The banking system and the money supply
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The Banking System and the Money Supply. What Counts as Money. Money has several useful functions Provides a unit of account Standardized way of measuring value of things that are traded Serves as store of value One of several ways in which households can hold their wealth

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The Banking System and the Money Supply

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The banking system and the money supply

The Banking System and the Money Supply

What counts as money

What Counts as Money

  • Money has several useful functions

    • Provides a unit of account

      • Standardized way of measuring value of things that are traded

    • Serves as store of value

      • One of several ways in which households can hold their wealth

  • Yet credit cards are not considered money, even though you can use them to buy things

  • Why is this?

    • A more formal definition of money helps to answer questions like this

      • Money is an asset that is widely accepted as a means of payment

        • Only assets—things of value that people own—can be considered as money

          • This is why credit limit on your credit card, or your ability to go into a bank and borrow funds, is not considered money

        • Only things that are widely acceptable as a means of payment are regarded as money

          • Other assets—such as stocks and bonds or even gold bars—cannot generally be used to pay for goods and services

          • They fail the acceptability test

Measuring the money supply

Measuring the Money Supply

  • Amount of money in circulation can affect macroeconomy

  • Money Supply

    • Total amount of money held by the public

  • In practice, measuring money supply is not as straightforward as it might seem

  • Governments have decided best way to deal with them is to have different measures of the money supply

    • In effect, alternative ways of defining what is and what is not money

    • Each measure includes a selection of assets that are widely acceptable as a means of payment and are relatively liquid

      • An asset is considered liquid if it can be converted to cash quickly and at little cost

        • An illiquid asset can be converted to cash only after a delay, or at considerable cost

Assets and their liquidity

Assets and Their Liquidity

  • Most liquid asset is cash in the hands of the public

  • Next in line are asset categories of about equal liquidity

    • Demand deposits

      • Checking accounts held by households and business firms at commercial banks

    • Other checkable deposits

      • Catchall category for several types of checking accounts that work very much like demand deposits

    • Travelers checks

      • Specially printed checks that you can buy from banks or other private companies, like American Express

    • Savings-type accounts

      • At banks and other financial institutions

      • Are less liquid than checking-type accounts, since they do not allow you to write checks

  • Next on the list are deposits in retail money market mutual funds

    • Time deposits (sometimes called certificates of deposit, or CDs)

      • Require you to keep your money in the bank for a specified period of time (usually six months or longer)

        • Impose an interest penalty if you withdraw early

Figure 1 monetary assets and their liquidity july 14 2003




($3,093 billion)





($880 billion)




($903 billion)




($846 billion)

Cash in the

Hands of the


($646 billion)

Figure 1: Monetary Assets and Their Liquidity (July 14, 2003)



($314 billion)





($298 billion)




($8 billion)

More Liquid

Less Liquid

M1 and m2

M1 And M2

  • Standard measure of money stock is M1

    • Sum of the first four assets in our list

      • M1 = cash in the hands of the public + demand deposits + other checking account deposits + travelers checks

    • When economists or government officials speak about “money supply,” they usually mean M1

  • Another common measure of money supply, M2, adds some other types of assets to M1

    • M2 = M1 + savings-type accounts + retail MMMF balances + small denomination time deposits

  • Other official measures of money supply besides M1 and M2 that add in assets that are less liquid than those in M2

    • M1 and M2 have been most popular, and most commonly watched, definitions

M1 and m21

M1 And M2

  • Important to understand that M1 and M2 money stock measures exclude many things that people use regularly as a means of payment

  • Technological advances—now and in the future—will continue trend toward new and more varied ways to make payments

  • We will assume money supply consists of just two components

    • Cash in the hands of the public and demand deposits

  • Our definition of the money supply corresponds closely to liquid assets that our national monetary authority—the Federal Reserve—can control

The banking system financial intermediaries

The Banking System: Financial Intermediaries

  • What are banks?

    • Financial intermediaries—business firms that specialize in

      • Assembling loanable funds from households and firms whose revenues exceed their expenditures

      • Channeling those funds to households and firms (and sometimes the government) whose expenditures exceed revenues

  • An intermediary helps to solve problems by combining a large number of small savers’ funds into custom-designed packages

    • Then lending them to larger borrowers

  • Intermediaries must earn a profit for providing brokering services

    • By charging a higher interest rate on funds they lend than rate they pay to depositors

The banking system financial intermediaries1

The Banking System: Financial Intermediaries

  • United States boasts a wide variety of financial intermediaries, including

    • Commercial banks

    • Savings and loan associations

    • Mutual savings banks

    • Credit unions

    • Insurance companies

    • Some government agencies

  • There are four types of depository institutions

    • Savings and Loan associations

    • Mutual savings banks

    • Credit unions

    • Commercial banks

Commercial banks

Commercial Banks

  • A commercial bank (or just “bank” for short) is a private corporation that provides services to the public

    • Owned by its stockholders

  • For our purposes, most important service is to provide checking accounts

    • Enables bank’s customers to pay bills and make purchases without holding large amounts of cash that could be lost or stolen

  • Banks provide checking account services in order to earn a profit

A bank s balance sheet

A Bank’s Balance Sheet

  • A balance sheet is a two-column list that provides information about financial condition of a bank at a particular point in time

    • In one column, bank’s assets are listed

      • Everything of value that it owns

    • On the other side, the bank’s liabilities are listed

      • Amounts bank owes

  • Bond

    • A promise to pay back borrowed funds, issued by a corporation or government agency

  • Loan

    • An agreement to pay back borrowed funds, signed by a household or noncorporate business

  • Next come two categories that might seem curious

    • “Vault cash”

    • “Account with the Federal Reserve”

  • Why does the bank hold them?

A bank s balance sheet1

A Bank’s Balance Sheet

  • Explanations for vault cash and accounts with Federal Reserve

    • On any given day, some of the bank’s customers might want to withdraw more cash than other customers are depositing

    • Banks are required by law to hold reserves

      • Sum of cash in vault and accounts with Federal Reserve

  • Required reserve ratio tells banks the fraction of their checking accounts that they must hold as required reserves

    • Set by Federal Reserve

  • Net worth = Total assets – Total liabilities

    • Include net worth on liabilities side of balance sheet because it is, in a sense, what bank would owe to its owners if it went out of business

      • A balance sheet always balances

The federal reserve system

The Federal Reserve System

  • Every large nation controls its money supply with a central bank

    • A nation’s principal monetary authority

    • Most developed countries established central banks long ago

      • England’s central bank—Bank of England—was created in 1694

      • France established Banque de France in 1800

      • United States established Federal Reserve System in 1913

  • U.S. waited such a long time to establish a central authority because of

    • Suspicion of central authority that has always been part of U.S. politics and culture

    • Large size and extreme diversity of our country

    • Fear that a powerful central bank might be dominated by the interests of one region to the detriment of others

The federal reserve system1

The Federal Reserve System

  • Our central bank is different in form from its European counterparts

  • One major difference is indicated in the very name of the institution

    • Does not have the word “central” or “bank” anywhere in its title

  • Another difference is the way the system is organized

  • Another interesting feature of Federal Reserve System is its peculiar status within government

    • Strictly speaking, it is not even a part of any branch of government

    • Both President and Congress exert some influence on Fed through their appointments of key officials

Figure 2 the geography of the federal reserve system







New York








San Francisco

Kansas City



St. Louis







Note: Both Alaska and Hawaii are in the Twelfth District

District boundaries

State boundaries

Reserve Bank cities

Board of Governors of the Federal Reserve System

Figure 2: The Geography of the Federal Reserve System

Figure 3 the structure of the federal reserve system

Chair of Board of Governors

Appoints 3 directors of each Federal Reserve Bank

President appoints

  • Board of Governors

  • (7 members, including chair)

  • Supervises and regulates member banks

  • Supervises 12 FederalReserve District Banks

  • Sets reserve requirements and approves discount rate

  • 12 Federal Reserve

  • District Banks

  • Lend reserves

  • Clear checks

  • Provide currency

Senate confirms

Elect 6 directors

of each

Federal Reserve


  • Federal Open Market

  • Committee

  • (7 Governors + 5 Reserve

  • Bank Presidents)

  • Conducts open market operations to control the money supply

3,500 Member Banks

Figure 3: The Structure of the Federal Reserve System

The structure of the fed

The Structure of the Fed

  • Board of Governors

    • Consists of seven members who are appointed by President and confirmed by Senate for a 14-year term

    • In order to keep any President or Congress from having too much influence over Fed

      • Four-year term of the chair is not coterminous with four-year term of the President

  • Each of 12 Federal Reserve Banks is supervised by nine directors

    • Three of whom are appointed by Board of Governors

    • Other six are elected by private commercial banks—the official stockholders of the system

    • Directors of each Federal Reserve Bank choose a president of that bank, who manages its day-to-day operations

  • Only about 3,500 of the 8,000 or so commercial banks in United States are members of Federal Reserve System

    • But they include all national banks and state banks

    • All of the largest banks in United States are nationally chartered banks and therefore member banks as well

The federal open market committee

The Federal Open Market Committee

  • Federal Open Market Committee (FOMC)

    • A committee of Federal Reserve officials that establishes U.S. monetary policy

  • Most economists regard FOMC as most important part of Fed

  • Consists of all 7 governors of Fed, along with 5 of the 12 district bank presidents

  • Not even President of United States knows details behind the decisions, or what FOMC actually discussed at its meeting, until summary of meeting is finally released

    • Committee exerts control over nation’s money supply by buying and selling bonds in public (“open”) bond market

The functions of the federal reserve

The Functions of the Federal Reserve

  • Federal Reserve, as overseer of the nation’s monetary system, has a variety of important responsibilities including

    • Supervising and regulating banks

    • Acting as a “bank for banks”

    • Issuing paper currency

    • Check clearing

    • Controlling money supply

The fed and the money supply

The Fed and the Money Supply

  • Suppose Fed wants to change nation’s money supply

    • It buys or sells government bonds to bond dealers, banks, or other financial institutions

      • Actions are called open market operations

  • We’ll make two special assumptions to keep our analysis of open market operations simple for now

    • Households and business are satisfied holding the amount of cash they are currently holding

      • Any additional funds they might acquire are deposited in their checking accounts

      • Any decrease in their funds comes from their checking accounts

    • Banks never hold reserves in excess of those legally required by law

How the fed increases the money supply

How the Fed Increases the Money Supply

  • To increase money supply, Fed will buy government bonds

    • Called an open market purchase

  • Suppose Fed buys $1,000 bond from Lehman Brothers, which deposits the total into its checking account

    • Two important things have happened

      • Fed has injected reserve into banking system

      • Money supply has increased

        • Demand deposits have increased by $1,000 and demand deposits are part of money supply

        • Lehman Brothers’ bank now has excess reserves

          • Reserves in excess of required reserves

          • If required reserve ratio is 10% bank has excess reserves of $900 to lend

          • Demand deposits increase each time a bank lends out excess reserves

The demand deposit multiplier

The Demand Deposit Multiplier

  • How much will demand deposits increase in total?

    • Each bank creates less in demand deposits than the bank before

    • In each round, a bank lent 90% of deposit it received

  • Whatever the injection of reserves, demand deposits will increase by a factor of 10, so we can write

    • ΔDD = 10 x reserve injection

  • Demand deposit multiplier is number by which we must multiply injection of reserves to get total change in demand deposits

  • Size of demand deposit multiplier depends on value of required reserve ratio set by Fed

The demand deposit multiplier1

The Demand Deposit Multiplier

  • For any value of required reserve ratio (RRR), formula for demand deposit multiplier is 1/RRR

  • Using general formula for demand deposit multiplier, can restate what happens when Fed injects reserves into banking system as follows

    • ΔDD = (1 / RRR) x ΔReserves

  • Since we’ve been assuming that the amount of cash in the hands of the public (the other component of the money supply) does not change, we can also write

    • ΔMoney Supply = (1 / RRR) x ΔReserves

The fed s influence on the banking system as a whole

The Fed’s Influence on the Banking System as a Whole

  • Can also look at what happened to total demand deposits and money supply from another perspective

    • Where did additional $1,000 in reserves end up?

    • In the end, additional $1,000 in reserves will be distributed among different banks in system as required reserves

      • After an injection of reserves, demand deposit multiplier stops working—and the money supply stops increasing—only when all reserves injected are being held by banks as required reserves

  • In the end, total reserves in system have increased by $1,000

    • Amount of open market purchase

How the fed decreases the money supply

How the Fed Decreases the Money Supply

  • Just as Fed can increase money supply by purchasing government bonds

    • Can also decrease money supply by selling government bonds

      • An open market sale

  • Process of calling in loans will involve many banks

    • Each time a bank calls in a loan, demand deposits are destroyed

    • Total decline in demand deposits will be a multiple of initial withdrawal of reserves

    • Keeping in mind that a withdrawal of reserves is a negative change in reserves

      • Can still use our demand deposit multiplier—1/(RRR)—and our general formula

      • ΔDD = (1/RRR) x ΔReserves

Some important provisos about the demand deposit multiplier

Some Important Provisos About the Demand Deposit Multiplier

  • Although process of money creation and destruction as we’ve described it illustrates the basic ideas, formula for demand deposit multiplier—1/RRR—is oversimplified

    • In reality, multiplier is likely to be smaller than formula suggests, for two reasons

      • We’ve assumed that as money supply changes, public does not change its holdings of cash

      • We’ve assumed that banks will always lend out all of their excess reserves

Other tools for controlling the money supply

Other Tools for Controlling the Money Supply

  • While other tools can affect the money supply, open market operations have two advantages over them

    • Precision and secrecy

    • This is why open market operations remain Fed’s primary means of changing money supply

  • Fed’s ability to conduct its policies in secret—and its independent status in general—is controversial

    • In recent years, because Fed has been so successful in guiding economy, controversy has largely subsided

Other tools for controlling the money supply1

Other Tools for Controlling the Money Supply

  • There are two other tools Fed can use to increase or decrease money supply

    • Changes in required reserve ratio

    • Changes in discount rate

  • Changes in either required reserve ratio or discount rate could set off the process of deposit creation or deposit destruction in much the same way outlined in this chapter

    • In reality, neither of these policy tools is used very often

  • Why are these other tools used so seldom?

    • Partly because they can have unpredictable effects

Using the theory bank failures and banking panics

Using the Theory: Bank Failures and Banking Panics

  • A bank failure occurs when a bank cannot meet its obligations to those who have claims on the bank

    • Includes those who have lent money to the bank, as well as those who deposited their money there

  • Historically, many bank failures have occurred when depositors began to worry about a bank’s financial health

  • Run on the bank

    • An attempt by many of a bank’s depositors to withdraw their funds

  • Ironically, a bank can fail even if it is in good financial health, with more than enough assets to cover its liabilities

    • Just because people think bank is in trouble

  • Banking panic occurs when many banks fail simultaneously

Using the theory bank failures and banking panics1

Using the Theory: Bank Failures and Banking Panics

  • Banking panics can cause serious problems for the nation

    • Hardship suffered by people who lose their accounts when their bank fails

    • Even when banks do not fail, withdrawal of cash decreases banking system’s reserves

      • Money supply can decrease suddenly and severely, causing a serious recession

  • Banking panic of 1907 convinced Congress to establish Federal Reserve System

    • But creation of Fed did not, in itself, solve problem

  • Great Depression is a good example of this problem

    • Officials of Federal Reserve System, not quite grasping seriousness of the problem, stood by and let it happen

Using the theory bank failures and banking panics2

Using the Theory: Bank Failures and Banking Panics

  • For five-year period ending in May 2003, a total of 26 banks failed—an average of about 6 per year

    • Why the dramatic improvement?

      • Federal Reserve learned an important lesson from Great Depression

        • It now stands ready to inject reserves into system more quickly in a crisis

      • In 1933 Congress created Federal Deposit Insurance Corporation (FDIC) to reimburse those who lose their deposits

  • FDIC has had a major impact on the psychology of banking public

  • FDIC protection for bank accounts has not been costless

  • To many observers, experience of late 1980s and early 1990s was a reminder of the need for a sound insurance system and close monitoring of banking system

Figure 4 bank failures in the united states 1921 1999





Number of Bank Failures















Figure 4: Bank Failures in the United States, 1921-1999

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