N.

GREGORY
MANKIW
PRINCIPLES OF

ECONOMICS
Eighth Edition

CHAPTER
The Monetary System
29
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 Look for the answers to these questions:
• What assets are considered “money”? What
are the functions of money? The types of
money?
• What is the Federal Reserve?
• What role do banks play in the monetary
system? How do banks “create money”?
• How does the Federal Reserve control the
money supply?

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 What Money Is and
Why It’s Important
• Without money
– Trade would require barter: the exchange of
one good or service for another.
• Requires a double coincidence of wants:
unlikely occurrence that two people each have
a good the other wants.
• Waste of resources: people spend time
searching for others to trade with
• Using money
– Solves those problems
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 The 3 Functions of Money
1. Medium of exchange
– Item that buyers give to sellers when they
want to purchase goods and services
2. Unit of account
– Yardstick people use to post prices and
record debts
3. Store of value
– Item that people can use to transfer
purchasing power from the present to the
future
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 The 2 Kinds of Money
• Commodity money:
– Takes the form of a commodity with
intrinsic value
• Examples: gold coins, cigarettes in POW
camps
• Fiat money:
– Money without intrinsic value, used as
money because of government decree
• Example: the U.S. dollar

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 The Money Supply
• The money supply (or money stock):
– Quantity of money available in the
economy
• Currency:
– Paper bills and coins in the hands of the
(non-bank) public
• Demand deposits:
– Balances in bank accounts that depositors
can access on demand by writing a check
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 The Money Supply
• M1 = $3.2 trillion (May 2016)
– Currency, demand deposits, traveler’s
checks, and other checkable deposits.
• M2 =$12.7 trillion (May 2016)
– Everything in M1 plus savings deposits,
small time deposits, money market mutual
funds, and a few minor categories.
The distinction between M1 and M2 will often not
matter when we talk about “the money supply” in
this course.
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 Monetary aggregates in India
• Monetary aggregates or money aggregates
are vital tools used by central banks and
economists to measure the total supply of
money circulating within an economy.

• RBI has been publishing four monetary

aggregates – M0, M1, M2 and M3.

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 Monetary aggregates in India
• M0 (weekly compiled) = Reserve money/Monetary Base = Currency in Circulation
+ Bankers’ Deposits with RBI + ‘Other’ Deposits with RBI
– ‘Other’ deposits with RBI comprise mainly: (i) deposits of quasi-government
and other financial institutions including primary dealers, (ii) balances in the
accounts of foreign Central banks and Governments, (iii) accounts of
international agencies such as the International Monetary Fund, etc.

• M1 = Currency with the Public + Demand Deposits with the Banking System +
‘Other’ Deposits with RBI
= Currency with the Public + Current Deposits with the Banking System +
Demand Liabilities Portion of Savings Deposits with the Banking System +
‘Other’ Deposits with RBI

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 Monetary aggregates in India
• M2 = M1+ Time Liabilities Portion of Savings Deposits with the Banking System +
Certificates of Deposit issued by Banks + Term Deposits of residents with a
contractual maturity of up to and including one year with the Banking System
= Currency with the Public + Current Deposits with the Banking System +
Savings Deposits with the Banking System + Certificates of Deposits issued
by Banks + Term Deposits of residents with a contractual maturity up to and
including one year with the Banking System + ‘Other’ Deposits with RBI

• M3 = M2+ Term Deposits of residents with a contractual maturity of over one year
with the Banking System + Call/Term borrowings from ‘Non-depository’ financial
corporations by the Banking System

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 Central Banks & Monetary Policy
• Central bank:
– Institution that oversees the banking
system and regulates the money supply
• Monetary policy:
– Setting of the money supply by
policymakers in the central bank
• Federal Reserve (Fed):
– The central bank of the U.S.

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 The Structure of the Fed
• The Federal Reserve System consists of:
– Board of Governors
• (7 members), located in Washington, DC
– 12 regional Fed banks
• Located around the U.S.
– Federal Open Market Committee (FOMC),
• includes the Board of Governors and
presidents of some of the regional Fed banks.
• The FOMC decides monetary policy.

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 Bank Reserves
• In a fractional reserve banking system
– Banks keep a fraction of deposits as reserves and
use the rest to make loans.
• The Fed establishes reserve requirements
– Regulations on the minimum amount of reserves
that banks must hold against deposits.
• Banks may hold more than this minimum
• The reserve ratio, R
=fraction of deposits that banks hold as reserves
=total reserves as a percentage of total deposits
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 Bank T-Account
• T-account: a simplified accounting
statement that shows a bank’s assets &
liabilities.
FIRST NATIONAL BANK
Assets Liabilities
Reserves $ 10 Deposits$100
Loans $ 90

• Banks’ liabilities include deposits,

• Assets include loans & reserves.
• Notice that R = $10/$100 = 10%.
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 Banks and the Money Supply: An
Example
Suppose $100 of currency is in circulation.
To determine banks’ impact on money supply,
we calculate the money supply in 3 different
cases:
1. No banking system
2. 100% reserve banking system (banks hold
100% of deposits as reserves, make no
loans)
3. Fractional reserve banking system

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 Banks and the Money Supply: An
Example
Case 1: No banking system

• Public holds the $100 as currency.

• Money supply = $100.

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 Banks and the Money Supply: An
Example
Case 2: 100% reserve banking system
Public deposits the $100 at First National Bank
(FNB).
• FNB holds FIRST NATIONAL BANK
100% of Assets Liabilities
deposit
Reserves $100 Deposits$100
as reserves:
Loans $ 0
Money supply
= currency + deposits = $0 + $100 = $100
In a 100% reserve banking system, banks do not
affect size of money supply.
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 Banks and the Money Supply: An
Example
Case 3: Fractional reserve banking system
• Suppose R = 10%. FNB loans all but 10%
of the deposit:
FIRST NATIONAL BANK
Assets Liabilities
Reserves $10
$100 Deposits$100
Loans $90
$ 0
• Depositors have $100 in deposits, borrowers
have $90 in currency.
Money supply = C + D = $90 + $100 = $190 (!!!)
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 Banks and the Money Supply: An
Example
Case 3: Fractional reserve banking system
How did the money supply suddenly grow?
• When banks make loans, they create money.
• The borrower gets
– $90 in currency—an asset counted in the
money supply
– $90 in new debt—a liability that does not have
an offsetting effect on the money supply
A fractional reserve banking system creates
money, but not wealth.
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 Banks and the Money Supply: An
Example
Case 3: Fractional reserve banking system
Borrower deposits the $90 at Second National
Bank. SECOND NATIONAL BANK
Initially, Assets Liabilities
SNB’s Reserves $$90
9 Deposits$90
T-account Loans $81
$0
looks like this:
• If R = 10% for SNB, it will loan all but 10%
of the deposit.
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 Banks and the Money Supply: An
Example
Case 3: Fractional reserve banking system
SNB’s borrower deposits the $81 at Third
National Bank. THIRD NATIONAL BANK
Initially, Assets Liabilities
TNB’s Reserves $$81
8.10 Deposits$81
T-account Loans $ $72.90
0
looks like this:
• If R = 10% for TNB, it will loan all but 10%
of the deposit.
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 Banks and the Money Supply: An
Example
Case 3: Fractional reserve banking system
The process continues, and money is created
with each new loan.
Original deposit = $100.00
FNB lending = $ 90.00
SNB lending = $ 81.00
TNB lending = $ 72.90
… …

Total money supply = $1,000.00

In this example, $100 of reserves generates $1,000 of
money.
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 The Money Multiplier
• Money multiplier = 1/R
– Amount of money the banking system
generates with each dollar of reserves
• In our example, R = 10%
– Money multiplier = 1/R = 10
– $100 of reserves creates $1,000 of money

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 Active Learning 1 Banks and the money supply

While cleaning your apartment, you look

under the sofa cushion and find a $50 bill (and
a half-eaten taco). You deposit the bill in your
checking account.
The Fed’s reserve requirement is 20% of
deposits.
A. What is the maximum amount that the
money supply could increase?
B. What is the minimum amount that the
money supply could increase?
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 Active Learning 1 Answers
You deposit $50 in your checking account.
A. What is the maximum amount that the
money supply could increase?
• If banks hold no excess reserves, then
money multiplier = 1/R = 1/0.2 = 5
• The maximum possible increase in deposits is
5 x $50 = $250
• But money supply also includes currency,
which falls by $50.
• Hence, max increase in money supply = $200.
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 Active Learning 1 Answers
You deposit $50 in your checking account.
A. What is the maximum amount that the
money supply could increase?
Answer = $200.
B. What is the minimum amount that the
money supply could increase?
Answer: $0
– If your bank makes no loans from your deposit,
currency falls by $50, deposits increase by $50,
money supply does not change.

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 A More Realistic Balance Sheet
• Assets:
– Besides reserves and loans, banks also hold
securities.
• Liabilities:
– Besides deposits, banks also obtain funds
from issuing debt and equity.
• Bank capital:
– The resources a bank obtains by issuing
equity to its owners
– Also: bank assets minus bank liabilities
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 A More Realistic Balance Sheet
• Capital requirement:
– A government regulation that specifies a
minimum amount of capital,
– Intended to ensure banks will be able to
pay off depositors and debts
• Leverage:
– The use of borrowed funds to supplement
existing funds for investment purposes

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 A More Realistic Balance Sheet
• Leverage ratio: ratio of assets to bank capital
MORE REALISTIC NATIONAL BANK
Assets Liabilities
Reserves $ 200 Deposits$ 800
Loans $ 700 Debt $ 150
Securities $ 100 Capital $ 50
• In this example, the leverage ratio = $1000/$50 = 20
• Interpretation: for every $20 in assets,
$ 1 is from the bank’s owners,
$19 is financed with borrowed money.
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 Leverage Amplifies Profits and Losses
• In our example, suppose bank assets
appreciate by 5%, from $1000 to $1050.
– This increases bank capital from $50 to
$100, doubling owners’ equity.
• Instead, if bank assets decrease by 5%,
– Bank capital falls from $50 to $0.
• If bank assets decrease more than 5%,
– Bank capital is negative and bank is
insolvent.

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 Leverage and the Financial Crisis
• Financial crisis of 2008–2009
– Banks suffered losses on mortgage loans and
mortgage-backed securities due to widespread
defaults.
– Many banks became insolvent:
• In the U.S., 27 banks failed during 2000–2007,
• 166 during 2008–2009.
– Many other banks found themselves with too
little capital, responded by reducing lending,
causing a credit crunch.
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 The Government’s Response
• To ease the credit crunch
– The Federal Reserve and U.S. Treasury
injected hundreds of billions of dollars’
worth of capital into the banking system.
– This unusual policy temporarily made U.S.
taxpayers part-owners of many banks.
– The policy succeeded in recapitalizing the
banking system and helped restore
lending to normal levels in 2009.

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 The Fed’s Tools of Monetary
Control
• Earlier, we learned
money supply = money multiplier × bank reserves
• The Fed can change the money supply by
– Changing bank reserves or
– Changing the money multiplier

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 How the Fed Influences Reserves
• Open-Market Operations (OMOs):
– The purchase and sale of U.S.
government bonds by the Fed.
• To increase bank reserves and the money
supply:
– The Fed buys a government bond from a bank
• Pays by depositing new reserves in that
bank’s reserve account.
• With more reserves, the bank can make more
loans, increasing the money supply
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 How the Fed Influences Reserves
• The Fed makes loans to banks, increasing
their reserves
– Traditional method: adjusting the discount rate
(interest rate on loans the Fed makes to banks) to
influence the amount of reserves banks borrow
– New method: Term Auction Facility (the Fed
chooses the quantity of reserves it will loan, then
banks bid against each other for these loans.)
• The more banks borrow,
– The more reserves they have for funding new
loans and increasing the money supply.
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 How the Fed Influences
the Reserve Ratio
• The Fed sets reserve requirements:
– Regulations on the minimum amount of
reserves banks must hold against deposits.
– Reducing reserve requirements would lower
the reserve ratio and increase the money
multiplier.
• Since 10/2008, the Fed has paid interest on
reserves banks keep in accounts at the Fed.
– Raising this interest rate would increase the
reserve ratio and lower the money multiplier.
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 RBI Monetary Policy
• Under the Reserve Bank of India, Act,1934
(RBI Act,1934) (as amended in 2016), RBI
is entrusted with the responsibility of
conducting monetary policy in India with
the primary objective of maintaining price
stability while keeping in mind the objective
of growth.

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 Monetary Policy Framework
• In May 2016, the RBI Act was amended to
provide a statutory basis for the
implementation of the flexible inflation
targeting framework.
• Inflation Target: Central Government, in
consultation with the RBI, determines the
inflation target in terms of the Consumer
Price Index (CPI), once in five years and
notifies it in the Official Gazette.
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 Monetary Policy Framework
• Failure to Maintain Inflation Target: The
Central Government has notified the
following as the factors that constitute
failure to achieve the inflation target:
1. the average inflation is more than the
upper tolerance level of the inflation target
for any three consecutive quarters; or
2. the average inflation is less than the lower
tolerance level for any three consecutive
quarters.
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 Monetary Policy Framework
• Where the Bank fails to meet the inflation
target, it shall set out in a report to the Central
Government:
a. the reasons for failure to achieve the inflation
target;
b. remedial actions proposed to be taken by the
Bank; and
c. an estimate of the time-period within which the
inflation target shall be achieved pursuant to
timely implementation of proposed remedial
actions.
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 Monetary Policy Committee
• The amended RBI Act, 1934 provides for
an empowered six-member monetary
policy committee (MPC) to be constituted
by the Central Government by notification
in the Official Gazette.
• The first such MPC was constituted on
September 29, 2016.

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 Monetary Policy Committee
• The present MPC members, as notified on
October 5, 2020, are as under:
1. Governor of the Reserve Bank of India—Chairperson, ex officio;
2. Deputy Governor of the Reserve Bank of India, in charge of Monetary
Policy—Member, ex officio;
3. One officer of the Reserve Bank of India to be nominated by the Central
Board—Member, ex officio;
4. Prof. Ashima Goyal, Professor, Indira Gandhi Institute of Development
Research —Member;
5. Prof. Jayanth R. Varma, Professor, Indian Institute of Management,
Ahmedabad—Member; and
6. Dr. Shashanka Bhide, Senior Advisor, National Council of Applied Economic
Research, Delhi—Member.
(Members referred to at 4 to 6 above, will hold office for a period of four years or
until further orders, whichever is earlier)

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 Monetary Policy Committee
• The MPC determines the policy repo rate required to
achieve the inflation target.
• The MPC is required to meet at least four times in a
year. The quorum for the meeting of the MPC is four
members.
• Each member of the MPC has one vote, and in the
event of an equality of votes, the Governor has a
second or casting vote.
• Each Member of the Monetary Policy Committee
writes a statement specifying the reasons for voting
in favour of, or against the proposed resolution.
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 Instruments of Monetary Policy
• Repo Rate: The interest rate at which the Reserve Bank
provides liquidity under the liquidity adjustment facility (LAF)
to all LAF participants against the collateral of government
and other approved securities.
• Standing Deposit Facility (SDF) Rate: The rate at which the
Reserve Bank accepts uncollateralized deposits, on an
overnight basis, from all LAF participants.
– The SDF is also a financial stability tool in addition to its
role in liquidity management. The SDF rate is placed at 25
basis points below the policy repo rate. With introduction of
SDF in April 2022, the SDF rate replaced the fixed reverse
repo rate as the floor of the LAF corridor.

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 Instruments of Monetary Policy
• Marginal Standing Facility (MSF) Rate: The penal rate at
which banks can borrow, on an overnight basis, from the
Reserve Bank by dipping into their Statutory Liquidity Ratio
(SLR) portfolio up to a predefined limit (2 per cent).
– This provides a safety valve against unanticipated liquidity
shocks to the banking system. The MSF rate is placed at 25
basis points above the policy repo rate.
• Liquidity Adjustment Facility (LAF): The LAF refers to the
Reserve Bank’s operations through which it injects/absorbs
liquidity into/from the banking system.
– It consists of overnight as well as term repo/reverse repos (fixed
as well as variable rates), SDF and MSF.

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 Instruments of Monetary Policy
• LAF Corridor: The LAF corridor has the marginal standing
facility (MSF) rate as its upper bound (ceiling) and the
standing deposit facility (SDF) rate as the lower bound (floor),
with the policy repo rate in the middle of the corridor.

• Main Liquidity Management Tool: A 14-day term

repo/reverse repo auction operation at a variable rate
conducted to coincide with the cash reserve ratio (CRR)
maintenance cycle is the main liquidity management tool for
managing frictional liquidity requirements.

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 Instruments of Monetary Policy
• Reverse Repo Rate: The interest rate at which the Reserve
Bank absorbs liquidity from banks against the collateral of
eligible government securities under the LAF.
o Following the introduction of SDF, the fixed rate reverse repo
operations will be at the discretion of the RBI for purposes specified
from time to time.
• Bank Rate: The rate at which the Reserve Bank is ready to
buy or rediscount bills of exchange or other commercial
papers.
• It acts as the penal rate charged on banks for shortfalls in meeting
their reserve requirements (cash reserve ratio and statutory liquidity
ratio).
• It has been aligned with the MSF rate and, changes automatically as
and when the MSF rate changes alongside policy repo rate changes.

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 Instruments of Monetary Policy
• Cash Reserve Ratio (CRR): The average daily balance that
a bank is required to maintain with the Reserve Bank as a per
cent of its net demand and time liabilities (NDTL) as on the
last Friday of the second preceding fortnight that the Reserve
Bank may notify from time to time in the Official Gazette.

• Statutory Liquidity Ratio (SLR): Every bank shall maintain

in India assets, the value of which shall not be less than such
percentage of the total of its demand and time liabilities in
India as on the last Friday of the second preceding fortnight,
as the Reserve Bank may, by notification in the Official
Gazette, specify from time to time and such assets shall be
maintained as may be specified in such notification (typically
in unencumbered government securities, cash and gold).
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 Instruments of Monetary Policy
• Open Market Operations (OMOs): These include outright
purchase/sale of government securities by the Reserve Bank
for injection/absorption of durable liquidity in the banking
system.

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 The Monetary Policy Process
• The Reserve Bank’s Monetary Policy Department (MPD)
assists the MPC in formulating the monetary policy.
• The MPC in its meetings reviews the surveys conducted by
the Reserve Bank to gauge
• consumer confidence, households’ inflation expectations, corporate
sector performance, credit conditions, the outlook for the industrial,
services and infrastructure sectors, and the projections of professional
forecasters.
• The MPC also reviews in detail the staff’s macroeconomic
projections, and alternative scenarios around various risks to
the outlook.
• Drawing on the above and after extensive discussions on the
stance of monetary policy, the MPC adopts a resolution.

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 The Monetary Policy Process
• The MPC Resolution: The Bank publishes, after the
conclusion of every meeting of the MPC, the resolution
adopted by the said Committee. The resolution includes the
MPC’s decision on the policy repo rate.

• On the 14th day after every meeting of the MPC, the minutes
of the proceedings of the MPC are published which include:
a. the resolution adopted by the MPC;
b. the voting of each member on the resolution; and
c. short written statements of individual members justifying the vote.

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 The Monetary Policy Process
• The Monetary Policy Report: Once in every six months, the
Reserve Bank publishes it containing the following elements:
I. Explanation of inflation dynamics in the last six months and the near
term inflation outlook;
II. Projections of inflation and growth and the balance of risks;
III. An assessment of the state of the economy, covering the real
economy, financial markets and stability, fiscal situation, and the
external sector, which may entail a bearing on monetary policy
decisions;
IV. An updated review of the operating procedure of monetary policy;
and
V. An assessment of projection performance.

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 Problems Controlling
the Money Supply
• The RBI does not control:
– The amount of money that households
choose to hold as deposits in banks
– The amount that bankers choose to lend
Yet, the RBI can compensate for household and
bank behavior to retain fairly precise control
over the money supply

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 Bank Runs and the Money Supply
• A run on banks:
– When people suspect their banks are in trouble,
they may “run” to the bank to withdraw their
funds, holding more currency and less deposits.
• Under fractional-reserve banking
– Banks don’t have enough reserves to pay off ALL
depositors, hence banks may have to close.
– Also, banks may make fewer loans and hold
more reserves to satisfy depositors.
• These events increase R,
– Reverse the process of money creation, cause
money supply to fall.
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 Bank Runs and the Money Supply
• During 1929–1933
– A wave of bank runs and bank closings
caused money supply to fall 28%.
– Many economists believe this contributed
to the severity of the Great Depression.
• Since then, federal deposit insurance
– Helped prevent bank runs in the U.S.
• 2007, bank run in the U.K.
– Northern Rock bank - was eventually
taken over by the British government.
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 The Federal Funds Rate
• The federal funds rate
– Interest rate at which banks make
overnight loans to one another
• Lender – has excess reserves
• Borrower – needs reserves
– A change in federal funds rate
• Cause changes in other rates and have a big
impact on the economy.

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 The Fed Funds rate and other rates, 1970–2016

Fed. Funds
Mortgage
Prime
3 Month T-bill

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 Monetary Policy and the Fed Funds Rate
Federal
funds rate
The Federal
rf Funds market
To raise fed funds S2 S1
rate, Fed sells
government bonds 1.75%
(OMO).
1.50%
This removes
reserves from the
banking system,
reduces supply of D1
federal funds, F
causes rf to rise. F2 F1
Quantity of federal funds
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 Summary
• Money serves three functions: medium of
exchange, unit of account, and store of
value.
• There are two types of money: commodity
money has intrinsic value; fiat money does
not.
• The U.S. uses fiat money, which includes
currency and various types of bank deposits.

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 Summary
• In a fractional reserve banking system, banks
create money when they make loans.
• Bank reserves have a multiplier effect on the
money supply.
• Because banks are highly leveraged, a small
change in the value of a bank’s assets
causes a large change in bank capital.
• To protect depositors from bank insolvency,
regulators impose minimum capital
requirements.
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 Summary
• The Federal Reserve is the central bank of the
U.S. The Fed is responsible for regulating the
monetary system.
• The Fed controls the money supply mainly
through open-market operations.
• Purchasing government bonds increases the
money supply, selling government bonds
decreases it.
• In recent years, the Fed has set monetary policy
by choosing a target for the federal funds rate.
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