The Monetary System: Structure, Functions, and Policy in Macroeconomics

The Monetary System

Introduction

The monetary system is a foundational concept in macroeconomics, encompassing the mechanisms, institutions, and policies that govern the creation, distribution, and regulation of money in an economy. Understanding the monetary system is essential for analyzing economic activity, inflation, and the role of central banks.

What Money Is and Why It's Important

Barter and the Double Coincidence of Wants

• Barter is the direct exchange of goods and services without using money. It requires a double coincidence of wants, meaning both parties must have what the other desires.

• This requirement makes trade inefficient, as individuals must spend time searching for suitable trading partners.

• Money eliminates this inefficiency by serving as a universally accepted medium for exchange.

The Functions of Money

Three Key Functions

• Medium of Exchange: Money is used to buy goods and services, facilitating transactions.

• Unit of Account: Money provides a common measure for valuing goods and services, posting prices, and recording debts.

• Store of Value: Money allows individuals to transfer purchasing power from the present to the future.

• Wealth is the total of all stores of value held by an individual or entity.

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

The Two Kinds of Money

Commodity Money vs. Fiat Money

• Commodity Money: Has intrinsic value and can be used for purposes other than as money. Examples include gold coins and Ramen noodles in prisons.

• Fiat Money: Has no intrinsic value; its value is established by government decree. Example: the U.S. dollar.

The Money Supply

Definition and Components

• Money Supply (Money Stock): The total quantity of money available in the economy.

• Key components:

  • Currency: Paper bills and coins held by the public (excluding banks).

  • Demand Deposits: Bank account balances accessible on demand via checks or debit cards.

Measures of the U.S. Money Supply

M1 and M2

• M1: Includes currency, demand deposits, savings deposits, and other checkable deposits. M1 (May 2025): $18.713 trillion

• M2: Includes everything in M1 plus small time deposits, retail money market mutual funds, and minor categories. M2 (May 2025): $21.942 trillion

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

Central Banks & Monetary Policy

Role and Structure

• Central Bank: Oversees the banking system and regulates the money supply.

• Monetary Policy: The process by which the central bank sets the money supply.

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

The Structure of the Federal Reserve

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

• 12 Regional Fed Banks: Located throughout the U.S.

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

Bank Reserves

Fractional Reserve Banking System

• Banks keep a fraction of deposits as reserves and lend out the rest.

• The Fed sets reserve requirements, the minimum reserves banks must hold.

• Banks may hold more than the required minimum.

• Reserve Ratio (R): Fraction of deposits held as reserves. $R = \frac{\text{Reserves}}{\text{Deposits}}$

Bank T-Account

Understanding Bank Balance Sheets

• T-account: Simplified statement showing changes in a bank's assets and liabilities.

FIRST NATIONAL BANK
Assets	Liabilities
Reserves $10	Deposits $100
Loans $90

• Liabilities: Deposits

• Assets: Loans and Reserves

• Example reserve ratio: $R = \frac{10}{100} = 10\%$

Banks and the Money Supply: An Example

Three Banking Scenarios

• Case 1: No Banking System Public holds $100 as currency. Money supply = $100

• Case 2: 100% Reserve Banking System Public deposits $100 at a bank, which holds all as reserves. Money supply = currency + deposits = $0 + $100 = $100

• Case 3: Fractional Reserve Banking System Reserve ratio $R = 10\%$. Bank loans out $90, keeps $10 as reserves. Depositors have $100 in deposits, borrowers have $90 in currency. Money supply = $90 + $100 = $190$

Money Creation Process

• When banks make loans, they create money (not wealth).

• Borrowers receive currency (counted in money supply) and incur debt (not counted).

• The process continues as loans are redeposited and re-loaned, expanding the money supply.

The Money Multiplier

Definition and Calculation

• Money Multiplier: The amount of money generated by each dollar of reserves.

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

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

• $100 of reserves creates $1000 of money.

Active Learning: Banks and the Money Supply

Application Example

• Deposit $50 in checking account; reserve requirement is 20%.

• Maximum increase: $\text{Money Multiplier} = \frac{1}{0.2} = 5$ $5 \times 50 = 250$ (deposits), but currency falls by $50$ Max increase in money supply = $200

• Minimum increase: If no loans are made, currency falls by $50$, deposits rise by $50$, no change in money supply

The Fed’s Tools of Monetary Control

Changing the Money Supply

• Money supply formula: $\text{Money Supply} = \text{Money Multiplier} \times \text{Bank Reserves}$

• The Fed can alter the money supply by changing bank reserves or the money multiplier.

How the Fed Influences Reserves

• Open-Market Operations (OMOs): Buying and selling U.S. government bonds to adjust bank reserves.

• Buying bonds increases reserves and money supply; selling bonds decreases them.

• The Fed also makes loans to banks, affecting reserves via the discount rate and Standing Repo Facility.

How the Fed Influences the Reserve Ratio

• Reserve Requirements: Regulations on minimum reserves.

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

• Since October 2008, the Fed pays interest on reserves, which can incentivize banks to hold more reserves and reduce the money multiplier.

Problems Controlling the Money Supply

Limitations of Monetary Policy

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

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

• The Fed can attempt to offset these behaviors but cannot fully control the money supply.