The Federal Reserve,

Commercial Banking, and the

Supply of Money
Remember the story of Goldilocks and the three
bears?

“ Papa bear’s bed was too

hard…..Mama bear’s bed was too
soft…..but baby bear’s bed was
just right!
Baby bear’s bed and the supply of
money…

Without enough money, it Like any commodity, excess

becomes difficult to conduct supply lowers the value of
commerce…transactions slow money….too much money
down and the economy falls creates inflation.
into recession

We need to find a balance

between the two…
The Constitution grants the
federal government the
power "to coin Money,
regulate the Value thereof...”
The US began minting US coins shortly
after the constitution was ratified

Half Cent One Cent Two Cents Three Cents

(Copper) (Copper) (Copper) (Nickel/Copper)

Nickel/Half Dime Dime Twenty Cents Quarter Dollar

(Silver/Copper) (Silver/Copper (Silver) (Silver)
Production of gold coins ceased in 1934. Silver
coins were minted until 1964.

Half Dollar One Dollar One Dollar 2 ½ Dollar

(Silver) (Silver) (Gold) (Quarter Eagle)

Five Dollar Ten Dollar Twenty Dollar

Three Dollar
(Half Eagle) (Eagle) (Double Eagle)
 Current US Coins

99% Zinc, 1%Copper 75% Copper, 25% Nickel 75% Copper, 25% Nickel
Annual Production: 6.8M Annual Production: 1.4B Annual Production: 2.5B

75% Copper, 25% Nickel 75% Copper, 25% Nickel 88% Copper, 6% Zinc,
3% Magnesium, 3% Nickel
Annual Production: 2.4B Annual Production: 5.8M
Annual Production: 5.3M
 Paper money was initially
issued by commercial
banks as claims to their
deposits of gold and silver
(coins or bars)

Northampton Bank
Assets Liabilities
The supply of money was
$500 (Gold) $300 (Deposits) determined by the
$1,000 (Loans) $1,000 (Notes) individual bank’s profit
motive - they created loans
by issuing bank notes

$200 (Equity)

Bank notes were only redeemable (for gold/silver) at the issuing bank
 The US began issuing
Greenbacks in 1862 after
passing the legal tender act.
US Notes were fractionally
backed by gold, but were
“legal tender for all debts
public and private

US Treasury
Assets Liabilities
United States notes were
$1,000 (Gold) $10,000 (T-Bills)
printed until 1963, but
$20,000 (US Notes) were a small fraction of
total money
1910: one tenth
1960: one hundredth
Gold/Silver Certificates were 100% backed by gold/silver reserves at
the US Treasury, but were not legal tender

US Treasury
Gold notes were printed
Assets Liabilities until 1934.

$1,000 (Gold) $1,000 (Gold Notes) All $1 bills in the US were

silver certificates until
$10,000 (Silver) $10,000 (Silver Notes) 1963 and were still
convertible to silver until
1968
The National Banking Act of 1863 allowed Nationally chartered banks to
distribute bank notes (deemed legal tender) secured by US Debt (banks
could issue notes equal to 90% of their US debt holdings)

1st National Bank of Forest City

National notes were
Assets Liabilities
convertible to T-Bills at
$50,000 (T-Bills) $25,000 (Deposits) any national bank
$50,000 (Loans) $45,000 (Notes)
National Bank notes were
issued until 1934

$30,000 (Equity)
The Federal Reserve was created in 1913 to essentially take over the money
supply role of national banks.

The Federal Reserve

Federal Reserve Bank could issue new currency
Assets Liabilities by purchasing US Debt
either in private markets
$50,000 (T-Bills) $60,000 (Notes) or directly from the
$10,000 (Gold) Treasury
Federal Reserve notes
were convertible to gold
until 1934 (individuals)
1971 (Central Banks)
Denominations of $500, $1,000, $5,000, and
$10,000 were no longer printed after 1946 for
fear of German counterfeiting
The Largest denomination ever printed was a
$100,000 gold certificate. It was never circulated,
but was used for inter-bank transfers
Credit Channels
under the
National/State
Banking System
Money center banks
were the “root source”
of credit

National banks who were short of funds would

borrow from money center banks

Larger State banks who were short of funds

would borrow from National banks

Small State banks who were short of

funds would borrow from larger state
banks
Credit Channels
under the
National/State
Banking
System
 The Federal Reserve
 The Federal Reserve System was created
in 1913 by Woodrow Wilson.
 Regulate the banking industry
 “Lender of Last Resort”
 Regulate the money supply
 Provide banking services for the federal
government
 Check Clearing
Credit Channels
under the Federal Reserve
Federal
Reserve
System

= Federal Funds Market

= Discount Window
The Federal Reserve System Divides the country into
12 Districts numbered 1 - 12 from east to west
 The Chairman is elected from the Board for a renewable 4 year term

Alan Roger Edward Susan Mark Ben Donald

Greenspan Ferguson Gramlich Bies Olsen Bernanke Kohn
(1992) (2001) (1997) (2001) (2001) (2003) (2002)

The Federal Reserve board is headquartered in Washington DC. The

Board Consists of 7 “Governors” appointed by the President and
confirmed by the Senate for 14 Year Non-Renewable terms
Each district has a Federal Reserve Bank with a bank president
elected by the bank’s board of directors for 4 year renewable
terms

Bank President

Board of Directors

Class A (4) Class B (4) Class C (4)

Member Banks Local Business Federal Reserve

Board
The Federal Open Market Committee (FOMC) is the policymaking
group of the Federal Reserve System. They meet approximately 8
times per year. Policies are determined by majority vote

Board of NY Fed Regional Fed

Governors (7) President (1) Presidents (4)

Generally, all 12 bank presidents are present at the meeting, but

only 5 can vote. The NY Fed president has a permanent vote while
the remaining presidents vote on a revolving basis.
 Controlling the Supply of Money
Money can be anything that satisfies:
•Store of Value
•Unit of account
•Medium of exchange

Lots of things satisfy these properties

 Standard Definitions of Money
 Monetary Base (M0): Direct liabilities of the central bank
 Currency in circulation + Bank Reserves
 M1:
 Currency in circulation + Traveler's Checks +
Checking accounts
 M2:
 M1 + Savings accounts + Money Market Accounts +
Small Time Deposits
 M3:
 M2 + Large Time Deposits + Eurodollars
 The Federal Reserve can perfectly control the monetary
base (cash + bank reserves)

MB

M1 M3
M2
Once those reserves enter the banking sector, they are used as the basis
for creating loans. These loans make up the rest of the money supply.
The fed can’t control this, but can influence it
 Money Supply in the US
(in Billions)
10000
8,760
9000
8000
7000
6,015
6000
5000
4000
3000
2000 1,269
690 732
1000
0
Cash MB M1 M2 M3
 2000
4000
6000
8000
10000
12000
14000

0
1/1/1959

1/1/1962

1/1/1965

1/1/1968

1/1/1971

1/1/1974

1/1/1977

1/1/1980

1/1/1983

1/1/1986

1/1/1989

1/1/1992

1/1/1995

1/1/1998
Money Supply in the US

M1
M2
M3

MB
 The Reserve Requirement is the least used of the Fed’s
policy tools. A Bank is required to keep a minimum
percentage of its deposits either as cash or on deposit
at the federal reserve (reserve deposits pay no interest)

Federal Reserve Acme National Bank

Assets Liabilities Assets Liabilities

$ 2,500 (Reserves) $ 2,500 (Cash) $50,000 (Deposits)
$ 2,500 (Reserves)
$45,000 (T-Bills)
$100,000(Loans)

$100,000 (Equity)

Reserve Accounts are

Acme currently has 10% of its
liabilities of the Fed
deposit liabilities on Reserve
(Cash + Reserves)/Deposits
 Suppose Acme Bank wanted to create a $30,000 loan.
This is done by establishing a line of credit (i.e. creating
a new checkable deposit)

Acme National Bank

Assets Liabilities The loan shows up on

both sides of the
$ 2,500 (Cash) $50,000 (Deposits) balance sheet
$ 2,500 (Reserves) $30,000 (Deposit)
$45,000 (T-Bills)
$100,000(Loans)
$30,000 (Loan)

$100,000 (Equity)
Acme’s reserve ratio drops
to 6.25% (5/80)
 Reserves and cash are components of M0 while the
newly created loans are components of M1 or M2

Acme National Bank

Monetary Base
Assets Liabilities
•Cash in Circulation
$ 2,500 (Cash) $50,000 (Deposits)
•Bank Reserves
$ 2,500 (Reserves) $30,000 (Deposit)
$45,000 (T-Bills)
M1
$100,000(Loans)
•Cash in Circulation
$30,000 (Loan)
•Checking Accounts
$100,000 (Equity) M2
•M1
•Savings Accounts
Type of Liability Reserve Requirement
Transaction Account
$0 - $7M 0%
$7M - $47.6M 3%
More than $47.6M 10%

Time Deposits 0%
Eurocurrencies 0%

The Reserve Requirement has no impact on the

monetary base, but it restricts the ability of banks to
create loans – this influences the broader aggregates.
 The discount window was the primary policy tool of the
federal reserve when it was first established in 1913.
Discount window loans are collateralized by the assets
of the bank (equal to around 90% of the loan)

Federal Reserve Acme National Bank

Assets Liabilities Assets Liabilities

$ 2,500 (Loan) $ 2,500 (Reserves) $ 2,500 (Cash) $80,000 (Deposits)
$ 2,500 (Reserves) $ 2,500 (Reserves)
$ 2,500 (Reserves) $ 2,500 (Disc. Loan)

$45,000 (T-Bills)
$130,000(Loans)

Res. Req. = 5% $50,000 (Equity)

A $2,500 loan from the discount This bank would like to create
window would raise reserves to $70,000 loan, but doesn’t have
the required 5% the reserves to back it up
Type of Credit Interest Rate
Primary (No Questions Fed Funds + 1% (3.5%)
Asked)

Secondary (Additional Fed Funds + 1.5% (4.0%)

Financial Information
Required)

Seasonal (Must demonstrate Fed Funds + .2% (2.7%)

reoccurring seasonal
liquidity needs, <$500M in
Deposits)
Discount Lending
By purchasing and/or selling securities, the Fed can directly control the
quantity of non-borrowed reserves in the banking sector.

The Fed
debits/credits the
reserve account of
the dealer’s bank

Federal Reserve
Dealers Buy/Sell Bond Dealer
bonds from the Fed

Most transactions are done with repurchase agreements (Repos). These

are purchases/sales along with an agreement to reverse the transaction
at a later date
 Currently, open market operations are the primary
policy tool of the Fed. Trading takes place in NYC

Federal Reserve Acme National Bank

Assets Liabilities Assets Liabilities

$ 2,500 (T- Bills) $ 2,500 (Reserves) $ 2,500 (Cash) $80,000 (Deposits)
$ 2,500 (Reserves) $ 2,500 (Reserves)
$ 2,500 (Reserves)
- $ 2,500 (T- Bills)
$45,000 (T-Bills)
$130,000(Loans)

Res. Req. = 5% $50,000 (Equity)

An open market purchase increases the reserves of the banking

sector – this raises M0
 Federal Reserve Banking Sector

Assets Liabilities Assets Liabilities

$700B (T- Bills) $ 700B (Currency) $ 54B (Cash) $ 800B (Checking)

$ 1B (Loans) Reserves $ 46B (Reserves) $ 4,500B (Saving)
$ 44B (Required) $ 2,000 (T-Bills) Loans
$25B (Gold)
$ 1B (Excess) Loans $ 1B (Discount)
$20B (Other) $ 2,701 (Mortgage) $ 1,500B(Fed Funds)
$ 1B (Borrowed)
$ 3,000 (Other)
Res. Req. = 5% $1,000B (Equity)

M1 MB = $746B
= 2.01 M2 = 8.04
MB M1 = $700B + $800B = 1,500B
MB
M2 = $700B + $800B + $4,500B = $6,000B
 The Money multipliers describe the relationship between a
change in the monetary base (controlled by the Fed) and the
broader aggregates

$ Change in M1 = mm1 * $ Change in MB

Cash
1 + Deposits
mm =
Cash Reserves
+
Deposits Deposits

$ Change in M2 = mm2 * $ Change in MB

Cash + M2-M1
1 + Deposits Deposits
mm2 =
Cash Reserves
+
Deposits Deposits

The Fed can influence total bank reserves, which affects the multipliers!
Fed Policy from start to finish….
Staff economists at each
federal reserve bank brief
the president of
local/national economic
conditions
Trading desk calls bond dealers
and asks for bids
Bank Presidents/Governors
present policy
recommendations to the
FOMC – A vote is taken.
The monetary base is to be
increased by $100M
This order is passed to the trading
desk in NYC
Fed Policy from start to finish….
Acme National Bank
The dealers with the winning
Assets Liabilities
bids deliver the bonds. Their
+$100M (Reserves) + $100M (Deposits) bank’s reserve accounts are
credited

The bank must keep approximately 5% (reserve requirement) of the new

deposit on reserve, but is free to loan out the remaining $95M. Some of
this will be loaned to business customers, some finds its way into the
Federal Funds market

FF Rate Excess supply of

Supply
reserves pushes down
the Fed Funds Rate
5%

Reserves
Fed Policy from start to finish….

Through the Fed Funds

Market, the reserves are
distributed throughout
the banking sector

Fed Funds Market

Each bank uses its new reserves to create additional loans

As banks increase the supplies of the various
aggregates, their rates drop as well

M1 Rate M2 Rate
Supply Supply

6% 7%

M1 M2

$ Change $ Change
= mm1 * $100M = mm2 * $100M
in M1 in M2

2 8

These newly created loans are used to purchase labor,

materials, consumer goods, etc.
Eventually, this newly created demand will influence
prices…

Wages Prices

Demand Demand

Hours GDP

Higher demand for goods and services drive up their prices

(wages and prices)

Increases in Nominal Real Expected

inflation raise Interest = Interest +
Inflation
the nominal Rate Rate
interest rate
If all goes well, the open market
purchase of securities (an increase in
the monetary base) will raise
employment and GDP in the short run,
but raise prices in the long run.
However, the economy can always
through a wrench in the Fed’s plans!