for trading partners.

• Money is defined as the set of assets regularly used to buy goods and services from others.

The Three Functions of Money

Money performs three essential functions in the economy:

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

• Unit of Account: The yardstick people use to post prices and record debts.

• Store of Value: An item that people can use to transfer purchasing power from the present to the future.

• Wealth is the total of all stores of value.

• Liquidity describes how quickly an asset can be converted into the medium of exchange (money).

The Types and Measures of Money

The Two Kinds of Money

• Commodity Money: Takes the form of a commodity with intrinsic value (e.g., gold coins, Ramen noodles in prisons).

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

The Money Supply

The money supply (or money stock) is the total quantity of money available in the economy.

• Currency: Paper bills and coins in the hands of the (non-bank) public.

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

Measures of the U.S. Money Supply

The U.S. money supply is measured using two main aggregates:

Measure	Components	Value (May 2025)
M1	Currency, demand deposits, savings deposits, other checkable deposits	$18.713 trillion
M2	Everything in M1 plus small time deposits, retail money market mutual funds, and a few minor categories	$21.942 trillion

Note: The distinction between M1 and M2 is often not critical for basic macroeconomic analysis.

Central Banks and Monetary Policy

Central Banks & Monetary Policy

• Central Bank: An institution that oversees the banking system and regulates the money supply.

• Monetary Policy: The setting of the money supply by policymakers in the central bank.

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

The Structure of the Federal Reserve System

• Board of Governors: 7 members located in Washington, DC.

• 12 Regional Federal Reserve Banks: Located throughout the U.S.

• Federal Open Market Committee (FOMC): Includes the 7 Board of Governors and presidents of 5 regional Fed banks; decides monetary policy.

Banks and the Money Supply

Bank Reserves and Reserve Requirements

• In a fractional reserve banking system, banks keep a fraction of deposits as reserves and lend out the rest.

• The Federal Reserve sets reserve requirements, which are regulations on the minimum quantity of reserves banks must hold against deposits.

• Banks may hold more than the required minimum (excess reserves).

• 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	Liabilities
Reserves: $10 Loans: $90	Deposits: $100

In this example, $R = \frac{10}{100} = 10\%$

Banks and the Money Supply: Three Cases

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

2. 100% Reserve Banking System: Banks hold all deposits as reserves, make no loans; money supply equals deposits.

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

Case Examples

• Case 1: $100 in currency, money supply = $100.

• Case 2: $100 deposited, all held as reserves, money supply = $100 (currency + deposits).

• Case 3: $100 deposited, 10% reserve ratio, $90 loaned out, money supply = $190 (deposits + currency).

Key Point: Fractional reserve banking creates money, but not wealth.

The Money Multiplier

The money multiplier quantifies the maximum amount of money the banking system can generate with each dollar of reserves.

• Formula: $\text{Money Multiplier} = \frac{1}{R}$

• Example: If $R = 10\%$, then $\text{Money Multiplier} = 10$

• $100 of reserves can create up to $1000 of money in the system.

Active Learning Example: Banks and the Money Supply

• Suppose you deposit $50 in your checking account; reserve requirement is 20%.

• Maximum increase in money supply: $\text{Money Multiplier} = \frac{1}{0.2} = 5$; $5 \times 50 = 250$ in deposits, but currency falls by $50$, so net increase is $200$.

• Minimum increase in money supply: $0$ (if the bank holds all deposits as reserves and makes no loans).

The Fed's Tools of Monetary Control

How the Fed Influences Reserves

• Open-Market Operations (OMOs): The purchase and sale of U.S. government bonds by the Fed. Buying bonds increases reserves and the money supply; selling bonds decreases them.

• Discount Rate: The interest rate on loans the Fed makes to banks. Lowering the rate encourages banks to borrow more reserves, increasing the money supply.

• Standing Repo Facility: Allows banks to swap reserves for collateral (e.g., U.S. Treasuries) and agree to repurchase the collateral the next day, increasing reserves.

How the Fed Influences the Reserve Ratio

• The Fed sets reserve requirements, affecting the reserve ratio and the money multiplier.

• Lowering reserve requirements increases the money multiplier; raising them decreases it.

• Since October 2008, the Fed pays interest on reserves. Raising this interest rate encourages banks to hold more reserves, increasing the reserve ratio and reducing the money multiplier.

Problems Controlling the Money Supply

• If households hold more money as currency, banks have fewer reserves, make fewer loans, and the money supply falls.

• If banks hold more reserves than required, they make fewer loans, and the money supply falls.

• The Fed can attempt to offset these behaviors, but complete control over the money supply is challenging.

Summary Table: Key Concepts

Concept	Definition	Formula/Example
Money Supply	Total quantity of money in the economy	M1, M2
Reserve Ratio (R)	Fraction of deposits held as reserves	$R = \frac{\text{Reserves}}{\text{Deposits}}$
Money Multiplier	Potential increase in money supply per dollar of reserves	$\text{Money Multiplier} = \frac{1}{R}$
Open-Market Operations	Fed buys/sells government bonds to change reserves	Buying bonds increases reserves
Discount Rate	Interest rate on Fed loans to banks	Lower rate increases reserves

Additional info: These notes cover core topics from "Financial Markets I" and related chapters in a college-level Macroeconomics course, including the structure and function of money, the banking system, and the tools of monetary policy.