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10 MONEY, BANKS, AND THE FEDERAL RESERVE**

* * This is Chapter 26 in Economics.

C h a p t e r K e y I d e a s

Money makes the World Go Around

A. Money has taken many forms; what is money now?

B. What do banks do, and can they create money?

C. How does the Federal Reserve influence the quantity of money?

O u t l i n e

I. What is Money?

A. Money is any commodity or token that is generally acceptable as a means of payment.

1. A means of payment is a method of settling a debt.

2. Money has three other functions:

a) Medium of exchange

b) Unit of account

c) Store of value

B. Medium of Exchange

1. A medium of exchange is an object that is generally accepted in exchange for goods and services.

2. In the absence of money, people would need to exchange goods and services directly, which is called barter.

3. Barter requires a double coincidence of wants, whereby each person in the barter transaction has what the other wants. This situation is rare, so barter is costly.

C. Unit of Account

1. A unit of account is an agreed measure for stating the prices of goods and services.

C h a p t e r

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2. Table 10.1 illustrates how a unit of account simplifies price comparisons.

D. Store of Value

As a store of value, money can be held for a time and later exchanged for goods and services.

E. Money in the United States Today

1. Money in the United States consists of bills and coins—called currency—and deposits at banks and other depository institutions.

2. The two main official measures of money in the United States are M1 and M2.

3. M1 consists of currency outside of banks, traveler’s checks, and checking deposits owned by individuals and businesses.

4. M2 consists of M1 plus time deposits, savings deposits, and money market mutual funds and other deposits.

5. Figure 10.1 graphically illustrates the composition of these two measures in 2003 and shows the relative magnitudes of the components of money.

6. The items in M1 clearly meet the definition of money; the items in M2 do not do so quite so clearly but still are quite liquid. Liquidity is the property of being instantly convertible into a means of payment with little loss in value.

7. Checkable deposits are money, but checks are not; checks merely are the means by which the money is transferred among people.

8. Credit cards are not money. Credit cards enable the holder to obtain a loan quickly, but ultimately the loan must be repaid with money.

II. Depository Institutions

A. A depository institution is a firm that takes deposits from households and firms and makes loans to other households and firms. The deposits of three types of depository institution make up the nation’s money:

1. Commercial banks

2. Thrift institutions

3. Money market mutual funds

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B. Commercial Banks

1. A commercial bank is a firm that is licensed by the Comptroller of the Currency or by a state agency to receive deposits and make loans.

2. Table 10.2 shows the aggregate balance sheet of the commercial banks in the United States at the end of June 2003.

3. A commercial bank’s balance sheet summarizes its business and lists the bank’s assets, liabilities, and net worth.

4. The objective of a commercial bank is to maximize the net worth of its stockholders.

5. To achieve this objective, banks make risky loans at a higher interest rate than the interest rate they pay on deposits.

6. But the banks must balance profit and prudence; loans generate profit, but depositors must be able to obtain their funds when they want them.

7. So banks divide their funds into two parts: reserves and loans.

8. Reserves are the cash in a bank’s vault and deposits at Federal Reserve Banks.

9. Bank lending takes the form of liquid assets, investment securities, and loans.

C. Thrift Institutions

1. The thrift institutions are savings and loan associations, savings banks, and credit unions.

2. A savings and loan association (S&L) is a depository institution that receives checking and savings deposits and that makes personal, commercial, and home-purchase loans.

3. A savings bank is a depository institution that accepts savings deposits and makes mainly mortgage loans.

4. A credit union is a depository institution owned by a social or economic group such as a firm’s employees that accepts savings deposits and makes mostly consumer loans.

D. Money Market Mutual Funds

A money market fund is a fund operated by a financial institution that sells shares in the fund and holds liquid assets such as U.S. Treasury bills or short-term commercial paper.

E. The Economic Functions of Depository Institutions

1. Depository institutions make a profit from the spread between the interest rate they pay on their deposits and the interest rate they charge on their loans.

2. Depository institutions provide four main types of services:

a) Create liquidity by accepting deposits that can be withdrawn instantly and using these deposits to make long-term loans.

b) Minimize the cost of obtaining funds by pooling many people’s relatively small deposits into large sums that can be loaned to many borrowers.

c) Minimize the cost of monitoring borrowers by specializing in this activity.

d) Pool risk by lending to many different borrowers so that if one borrower is unable to pay back the loan the lender loses only a small fraction of total deposits.

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F. Financial Regulation, Deregulation, and Innovation

1. Depository institutions face two types of regulations: deposit insurance and balance sheet rules.

2. Deposits at banks, S&Ls, savings banks, and credit unions are insured by the Federal Deposit Insurance Corporation (FDIC).

a) This insurance guarantees deposits of up to $100,000.

b) Banks benefit from deposit insurance because the risk of a bank run is minimized.

c) This guarantee gives depository institutions the incentive to make risky loans because the depositors believe their funds to be perfectly safe; because of this incentive balance sheet regulations have been established.

3. There are four main balance sheet rules:

a) Equity capital requirements — regulations setting the minimum amount of the owners’ financial wealth that must be at stake in the depository institution.

b) Reserve requirements — rules listing the minimum percentages of deposits that must be held in currency or in other safe assets.

c) Deposit rules — restrictions on the type of deposits that an intermediary may accept.

d) Lending rules — restrictions on the type and size of loans that can be made by a depository institution.

G. Deregulation in the 1980s and 1990s

1. The 1980s were marked by considerable financial deregulation, when federal legislation and rule changes lifted many of the restrictions on depository institutions, removing many of the distinctions between banks and others, and strengthening the control of the Federal Reserve over the system.

2. In 1994 the Riegle-Neal Interstate Banking and Branching Efficiency Act was passed, which permits U.S. banks to establish branches in any state. It led to a wave of mergers.

H. Financial Innovation

1. The 1980s and 1990s have been marked by financial innovation—the development of new financial products aimed at lowering the cost of making loans or at raising the return on lending.

2. Financial innovation occurred for three reasons:

a) The economic environment, especially of the 1980s, featured high inflation and high interest rates, which created risk for intermediaries. Some innovations, such as variable rate mortgages, were aimed at lowering this risk.

b) Massive technological change, especially reductions in the cost of computing and long-distance communication, brought other innovations.

c) Much innovation was directed at avoiding regulation.

I. Deregulation, Innovation, and Money

The combination of deregulation and innovation has produced large changes in the composition of money, both M1 and M2.

III. How Banks Create Money

A. Reserves: Actual and Required

1. The fraction of a bank’s total deposits held as reserves is the reserve ratio.


2. The required reserve ratio is the ratio of reserves to deposits that banks are required, by regulation, to hold. A bank’s required reserves are equal to its deposits multiplied by the required reserve ratio.

3. Excess reserves equal actual reserves minus required reserves.

B. Creating Deposits by Making Loans

1. When a bank receives a deposit of currency, its reserves increase by the amount deposited, but its required reserves increase by only a fraction (determined by the required reserve ratio) of the amount deposited.

2. The bank has excess reserves, which it loans. These loans can end up as deposits in another bank in the banking system. The new bank behaves the same as the previous bank (loaning the excess reserves) but has a smaller amount of excess reserves.

3. The process continues until the banking system has created enough deposits to eliminate its excess reserves.

3. Figure 10.2 illustrates this process when banks keep 25 percent of a deposit as reserves.

IV. The Federal Reserve System

A. The Federal Reserve System, or the Fed, is the central bank of the United States. A central bank is a bank’s bank and a public authority that regulates a nation’s depository institutions and controls the quantity of money.

B. The Fed’s Goals and Targets

1. The Fed conducts the nation’s monetary policy, which means that it adjusts the quantity of money in circulation.

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2. The Fed’s goals are to keep inflation in check, maintain full employment, moderate the business cycle, and contribute toward achieving long-term growth.

3. In pursuit of its goals, the Fed pays close attention to interest rates and sets a target that is consistent with its goals for the federal funds rate, which is the interest rate that the banks charge each other on overnight loans of reserves.

C. The Structure of the Fed

1. The key elements in the structure of the Fed are the Board of Governors, the regional Federal Reserve banks, and the Federal Open Market Committee.

2. The Board of Governors has seven members appointed by the president of the United States and confirmed by the Senate. Board terms are for 14 years and overlap so that one position becomes vacant every 2 years. The president appoints one member to a (renewable) four-year term as chairman.

3. Each of the 12 Federal Reserve Regional Banks has a nine-person board of directors and a president. Figure 10.3 shows the regions of the Federal Reserve System.

4. The Federal Open Market Committee (FOMC) is the main policy-making group of the Federal Reserve System. It consists of the members of the Board of Governors, the president of the Federal Reserve Bank of New York, and the 11 presidents of other regional Federal Reserve banks of whom, on a rotating basis, 4 are voting members. The FOMC meets every six weeks to formulate monetary policy.


5. Figure 10.4 summarizes the Fed’s structure and policy tools.

D. The Fed’s Power Center

1. In practice, the chairman of the Board of Governors (since 1987 Alan Greenspan) is the center of power in the Fed.

2. The chairman controls the agenda of the Board, has better contact with the Fed’s staff, and is the Fed’s spokesperson and point of contact with the federal government and with foreign central banks and governments.

E. The Fed’s Policy Tools

1. The Fed uses three monetary policy tools: the required reserve ratio, the discount rate, and open market operations.

a) The Fed sets required reserve ratios, which are the minimum percentages of deposits that depository institutions must hold as reserves.

b) The discount rate is the interest rate at which the Fed stands ready to lend reserves to depository institutions.

c) An open market operation is the purchase or sale of government securities—U.S. Treasury bills and bonds—by the Federal Reserve System in the open market.

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F. The Fed’s Balance Sheet

1. On the Fed’s balance sheet, the largest and most important asset is U.S. government securities. The most important liabilities are Federal Reserve notes in circulation and banks’ deposits. Table 10.3 shows the Fed’s balance sheet for February 2002.

2. The sum of Federal Reserve notes, coins, and banks’ deposits at the Fed is the monetary base.


V. Controlling the Quantity of Money

A. How Required Reserve Ratios Work

An increase in the required reserve ratio boosts the reserves that banks must hold, decreases their lending, and decreases the quantity of money.

B. How the Discount Rate Works

An increase in the discount rate raises the cost of borrowing reserves from the Fed, thereby decreasing banks’ reserves, which decreases their lending and decreases the quantity of money.

C. How an Open Market Operation Works

1. When the Fed conducts an open market operation by buying a government security, it increases banks’ reserves. Banks loan the excess reserves. By making loans, they create money. The reverse occurs when the Fed sells a government security.

2. Although the initial accounting details differ, the ultimate process of how an open market operation changes the money supply is the same regardless of whether the Fed conducts its open market transactions with a commercial bank or with a member of the public. Figure 10.5 illustrates both situations.

3. An open market operation that increases banks’ reserves also increases the monetary base.

D. The Monetary Base, The Quantity of Money, and the Money Multiplier

1. The money multiplier determines the change in the quantity of money that results from a given change in the monetary base. The money multiplier is the amount by which a change in the monetary base is multiplied to calculate the final change in the quantity of money.

2. An increase in currency held outside the banks is called a currency drain. A currency drain decreases the amount of money that banks can create from a given increase in the monetary base.

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3. Banks use excess reserves from the open market operation to make loans so that the banks where the loans are deposited acquire excess reserves which they, in turn, then loan. Because the initial loans are re-loaned, when the Fed conducts an open market operation, the ultimate change in the quantity of money is larger than the initiating open market operation.

5. Figure 10.6 and Figure 10.7 illustrate the multiplier effect of an open market purchase.

E. The Size of the Money Multiplier

1. The size of the money multiplier depends on the magnitudes of the required reserve ratio and the ratio of currency to deposits.


a) The formula for the money multiplier is [(1 + c) ÷ (r + c)] where c is ratio of currency to deposits and r is the required reserve ratio.

2. The magnitude of the U.S. money multiplier depends on the definition of money that is used. For M1, the money multiplier is 1.8. For M2, the money multiplier is 8.6.

R e a d i n g B e t w e e n t h e L i n e s The news article reports how electronic payments, such as debit cards, have grown in importance over the past four years. Debit cards are now used for 32 percent of in-store purchases, the same proportion as cash and more than checks or credit cards. The analysis stresses the role of transactions costs in determining what means of payment is used.

N e w i n t h e S e v e n t h E d i t i o n The topics in the 6th edition’s Chapters 12 and 13 (27 and 28 in Economics) have been reorganized into this editions Chapters 10 and 11 (26 and 27 in Economics). In this edition, all the institutional material—the definition of money, the description of the banking system, and the fundamentals of the Fed—are in this chapter. comes into one chapter—Chapter 26. The material on how monetary policy affects the economy and the demand for money has been moved to the next chapter.

The discussion of how banks create deposits by making loans has been simplified to consider only the more realistic case of an economy with many banks. There is a new discussion of the size of the money multiplier in the United States. The data and figures are updated to 2003. The new Reading Between the Lines discusses electronic payments and the role transactions costs play in determining how a payment is made.

Te a c h i n g S u g g e s t i o n s 1. What is Money? The defining characteristic of money. Adam Smith wrote, “Money is a commodity or token that

everyone will accept in exchange for the things they have to sell.” Most people have interpreted this statement as defining money as the medium of exchange. That interpretation is wrong. Smith is defining money as the means of payment. Money is a commodity or token that everyone will accept as payment for the things they have to sell.

When Michael Parkin was a young economist, he had the enormous good fortune to meet Anna Schwartz, Milton Friedman, and a group of other leading monetary economists. It was during the late 1960s when the monetarist debate was alive and well and people were still arguing about whether the demand for money was interest inelastic (as the monetarists claimed) or almost perfectly elastic (as the Keynesians claimed). Anna made a remark that for Michael was one of those defining moments. She said money is the means of payment. Nothing else performs this function. It is unique to money. Many things serve as a medium of exchange, unit of account, or store of value, but money alone serves as the means of payment—the means of settling a debt so that there is no remaining obligation between the parties to a transaction.

Get the class involved in figuring out what money is. To involve the students in the process of determining what money is, after noting its definition and three functions, ask them what they think should be counted as money. List the suggestions on the board before commenting on them. Coins and currency will certainly be mentioned. Usually each class has a few members who have read the

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text and will suggest checkable deposits. Almost always you will obtain some not-so-excellent answers, ranging from gold to shares of stock to credit cards.

The point of this exercise is to obtain these incorrect answers because they give you a chance to discuss why these items are not money. Without ridiculing the wrong answers, you might point out that students rarely pay for books by giving the bookstore shares of IBM stock and asking for change in AT&T stock. By being involved and having to think, the students emerge with a stronger grasp of why money is measured as it is.

Fiat money. To get across the idea of money, take a green piece of paper and cut it to the same size as a dollar bill. Then take the paper into class along with a dollar bill. Ask the students why one piece of paper has value and the other does not. Is there anything intrinsically more valuable about the dollar bill? If not, why won’t someone in class exchange his or her old wrinkled piece of green paper with writing on it for the nice new piece you offer?

The contrast between money in economics and money in everyday language. It can be helpful to emphasize that “money” is a technical term in economics that has a precise meaning and that differs from its looser usages in every day language. For example, an economist would not say “Bill Gates makes a lot of money.” Rather, the economist would say “Bill Gates earns a large income.” An interesting exercise is to have students think of statements containing the word “money” that make complete sense in normal language but that misuse the word in its precise economic sense, and to get them to explain why.

A picky point. The textbook is careful to not use the term money supply in this chapter. Instead, it talks about the quantity of money. The money supply appears in the next chapter and is reserved for the relationship between the quantity of money and the interest rate, other things remaining the same. It parallels the demand for money. Although this point might seem picky, you can help your students by using this same language convention.

2. Depository Institutions What do banks do? Students usually have bank accounts, but often they have never fully thought

through what banks do, how they do it, or what the differences are between banks and other deposit-taking institutions, so what tends to strike instructors as rather dry descriptive material can be interesting to students. It is worth being explicit about the fact, which students tend to be very aware of, that in practice commercial banks earn income not only by the spread between their deposit and lending rates, but also by charging fees for their services. The text focuses on the role of depository institutions as a source of credit creation; for most students, like most customers, their most important function is actually facilitating the payment process, and a little discussion on that (and how relatively cheap it is) can also engage students.

Financial Regulation, Deregulation, and Innovation. This topic can be easily motivated with a few ‘horror stories’—either of the 1930s or of the Savings and Loan scandals of the 1980s. Deposit insurance is a great example of an idea that created unintended consequences because of how it changed incentives for bankers; the Savings and Loan debacle illustrates the problem very well.

A good discussion can arise out of asking students for suggestions as to how the negative consequences of current deposit insurance could be avoided while maintaining the benefits—bright students may see the possibilities in risk-adjusting premiums for banks or privatizing the insurance mechanisms. Students often think of innovation as inherently involving new concrete things—machines or products. Financial innovation is a great context in which to get over the idea that non-material innovations can be at least as important economically—perhaps the idea of limited liability being the archetype of a financial innovation with enormous economic impact.


3. How Banks Create Money A money creation experiment. The process through which banks “create money” can be a dark and

mysterious secret to the students. Indeed, even though the text contains a superb description of the process, students still manage to end up confused.

The first prerequisite to students understanding the process is that they be comfortable with balance sheets shown in the form of T-accounts, and it is well worth spending time on them to make sure students understand what they are and what they show. This will be the first time some students have ever had to interpret a balance sheet, and it is key that they understand that assets are what are owned, liabilities are what are owed, by the institution for which the balance sheet is constructed; and that the two sides must balance.

Mark Rush (our study guide author and supplements czar) tackles the problem of getting students to understand bank money creation head-on by (again) involving the class in a demonstration. Prepare by decorating a piece of green paper with currency-like symbols. (For instance, Mark draws a seal and around it write “In Rush We Trust.” You may write the same slogan, but substituting your name for his probably will be more effective; an alternative is to use “play money”). Label this piece of paper a “$100 bill.”

In class use one of the students by handing him the bill. Tell him that he has decided to deposit it in his bank and ask him his bank’s name. On the chalkboard draw a balance sheet for the bank with deposits of $100, reserves of $10, and loans of $90. Tell the students that the required reserve ratio is 10 percent, so this bank currently has no excess reserves. Now, instruct the student to deposit the money in his bank, which coincidentally happens to be run by the student next to him. Show the class what happens to the balance sheet and how the bank now has excess reserves of $90.

Clearly the “banker” will loan these reserves to the next student in the class, who wants a $90 dollar loan so she can take a bus ride to some nearby dismal location. (Being located in Gainesville, Florida, Mark picks on the city of Stark, home to Florida’s electric chair and a town with an apt name.) When the loan takes place, rip the $100 bill so that only about nine tenths of it is given as the loan. This student pays the money to Greyhound—coincidentally the next student. Ask the name of Greyhound’s bank and draw an initial balance sheet for this bank identical to the initial balance sheet of the first bank. Greyhound deposits the money in the bank—the next student in the row.

Work with the balance sheets to show what happens to the first bank and what happens to the second bank. Clearly the first one no longer has excess reserves but the second bank now has $81 of excess reserves ($90 of additional deposits minus $9 of required reserves). The second bank will make a loan, which you can act out with more students in the class, again ripping off nine tenths of the remaining bill. Work through the point where the second loan winds up deposited in a third bank and then stop to take stock. At this point the quantity of money has increased by $90 in the second bank and $81 in the third, for a total increase—so far—of $171. The students will see that this loaning and reloaning process is not yet over and that the quantity of money will increase by still more. Moreover (and more important) the students will grasp how banks “create money.”

4. The Federal Reserve System Conspiracy theory of the Fed. Some students will have heard about a “conspiracy theory of the Fed.”

This theory, advanced by the ignorant, the misinformed, or the deceitful, is that the commercial banks own the Fed, which is run solely to benefit the banks to ensure that they earn large profits. Point out that commercial banks do indeed own the Fed—they own all the stock issued by the Fed. But Fed stock is not like shares in General Electric or Microsoft. The dividend on the Fed’s stock is fixed at 6 percent of the purchase price, and the stock cannot be sold in a marketplace. So this stock is a lousy investment

What privileges come with the stock? Commercial banks elect six of the nine directors of their Federal Reserve Regional bank; each commercial bank’s votes are proportional to the stock it owns. But the

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directors of the regional banks are hardly key players in the Federal Reserve System. Essentially, the most important task they perform is nominating a president for the regional bank. The regional banks’ presidents are important. The directors, however, do not get much freedom in this choice because their nominee must be approved by the Board of Governors, which does not hesitate to veto anyone considered unacceptable.

Regional bank presidents gain their power from sitting on the FOMC. But there they are a minority because the voting members of the FOMC consist of five regional bank presidents and seven members of the Board of Governors. Because the board members are appointed by the president and approved by the Senate, the government thus wields the ultimate power in the Federal Reserve. The regional bank presidents must be approved by the publicly appointed board members and the board members constitute a majority on the FOMC.

5. Controlling the Quantity of Money It is useful to look at the Fed’s balance sheet (available on its excellent Web site). It shows very

quickly that loans to banks usually are a trivial portion of the Fed’s assets. Of the Fed’s theoretical three tools, only open market operations really matter and there is no harm in being blunt about this. Students can easily see why required reserve ratio changes would work, but also can see quickly how discontinuous and disruptive they would be. Tell students that (a) many industrialized countries no longer bother with required reserve ratios at all, and (b) changes in required reserve ratios are normally only used as monetary policy tools in developing countries without capital markets in which open market operations would be possible. The discount rate looks like it ought to matter more, and certainly changes in it are announced, but explain that it is in practice a signal: banks only borrow from the Fed as a last resort. Why? Because banks believe that if they borrow from the Fed, that will be interpreted as meaning that they cannot borrow from any other source, so they are in very bad trouble. So what actually matters is the Federal Funds Rate, which the Fed can influence very strongly by changing the supply of reserves by Open Market Operations.

T h e B i g P i c t u r e

Where we have been

Because Chapter 10 is the first chapter on money, it introduces a lot of new material. The discussion of monetary policy goals relates back to Chapter 5 which introduced the main topics of macroeconomics.

Where we are going

Chapter 10 is the first of three chapters that examine money and the economy. Chapter 11 examines how money influences interest rates, real GDP, and the price level. Chapter 12 looks at the monetary phenomenon of inflation and how it impacts unemployment and interest rates.


O v e r h e a d Tr a n s p a r e n c i e s

Transparency Text figure Transparency title

59 Figure 10.1 Two Measures of Money

60 Figure 10.2 The Multiple Creation of Bank Deposits

61 Figure 10.4 The Structure of the Fed

62 Figure 10.7 The Multiplier Effect of an Open Market Purchases

E l e c t r o n i c S u p p l e m e n t s MyEconLab

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PowerPoint Lecture Notes

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A d d i t i o n a l D i s c u s s i o n Q u e s t i o n s 11. Why is the use of money in the exchange of goods and services less costly than using barter? 12. “Everyone knows that true money is issued by the government; that is, the only real form of money is

the nation’s currency.” Comment on this assertion. 13. Why do we need different types of depository institutions? Would the nation be better off if, say,

S&Ls became more like banks? Defend your answer. 14. Currently deposits in banks pay approximately 3 percent. Yet people borrowing these deposits from

banks pay approximately 9 percent. Why don’t people making deposits in banks get together with people borrowing from banks and “split the difference” between these rates? For instance, a loan could be made at 6 percent so that the lenders (the former depositors) receive 6 percent rather than 3 percent and the borrowers pay 6 percent rather than 9 percent.

15. What are required reserves, actual reserves, and excess reserves? How much in excess reserves do you think a bank wants to keep on hand? (Bear in mind that excess reserves earn no interest income.)

16. How does a currency drain affect the money multiplier?

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17. Define the monetary base. 18. List and discuss the three policy tools the Fed can use to increase the nation’s money supply. Which

do you consider to be the most important? Why? 19. How does a change in the required reserve ratio affect the money supply? A change in the discount

rate? 10. “Whenever the federal government runs a deficit, the Federal Reserve must sell government

securities.” Is this statement true or false? Why?


A n s w e r s t o t h e R e v i e w Q u i z z e s

Page 236 (page 608 in Economics) 1. Money is anything that is a means of payment. Money has three functions: medium of exchange

(money is accepted in exchange for goods and services), unit of account (prices are quoted in terms of money), and store of value (money can be held and exchanged for goods and services later). Packets of chewing gum do not function as money because they are not particularly good as stores of value—gum deteriorates. Additionally, packets of gum are not generally accepted in exchange for goods and services, so packets of gum are not a medium of exchange.

2. Commodities are not used as money because of several problems. Many commodities are bulky. And many commodities change in value over time. Using as money a commodity that changes in value would be awkward because prices would change simply because the commodity’s value changed. Additionally, using a commodity as money implies that money has a high opportunity cost, whereas currency and bank deposits have low opportunity costs.

3. The main component of money in the United States today is deposits at banks and other depository institutions. Currency and travelers’ checks are two other components of money.

4. The official measures of money are M1 (the sum of currency, travelers’ checks, and checking deposits owned by individuals and businesses), M2 (the sum of M1, savings deposits, time deposits, and money market mutual funds), and M3 (the sum of M2, large-scale time deposits, and term deposits). All the components of M1 are truly money because all the components serve as a means of payment. Some of the components of M2 and especially M3 are not truly money because they are not a means of payment. (For instance, funds at money market mutual funds cannot be used as a means of payment for small purchases.) But all of these “non-money” assets are highly liquid so they are operationally similar to money.

5. Checks and credit cards are not money because they are not a means of payment. A check is an order to transfer a deposit from one person to another. The deposits are money but the checks are not. Credit cards are a way to obtain an instant loan. The loan still needs to be repaid with money so the credit card is not a means of payment, that is, it is not money.

Page 241 (page 613 in Economics) 1. All depository institutions take deposits from households and firms and make credit available to

other households and firms. Savings and loan associations, savings banks, and credit unions differ from other depository institutions because they generally make consumer loans and home purchase loans. Money market mutual funds differ from other intermediaries because they use their deposits to buy liquid assets such as U.S. Treasury bills, that is, they provide credit but do not make loans as such.

2. Liquidity is the ability to turn an asset quickly into money at a fixed price. Depository institutions create liquidity when they offer deposits that can be withdrawn as money at short (or no) notice and then use these deposits to make long-term loans.

3. Depository institutions lower the cost of borrowing and lending because they specialize in borrowing and lending. For instance, a firm that wants to borrow a large sum of money need only visit a depository institution to arrange such a loan. In the absence of depository institutions, the firm would need to undertake many transactions with many loaners, which would be a costly endeavor. Similarly, a saver wishing to loan money simply deposits it with an institution which will loan it for the saver. In the absence of depository institutions, the saver would need to contact many potential borrowers, which would be a costly endeavor. Depository institutions lower the cost of monitoring borrowers because they specialize in this task. Such specialization, as well as the

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ability to spread the monitoring costs over many borrowers, lower the average cost of monitoring borrowers.

4. Depository institutions pool risk because they use funds obtained from many depositors to make loans to many borrowers. As a result, if a borrower defaults, no one depositor bears the entire loss because the loss is spread over all depositors. By spreading the risk, depository institutions are pooling risk.

5. Anyone opening a bank, taking deposits, and making loans faces several restrictions or regulations. The restrictions can be divided into two general types: deposit insurance and balance sheet rules. Deposit insurance reflects the fact that the deposits generally are insured by the Federal Deposit Insurance Corporation (FDIC). Because of this insurance, banks face balance sheet regulations to minimize their incentive to make high-risk loans. The balance sheet regulations are: capital requirements (regulations giving the minimum amount of an owner’s own wealth that must be invested in the bank); reserve requirements (rules telling the minimum percentages of deposits that must be retained as currency or at the Federal Reserve); deposit rules (regulations restricting the types of deposits an intermediary can accept); and, lending rules (regulations limiting the proportions of different types of loans an intermediary can make).

6. The financial deregulation that occurred in the 1980s made commercial banks more like other depository institutions primarily because the deregulation made other depository institutions more like banks. In particular, the deregulation eased constraints on the type of loans that other depository institutions (savings and loan associations and savings banks) could make and allowed these institutions the right to make types of loans similar to those made by commercial banks.

7. Financial innovation is influenced by the economic environment, technology, and regulation. For instance, when the economic environment was such that interest rates were high, variable rate mortgages were developed that took some of the risk out of extending mortgage loans. Gains in technology, by lowering the cost of computing and communication, have lead to increased usage of credit cards. And regulation, by limiting the profits that intermediaries can earn, constantly spur intermediaries to develop ways to avoid regulation and thereby earn larger profits.

8. Deregulation and innovation have changed the composition of money. Today new types of checking accounts (NOW and ATS) accounts are a large fraction of money even though these types of accounts did not exist in 1960. In M2, “traditional” savings deposits have declined, while new deposits, such as money market funds, have expanded.

Page 243 (page 615 in Economics) 1. Banks create deposits by making loans because part or all of the loans they make will be deposited

in another bank. For instance, a student given a loan may purchase books at the local bookstore. The bookstore will then deposit the proceeds into its bank as part of the bookstore’s checking account. Thus the loan has created new deposits at the bookstore’s bank. The factors that limit the amount of deposits and loans a bank can make are the bank’s reserves and the required reserve ratio. A bank must maintain at least the amount of reserves set by the required reserve ratio and so if the bank does not have enough excess reserves—reserves above the amount that legally must be maintained—the bank cannot make additional loans.

2. Though the manager does not see the entire process, nonetheless the loans the manager makes will create more deposits and hence more money. Point out to the manager that when he or she makes a loan, the deposits at his or her bank do not change. And, when the loan is spent, the recipient selling the goods or services that have been purchased will deposit part or all of the proceeds in his or her bank. When the recipient makes this deposit, the total amount of the nation’s deposits increase and, because deposits are part of the nation’s money, the quantity of money also increases.


3. When banks receive new deposits of $100 million dollars, they also have received new reserves of $100 million. The total amount of deposits will stop changing when deposits are at the level that makes required reserves equal to actual reserves.

Page 247 (page 619 in Economics) 1. The Federal Reserve is the central bank of the United States. The Federal Reserve conducts the

nation’s monetary policy and supervises the financial system.

2. The seven Federal Reserve board members are appointed by the President of the United States and confirmed by the Congress. Each member is appointed to a 14-year term and the terms are staggered so that a seat becomes vacant every two years.

3. The Federal Reserve has three policy tools: changes in required reserve ratios; changes in the discount rate; and, open market operations.

4. The Federal Open market Committee (FOMC) is the main policy-making group within the Federal Reserve System. It decides upon the nation’s monetary policy as conducted through open market operations.

5. The FOMC meets approximately once every six weeks.

Page 251 (page 623 in Economics) 1. When the Federal Reserve buys securities in the open market, bank reserves increase so that banks

have excess reserves. Because banks have excess reserves, they loan the excess and a multiple expansion of the quantity of money results. The initial increase in bank reserves from the Fed’s purchase of securities means that the monetary base increases when the Fed buys securities. When the Federal Reserve sells securities in the open market, bank reserves decrease so that banks have deficient reserves. Because banks have deficient reserves, they must call in loans and a multiple contraction of the money supply results. The initial decrease in bank reserves from the Fed’s sale of securities means that the monetary base decreases when the Fed sells securities.

2. With excess reserves, the banks increase their lending and the quantity of money increases.

3. With a shortage of reserves, the banks decrease their lending and the quantity of money decreases.

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A n s w e r s t o t h e P r o b l e m s 1. Of the list, money in the United States includes the quarters inside public telephones and the U.S.

dollar bills in your wallet. Money is composed of currency outside the banks and deposits at financial institutions. Currency inside the cash machines, Visa cards, checks, and loans are not money.

2. Of the list, money in the United States includes the checking deposits at Citicorp, the Susan B. Anthony dollar coin, and NOW accounts. The checking deposits at Citicorp and the NOW accounts are deposit money. The three money assets meet all the functions of money. IBM stock and U.S. government securities are not money. While IBM stock and U.S. Treasury securities are stores of value, they are definitely not a mediums of exchange and so are not money.

3. M1 increases by $1,000; M2 does not change. M1 is the sum of currency outside the banks, traveler’s checks, and checking deposits. M2 is the sum of M1 plus savings deposits, time deposits, and money market mutual funds and other deposits. The withdrawal of $1,000 from a savings account leaves M2 unchanged because the $1,000 goes into M1 types of money, which is part of M2. The $50 held as cash and the $950 held in a checking account increase M1 by $1,000.

4. M1 does not change; M2 does not change. M1 is the sum of currency outside the banks, traveler’s checks, and checking deposits. The $10,000 when it was kept in the savings account was not part of M1 and when it is put into a money market fund it still is not part of M1. So M1 does not change. M2 is the sum of M1 plus savings deposits, time deposits, and money market mutual funds and other deposits. When kept in the savings account, the $10,000 was part of M2. And, when put in the money market mutual fund, the $10,000 remains part of M2. So M2 does not change.

5 a. The balance sheet has the following assets: Reserves, $250 million; Loans, $1,000 million; Other assets, $1,250 million. It has the following liabilities: Deposits, $2,000 million; Other liabilities, $500 million.

Assets Liabilities

Reserves $250 million Deposits $2,000 million

Loans 1,000 million Other liabilities 500 million

Other assets 1,250 million

Total assets 2,500 million Total liabilities 2,500 million

b. The reserve ratio is 12.5 percent. The reserve ratio is the percentage of deposits that are held as reserves. Reserves are $250 million and deposits are $2,000, so the reserve ratio is 12.5 percent.

c. The deposit multiplier is 8. The deposit multiplier equals 1/(required reserve ratio). The required reserve ratio is 12.5 percent, so the deposit multiplier is 8.


6. a. The balance sheet has the following assets: Reserves, $125 million; Loans, $1,875 million; Other assets, $100 million. It has the following liabilities: Deposits, $2,000 million; Other liabilities, $100 million.

Assets Liabilities

Reserves $125 million Deposits $2,000 million

Loans 1,875 million Other liabilities 100 million

Other assets 100 million

Total assets 2,100 million Total liabilities 2,100 million

b. The reserve ratio is 6.25 percent. The reserve ratio is the percentage of deposits that are held as reserves. Reserves are $125 million and deposits are $2,000, so the reserve ratio is 6.25 percent.

c. The deposit multiplier is 16. The deposit multiplier equals 1/(required reserve ratio). The required reserve ratio is 6.25 percent, so the deposit multiplier is 16.

7. a. The initial increase in the quantity of money is $1,200. Money is equal to bank deposits and currency outside the banks. Deposits increase by $1,200, so the initial increase in the quantity of money is $1,200.

b. The initial increase in the quantity of bank deposits is $1,200. Deposits increase by $1,200 because the immigrant places all the new money on deposit.

c. The bank initially lends out $1,080. The bank has a new deposit of $1,200, and it must keep 10 percent of it ($120) as reserves and lends the rest ($1,200 minus $120), which equals $1,080.

d. The immigrant’s bank has loaned $1,080. This amount returns to the banks as new deposits. The banks keep $108 in reserves and lend a further $972. The banks have now created deposits of $1,200 plus $1,080, which equals $2,280.

e. The quantity of money has increased by $9,341.05. The first loan is $1,080, and the quantity of money increases by $1,080. When this money is spent and returned to the bank as a deposit, the banks keep 10 percent of it ($108) as reserves and lend out the rest ($972). The banks create $972 of new money. So, after 2 loans, the quantity of money has increased by $1,200 + $1,080 + $972, which equals $3,252. Similar calculations reveal that after 20 loans the quantity of money increases by $9,341.05.

f. The quantity of money increases by $12,000. Deposits increase by $12,000. Loans increase by $10,800. The deposit multiplier is 1/0.1, which equals 10. The deposit multiplier tells us that when reserves increase by $1,200 and the required reserve ratio is 10 percent, deposits will increase by 10 times $1,200, which is $12,000. T The quantity of money increases by the amount of the increase in deposits. Deposits increase by $12,000 and the reserve ratio is 10 percent, so reserves increase $1,200. Therefore bank loans increase by $12,000 minus $1,200, which is $10,800.

8. a. The initial increase in the quantity of money in the United States is $100,000. Money is equal to bank deposits and currency outside the banks. Deposits increase by $100,000 so the initial increase in the quantity of money is $100,000.

b. The initial increase in the quantity of bank deposits is $100,000. Deposits increase by $100,000 because the (trusting!) thief places all the new money on deposit.

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c. The bank lends out $95,000. The bank has a new deposit of $100,000 and it must keep 5 percent of it ($5,000) as reserves and lends the rest ($100,000 minus $5,000), which equals $95,000.

d. The thief’s bank has loaned $95,000. This amount returns to the banks as new deposits. The banks keep 5 percent, $4,750, in reserves and will lend a further $90,250. The banks have now created deposits of $100,000 plus $95,000, which equals $195,000.

e. The quantity of money has increased by $195,000. The first loan is $95,000 which increases the quantity of money by $95,000. When this money is spent and returned to the bank as a deposit, the banks keep 5 percent of it ($4,750) as reserves and lend out the rest ($90,250). The loan will be deposited, so in this round, the banks create $90,250 of new money. So, after 2 loans, the quantity of money has increased by $100,000 + $95,000 + $90,250, which equals $285,250.

f. The quantity of money increases by $2,000,000. Deposits increase by $2,000,000. Loans increase by $1,900,000. The increase in deposits depends on the proportion L of deposits that banks lend out. The total effect of new reserves on deposits is 1/(1-L), which is 1/(1-0.95), or 20. When reserves increase by $100,000 and the required reserve ratio is 5 percent, deposits will increase by 20 times $100,000 which is $2,000,000. The quantity of money increases by the amount of the increase in deposits. Deposits increase by $2,000,000 and the reserve ratio is 5 percent, so reserves increase $100,000. Therefore bank loans increase by $2,000,000 minus $100,000 which is $1,900,000.

9. a. The monetary base is $45 billion. The monetary base is the sum of the central bank’s notes outside the bank, banks’ deposits at the central bank, and coins held by households, firms, and banks. There are $30 billion in notes held by households and firms, banks’ deposits at the central bank are $10 billion (2/3 of $15 billion), the banks hold other reserves of $5 billion (which are notes), and there are no coins. The monetary base is $45 billion.

b. The quantity of money is $330 billion. In Nocoin, deposits are $300 billion and currency is $30 billion, so the quantity of money is $330 billion.

c. The banks’ reserve ratio is 5 percent. The banks’ reserve ratio is the percent of deposits that is held as reserves. In Nocoin, deposits are $300 billion and reserves are $15 billion, so the reserve ratio equals ($15 billion/$300 billion) ∞ 100, which is 5 percent.

d. The currency drain is 9.09 percent. The currency drain is the percent of the quantity of money that is held as currency by households and firms. In Nocoin, deposits are $300 billion and currency is $30 billion, so the quantity of money is $330 billion. The currency drain equals ($30 billion/$330 billion) × 100, which is 9.09 percent.

10. a. The monetary base is $110 billion. The monetary base is the sum of the central bank’s notes outside the bank, banks’ deposits at the central bank, and coins held by households, firms, and banks. There are $100 billion in notes and coin held by households and firms, banks’ deposits at the central bank are $5, the banks hold other reserves of $5 billion (which are notes and coins). The monetary base is $110 billion.

b. The quantity of money is $600 billion. In Fredzone, deposits are $500 billion and currency is $100 billion, so the quantity of money is $600 billion.


c. The banks’ reserve ratio is 2 percent. The banks’ reserve ratio is the percent of deposits that is held as reserves. In Fredzone, deposits are $500 billion and reserves are $10 billion, so the reserve ratio equals ($10 billion/$500 billion) × 100, which is 2 percent.

d. The currency drain is 16.67 percent. The currency drain is the percent of the quantity of money that is held as currency by households and firms. In Fredzone, deposits are $500 billion and currency is $100 billion, so the quantity of money is $600 billion. The currency drain equals ($100 billion/$600 billion) × 100, which is 16.67 percent.

11. a. The quantity of money increases to $333.67 billion. The quantity of money increases by the change in the monetary base multiplied by the money multiplier. The money multiplier is 7.33 (see 11c), so when the monetary base increases by $0.5 billion, the quantity of money increases by $3.67 billion. Initially, the quantity of money was $330 billion, so the new quantity of money is $333.67 billion.

b. The change in the quantity of money is not equal to the change in the monetary base because of the multiplier effect. The open market operation increases bank reserves and creates excess reserves, which banks use to make new loans. New loans are used to make payments and some of these loans are placed on deposit in banks. The increase in bank deposits increases banks’ reserves and increases desired reserves. But the banks now have excess reserves which they loan out and the process repeats until excess reserves have been eliminated.

c. The money multiplier is the ratio of the quantity of money to the monetary base, which equals $330 billion divided by $45 billion, which equals 7.33.

12. a. The quantity of money decreases to $594.55 billion. The quantity of money increases by the change in the monetary base multiplied by the money multiplier. The money multiplier is 5.45 (see 12c), so when the monetary base decreases by $1 billion, the quantity of money decreases by $5.45 billion. Initially, the quantity of money was $600 billion, so the new quantity of money is $594.55 billion.

b. The change in the quantity of money is not equal to the change in the monetary base because of the multiplier effect. The open market sale decreases bank reserves, so banks calls in loans to restore their reserves to their desired level. As loans are repaid, the deposits decrease and the quantity of money decreases. As deposits decrease, banks decrease their desired reserves further, but desired reserves remain less than actual reserves. Banks continue to call in loans until actual reserves equal desired reserves.

c. The money multiplier is the ratio of the quantity of money to the monetary base, which equals $600 billion divided by $110 billion, which equals 5.45.

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