CHAPTER

10
The Money Supply and the
Federal Reserve System

Prepared by: Fernando

Quijano and Yvonn Quijano

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

An Overview of Money
Money is anything that is generally
accepted as a medium of exchange.
Money is not income, and money is
not wealth. Money is:
a means of payment,
a store of value, and
a unit of account.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

An Overview of Money
Money as a means of payment, or medium
of exchange, is more efficient than barter.
Barter is the direct exchange of goods and
services for other goods and services.
A barter system requires a double
coincidence of wants for trade to take
place. Money eliminates this problem.
Money is a lubricant in the functioning of a
market economy.
2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

An Overview of Money
Money as a store of value refers to money as
an asset that can be used to transport
purchasing power from one time period to
another.
Money is easily portable, and easily exchanged
for goods at all times. The liquidity property
of money makes money a good medium of
exchange as well as a store of value.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

An Overview of Money
Money also serves as a unit of account, or a
standard unit that provides a consistent way of
quoting prices.
Commodity monies are items used as money
that also have intrinsic value in some other
use. Gold is one form of commodity money.
Fiat, or token, money is money that is
intrinsically worthless.
Legal tender is money that a government has
required to be accepted in settlement of debts.
2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Measuring the Supply of Money

in the United States
The two most common measures of
money are M1 and M2.
M1, or transactions money is money that
can be directly used for transactions. It
includes currency held outside banks, plus
demand deposits, plus travelers checks,
plus other checkable deposits
M1 is a stock measureit is measured at
a point in timeon a specific day. On
June 26, 2000, M1 was $1,103.3 billion.
2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Measuring the Supply of Money

in the United States
M2, or broad money, includes near
monies, or close substitutes for
transactions money.
M2 M1 + savings accounts + money market

accounts + other near monies

On June 26, 2000, M2 was $4,778.2

billion.
The main advantage of looking at M2
instead of M1 is that M2 is sometimes
more stable.
2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Private Banking System

Most of the money in the United States
today is bank money, or money held in
checking accounts rather than currency.
Financial intermediaries are banks
and other financial institutions that act
as a link between those who have
money to lend and those who want to
borrow money.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

How Banks Create Money

To see how banks create money, consider
the origins of the modern banking system:
Goldsmiths functioned as warehouses where

people stored gold for safekeeping.

Upon receiving the gold, a goldsmith would

issue a receipt to the depositor. After a time,

these receipts themselves, rather than the gold
that they represented, began to be traded for
goods.
At this point, all the receipts issued were

backed 100 percent by gold.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

How Banks Create Money

Goldsmiths realized that people did not

come often to withdraw gold and, as a

result, they had a large stock of gold
continuously on hand. They could lend
out some of this gold without any fear of
running out.
There were thus more claims than there

were ounces of gold.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

How Banks Create Money

Knowing there were more receipts

outstanding than there were ounces of

gold, people might start to demand gold
for receipts.
A run on a goldsmith (or a modern-day

bank) occurs when many people

present their claims at the same time.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Creation of Money

Banks usually make loans up to the point
where they can no longer do so because
of the reserve requirement restriction (or
up to the point where their excess reserves
are zero).

e x c e s s re s e rv e s a c tu a l re s e rv e s re q u ire d re s e rv e s

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Federal Reserve System

The Federal Open Market Committee
(FOMC) sets goals regarding the money
supply and interest rates and directs the
operations of the Open Market Desk in
New York.
The Open Market Desk is an office in the
New York Federal Reserve Bank from
which government securities are bought
and sold by the Fed.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Functions of the Fed

The Fed performs important functions for
banks including:
Clearing interbank payments.
Regulating the banking system.
Assisting banks in a difficult financial
position.
Managing exchange rates and the nations
foreign exchange reserves.
2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Functions of the Fed

The Fed performs important functions for
banks including:
Control of mergers between banks.
Examination of banks to ensure that they
are financially sound.
Setting of reserve requirements for all
financial institutions.
Lender of last resort.
2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Feds Balance Sheet

Although it is unrelated to the money
supply, the Feds gold counts as an asset
on its balance sheet.
The largest of the Feds assets, by far,
consists of government securities
purchased over the years.
A dollar bill is a liability, or IOU, of the Fed.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

How the Fed Controls

the Money Supply
The required reserve ratio establishes a link
between the reserves of the commercial
banks and the deposits (money) that
commercial banks are allowed to create.
If the Fed wants to increase the money
supply, it creates more reserves, thereby
freeing banks to create additional deposits
by making more loans. If it wants to
decrease the money supply, it reduces
reserves.
2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Discount Rate

Banks may borrow from the Fed. The
interest rate they pay the Fed is the
discount rate.
Bank borrowing from the Fed leads to an
increase in the money supply. The higher
the discount rate, the higher the cost of
borrowing, and the less borrowing banks
will want to do.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Discount Rate

In practice, the Fed does not often use the
discount rate to control the money supply.
The discount rate cannot be used to
control the money supply with great
precision, because its effects on banks
demand for reserves are uncertain.
Moral suasion is the pressure exerted by
the Fed on member banks to discourage
them from borrowing heavily from the Fed.
2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Open Market Operations

Open market operations is the purchase
and sale by the Fed of government
securities in the open market; a tool used
to expand or contract the amount of
reserves in the system and thus the
money supply.
Open market operations is by far the most
significant tool of the Fed for controlling
the supply of money.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Open Market Operations

An open market purchase of securities by
the Fed results in an increase in reserves
and an increase in the supply of money by
an amount equal to the money multiplier
times the change in reserves.
An open market sale of securities by the
Fed results in a decrease in reserves and
a decrease in the supply of money by an
amount equal to the money multiplier
times the change in reserves.
2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Open Market Operations

Open market operations are the Feds
preferred means of controlling the money
supply because:
they can be used with some precision,
are extremely flexible, and
are fairly predictable.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair