CHAPTER 4

The Monetary System: What It

Is and How It Works

There have been three great inventions since the beginning of time: fire, the wheel, and
central banking.

— Will Rogers

The two arms of macroeconomic policy are monetary policy and

fiscal policy. Fiscal policy encompasses the government’s decisions
about spending and taxation, as we saw in the previous chapter.
Monetary policy refers to decisions about the nation’s system of
coin, currency, and banking. While fiscal policy is usually made by
elected representatives, such as the U.S. Congress, British
Parliament, or Japanese Diet, monetary policy is made by central
banks, which are typically set up by elected representatives but
allowed to operate independently. Examples include the U.S. Federal
Reserve, the Bank of England, and the Bank of Japan. Will Rogers
may have been exaggerating when he said that central banking is
one of the three greatest inventions of all time, but he was right to
suggest that these policymaking institutions have a major influence
over the lives and livelihoods of people around the world.

Much of this book is aimed at explaining the effects and proper role
of monetary and fiscal policy. This chapter begins our analysis of
monetary policy. We address three related questions. First, what is
money? Second, what is the role of a nation’s banking system in
determining the amount of money in the economy? Third, how does
a nation’s central bank influence the banking system and the money
supply?

This chapter’s introduction to the monetary system provides the

foundation for understanding monetary policy. In the next chapter,
consistent with the long-run focus of this part of the book, we
examine the long-run effects of monetary policy. The short-run
effects of monetary policy are more complex. We start discussing
that topic in Chapter 11, but it will take several chapters to develop a
complete explanation. This chapter gets us ready. Both the long-run
analysis and short-run analysis of monetary policy must be
grounded in an understanding of what money is, how banks affect
it, and how central banks control it.
4-1 What Is Money?
When we say that a person has a lot of money, we usually mean that
he is wealthy. Economists, however, use the term “money” in a more
specialized way. To an economist, money refers not to all wealth but
only to one type of it: Money is the stock of assets that can be readily
used to make transactions. Roughly speaking, the dollars (or, in
other places, euros, pesos, pounds, or yen) in the hands of the public
make up the economy’s stock of money.

The Functions of Money

Money has three purposes: It is a store of value, a unit of account,
and a medium of exchange.

As a store of value, money provides a way to transfer purchasing

power from the present to the future. If you work today and earn
$100, you can hold the money and spend it tomorrow, next week, or
next month. Money is not a perfect store of value: If prices rise, the
amount you can buy with any given quantity of money falls. Even so,
people hold money because they can trade it for goods and services
at some time in the future.

As a unit of account, money provides the metric people use to quote

prices and record debts. Microeconomics teaches that resources are
allocated according to relative prices — the prices of goods relative
to other goods — yet stores post their prices in dollars and cents. A
car dealer says that a car costs $40,000, not 800 shirts (though the
two may be equivalent). Similarly, most debts require the debtor to
deliver a certain number of dollars in the future, not an amount of
some commodity. Money is the yardstick with which we measure
economic transactions.

As a medium of exchange, money is what people use to buy goods

and services. “This note is legal tender for all debts, public and
private” is printed on the U.S. dollar. When you walk into stores, you
are confident that shopkeepers will accept your money in exchange
for the items they are selling. The ease with which an asset can be
converted into the medium of exchange and used to buy other
things (goods, services, or capital assets) is called the asset’s
liquidity. Because money is the medium of exchange, it is the
economy’s most liquid asset.

To better understand the functions of money, try to imagine an

economy without it: a barter economy. In such a world, trade
requires the double coincidence of wants — the unlikely happenstance
of two people each having a good that the other wants at the right
time and place to make an exchange. A barter economy permits only
simple transactions.

Money makes more complex transactions possible. A professor uses

his salary to buy books; the book publisher uses its revenue from the
sale of books to buy paper; the paper company uses its revenue from
the sale of paper to buy wood that it grinds into paper pulp; the
lumber company uses revenue from the sale of wood to pay the
lumberjack; the lumberjack uses his income to send his child to
college; and the college uses its tuition receipts to pay the salary of
the professor. In a modern economy, trade often involves many
parties and is facilitated by the use of money.

The Types of Money

Money takes many forms. In the U.S. economy we make transactions
using an item whose sole function is to act as money: dollar bills.
These pieces of green paper with small portraits of famous
Americans would have little value if they were not widely accepted
as money. Money without intrinsic value is called fiat money
because it is established as money by government decree, or fiat.
 “And how would you like your funny money?”

Fiat money is the norm in most economies today, but many societies
in the past have used a commodity with some intrinsic value for
money. This type of money is called commodity money. The most
widespread example is gold. When people use gold as money (or use
paper money redeemable for gold), the economy is said to be on a
gold standard. Gold is a form of commodity money because it can
be used for various purposes — jewelry, dental fillings, and so on —
as well as for transactions. The gold standard was common
throughout the world during the late nineteenth century.
 CASE STUDY
Money in a POW Camp
An unusual form of commodity money developed in some Nazi prisoner of war (POW) camps
during World War II. The Red Cross supplied the prisoners with various goods — food,
clothing, cigarettes, and so on. Yet these rations were allocated without close attention to
personal preferences, so the allocations were often inefficient. One prisoner might have
preferred chocolate, while another might have preferred cheese, and a third might have
wanted a new shirt. The differing tastes and endowments of the prisoners led them to trade
with one another.

Barter was an inconvenient way to allocate these resources, however, because it required
the double coincidence of wants. In other words, a barter system was not the easiest way to
ensure that each prisoner received the goods he valued most. Even the limited economy of
the POW camp needed money to facilitate exchange.

Eventually, cigarettes became the established “currency” in which prices were quoted and
with which trades were made. A shirt, for example, cost about 80 cigarettes. Services were
also quoted in cigarettes: Some prisoners offered to do other prisoners’ laundry for two
cigarettes per garment. Even nonsmokers were happy to accept cigarettes in exchange,
knowing they could trade the cigarettes in the future for some good they did enjoy. Within
the POW camp the cigarette became the store of value, the unit of account, and the medium
of exchange.1

The Development of Fiat Money

It is not surprising that in any society, no matter how primitive,
some form of commodity money arises to facilitate exchange:
People are willing to accept a commodity currency such as gold
because it has intrinsic value. Fiat money, however, is more
perplexing. What would make people start valuing something that is
intrinsically useless?

To understand how the evolution from commodity money to fiat

money takes place, imagine an economy in which people carry
around bags of gold. When making a purchase, the buyer measures
out the appropriate amount of gold. If the seller is convinced that
the weight and purity of the gold are right, the exchange is made.

The government might first get involved in the monetary system to

help people reduce transaction costs. Using raw gold as money is
costly because it takes time to verify the purity of the gold and to
measure the correct quantity. To reduce these costs, the government
can mint gold coins of known purity and weight. The coins are more
convenient than gold bullion because their values are widely
recognized and trusted.

The next step is for the government to accept gold from the public in
exchange for gold certificates — pieces of paper that can be
redeemed for a certain quantity of gold. If people believe the
government’s promise to redeem the paper bills for gold, the bills
are just as valuable as the gold itself. In addition, because the bills
are lighter than gold (and gold coins), they are easier to use in
transactions. Eventually, no one carries gold around at all, and these
gold-backed government bills become the monetary standard.
Finally, the gold backing becomes irrelevant. If no one ever bothers
to redeem the bills for gold, no one cares if the option is abandoned.
As long as everyone accepts the paper bills in exchange, the bills will
have value and serve as money. Thus, the system of commodity
money evolves into a system of fiat money. In the end, the use of
money in exchange is a social convention: Everyone values fiat
money because they expect everyone else to value it.

CASE STUDY
Money and Social Conventions on the Islands of Yap
The economy of Yap, a group of small islands in the Pacific, once had a type of money that
was something between commodity and fiat money. The traditional medium of exchange in
Yap was fei, stone wheels up to 12 feet in diameter. These stones had holes in the center so
that they could be carried on poles and used for exchange.

Large stone wheels are not a convenient form of money. The stones were heavy, so it took
substantial effort for a new owner to take his fei home after completing a transaction. The
monetary system facilitated exchange, but it did so at great cost.

Eventually, it became common practice for the new owner of the fei not to bother taking
physical possession of the stone. Instead, the new owner accepted a claim to the fei without
moving it. In future bargains, he traded this claim for goods that he wanted. Having physical
possession of the stone became less important than having legal claim to it.

This practice was put to a test when a valuable stone was lost at sea during a storm. Because
the owner lost his money by accident rather than through negligence, everyone agreed that
his claim to the fei remained valid. Generations later, when no one alive had ever seen this
stone, the claim to this fei was still valued in exchange.

Even today, stone money remains valued on the Yap islands. But it is not the medium of
exchange used for routine transactions. For that purpose, the 11,000 residents of Yap use
something more prosaic: the U.S. dollar.2
FYI
Bitcoin: The Strange Case of a Digital Money
In 2009, the world was introduced to a new and unusual asset, called bitcoin. Conceived by
an anonymous computer expert (or group of experts) who goes by the name Satoshi
Nakamoto, bitcoin is intended to be a form of money that exists only in electronic form.
Individuals originally obtain bitcoins by using computers to solve complex mathematical
problems. The bitcoin protocol is designed to limit the number of bitcoins that can ever be
“mined” in this way to 21 million units (though experts disagree whether the number of
bitcoins is truly limited). After the bitcoins are created, they can be used in exchange. They
can be bought and sold for U.S. dollars and other currencies on organized bitcoin
exchanges, where the exchange rate is set by supply and demand. You can use bitcoins to
buy things from any vendor who is willing to accept them.

As a form of money, bitcoins are neither commodity money nor fiat money. Unlike
commodity money, they have no intrinsic value. You can’t use bitcoins for anything other
than exchange. Unlike fiat money, they are not created by government decree. Indeed, many
fans of bitcoin embrace the fact that this electronic cash exists apart from government.
(Some users of it are engaged in illicit transactions such as the drug trade and, therefore,
appreciate the anonymity that bitcoin transactions offer.) Bitcoins have value only to the
extent that people accept the social convention of taking them in exchange. From this
perspective, the modern bitcoin resembles the primitive money of Yap.

Throughout its brief history, the value of a bitcoin, as measured by its price in U.S. dollars,
has fluctuated wildly. Throughout 2010, the price of a bitcoin ranged from 5 cents to 39
cents. In 2011 the price rose to above $1, and in 2013 it briefly rose above $1,000 before
falling below $500 in 2014. Over the next few years, it skyrocketed, reaching more than
$19,000 in 2017, and then plummeted below $4,000 in the following year. Gold is often
considered a risky asset, but the day-to-day volatility of bitcoin prices has been several
times the volatility of gold prices.

The long-term success of bitcoin depends on whether it succeeds in performing the

functions of money: a store of value, a unit of account, and a medium of exchange. Many
economists are skeptical that it will perform these tasks well. Bitcoin’s volatility makes it a
risky way to hold wealth and an inconvenient measure in which to post prices. At least so far,
 few retailers accept it in exchange, and those that do have only a small volume of their sales
in bitcoin transactions.

Advocates of bitcoin see it as the money of the future. Another possibility, however, is that it
is a speculative fad that will eventually run its course.3

How the Quantity of Money Is

Controlled
The quantity of money available in an economy is called the money
supply. In a system of commodity money, the money supply is
simply the quantity of that commodity. In an economy that uses fiat
money, such as most economies today, the government controls the
supply of money: Legal restrictions give the government a monopoly
on the printing of money. Just as the levels of taxation and
government purchases are policy instruments of the government, so
is the quantity of money. The government’s control over the money
supply is called monetary policy.

In most countries, monetary policy is delegated to a partially

independent institution called the central bank. The central bank of
the United States is the Federal Reserve — often called the Fed. If you
look at a U.S. dollar bill, you will see that it is called a Federal Reserve
Note. Decisions about monetary policy are made by the Fed’s Federal
Open Market Committee (FOMC). This committee consists of two
groups: (1) members of the Federal Reserve Board, who are
appointed by the president and confirmed by the Senate, and (2) the
presidents of the regional Federal Reserve Banks, who are chosen by
these banks’ boards of directors. The FOMC meets about every six
weeks to discuss and set monetary policy.

The main way in which the Fed has traditionally controlled the
supply of money is through open-market operations — the
purchase and sale of government bonds. When the Fed wants to
increase the money supply, it uses dollars to buy government bonds
from the public. Because these dollars leave the Fed and enter the
hands of the public, the purchase increases the quantity of money in
circulation. Conversely, when the Fed wants to decrease the money
supply, it sells some government bonds from its own portfolio. This
open-market sale of bonds takes some dollars out of the hands of the
public and, thus, decreases the quantity of money in circulation.
(Later in the chapter, we explore in more detail how the Fed controls
the supply of money.)

How the Quantity of Money Is

Measured
One of our goals is to determine how the money supply affects the
economy; we turn to that topic in the next chapter. As a background
for that analysis, let’s first discuss how economists measure the
quantity of money.
Because money is the stock of assets used for transactions, the
quantity of money is the quantity of those assets. In simple
economies, this quantity is easy to measure. In the POW camp, the
quantity of money was the number of cigarettes in the camp. On the
island of Yap, the quantity of money was the number of fei on the
island. But how can we measure the quantity of money in more
complex economies? The answer is not obvious because no single
asset is used for all transactions. People can transact using various
assets, such as cash in their wallets or deposits in their checking
accounts, although some assets are more convenient to use than
others.

The most obvious asset to include in the quantity of money is

currency, the sum of outstanding paper money and coins. Many
day-to-day transactions use currency as the medium of exchange.

A second type of asset used for transactions is demand deposits, the

funds people hold in their checking accounts. If most sellers accept
personal checks or debit cards that access checking account
balances, then assets in these accounts are almost as convenient as
currency. That is, the assets are in a form that can easily facilitate a
transaction. Demand deposits are therefore added to currency when
measuring the quantity of money.

Once we accept the logic of including demand deposits in the

measured money stock, many other assets become candidates for
inclusion. Funds in savings accounts, for example, can be easily
transferred into checking accounts or accessed using debit cards;
these assets are almost as convenient for transactions. Money
market mutual funds allow investors to write checks against their
accounts, although restrictions sometimes apply regarding the size
of the check or number of checks written. Because these assets can
be easily used for transactions, they should arguably be included in
the quantity of money.

Because it is hard to judge which assets should be included in the

money stock, more than one measure is available. Table 4-1 presents
the three measures of the money stock that the Federal Reserve
calculates for the U.S. economy, along with a list of assets included
in each measure. From the smallest to the largest, they are denoted
C, M1, and M2. The most common measures for studying the effects
of money on the economy are M1 and M2.

TABLE 4-1 The Measures of Money

Symbol Assets Included Amount in March
2020 (billions of
dollars)

C Currency $ 1,745

M1 Currency plus demand deposits, traveler’s checks, and other 4,268

checkable deposits

M2 M1 plus retail money market mutual fund balances, saving 16,104

deposits (including money market deposit accounts), and
small time deposits
Data from: Federal Reserve.

FYI
How Do Credit Cards and Debit Cards Fit into the Monetary
System?
Many people use credit or debit cards to make purchases. Because money is the medium of
exchange, one might naturally wonder how these cards fit into the measurement and
analysis of money.

Let’s start with credit cards. One might guess that credit cards are part of the economy’s
stock of money. In fact, however, measures of the money stock do not take credit cards into
account because credit cards are not really a method of payment but a method of deferring
payment. When you buy an item with a credit card, the bank that issued the card pays the
store what it is due. Later, you repay the bank. When the time comes to pay your credit card
bill, you will likely do so by transferring funds from your checking account, either
electronically or by writing a check. The balance in this checking account is part of the
economy’s stock of money.

The story is different with debit cards, which automatically withdraw funds from a bank
account to pay for items bought. Rather than allowing users to postpone payment for their
purchases, a debit card gives users immediate access to deposits in their bank accounts.
Using a debit card is like writing a check. The account balances that lie behind debit cards
are included in measures of the quantity of money.

Even though credit cards are not a form of money, they are still important for analyzing the
monetary system. Because people with credit cards can pay many of their bills all at once at
the end of the month, rather than sporadically as they make purchases, they may hold less
money on average than people without credit cards. Thus, the increased popularity of credit
cards may reduce the amount of money that people choose to hold. In other words, credit
cards are not part of the supply of money, but they may affect the demand for money.
4-2 The Role of Banks in the
Monetary System
Earlier, we introduced the concept of “money supply” in a highly
simplified manner. We defined the quantity of money as the number
of dollars held by the public, and we assumed that the Federal
Reserve controls the money supply by changing the number of
dollars in circulation through open-market operations. This
explanation was a good starting point for understanding what
determines the supply of money, but it is incomplete because it
omits the role of the banking system in this process.

In this section, we see that the money supply is determined not only
by Fed policy but also by the behavior of households (which hold
money) and banks (in which money is held). We begin by recalling
that the money supply includes both currency in the hands of the
public and deposits (such as checking account balances) at banks
that households can use on demand for transactions. If M denotes
the money supply, C currency, and D demand deposits, we can write

Money Supply = Currency + Demand Deposits

M = C + D.
To understand the money supply, we must understand the
interaction between currency and demand deposits and how the
banking system, together with Fed policy, influences these two
components of the money supply.

100-Percent-Reserve Banking
Imagine a world without banks. In such a world, all money takes the
form of currency, and the quantity of money is simply the amount of
currency that the public holds. For this discussion, suppose that
there is $1,000 of currency in the economy.

Now introduce banks. At first, suppose that banks accept deposits

but do not make loans. The only purpose of the banks is to provide a
safe place for depositors to keep their money.

The deposits that banks have received but have not lent out are
called reserves. Some reserves are held in the vaults of local banks
throughout the country, but most are held at a central bank, such as
the Federal Reserve. In our hypothetical economy, all deposits are
held as reserves: Banks simply accept deposits, place the money in
reserve, and leave the money there until the depositor makes a
withdrawal or writes a check against the balance. This system is
called 100-percent-reserve banking.

Suppose that households deposit the economy’s entire $1,000 in

Firstbank. Firstbank’s balance sheet — its accounting statement of
assets and liabilities — is as follows:

Firstbank’s Balance Sheet

Assets Liabilities

Reserves $1,000 Deposits $1,000

The bank’s assets are the $1,000 it holds as reserves; the bank’s
liabilities are the $1,000 it owes to depositors. Unlike banks in our
economy, this bank is not making loans, so it will not earn profit
from its assets. The bank presumably charges depositors a small fee
to cover its costs.

What is the money supply in this economy? Before the creation of

Firstbank, the money supply was the $1,000 of currency. After the
creation of Firstbank, the money supply is the $1,000 of demand
deposits. A dollar deposited in a bank reduces currency by one
dollar and raises deposits by one dollar, so the money supply
remains the same. If banks hold 100 percent of deposits in reserve, the
banking system does not affect the supply of money.

Fractional-Reserve Banking
Now imagine that banks start lending out some of their deposits —
for example, to families buying houses or to firms investing in new
plants and equipment. The advantage to banks is that they can
charge interest on the loans. The banks must keep some reserves on
hand so that reserves are available whenever depositors want to
make withdrawals. But as long as the amount of new deposits
approximately equals the amount of withdrawals, a bank need not
keep all its deposits in reserve. Thus, bankers have an incentive to
lend. When they do so, we have fractional-reserve banking, a
system under which banks keep only a fraction of their deposits in
reserve.

Here is Firstbank’s balance sheet after it makes a loan:

Firstbank’s Balance Sheet

Assets Liabilities

Reserves $200 Deposits $1,000

Loans $800

This balance sheet assumes that the reserve–deposit ratio — the

fraction of deposits kept in reserve — is 20 percent. Firstbank keeps
$200 of the $1,000 in deposits in reserve and lends out the remaining
$800.

Notice that Firstbank increases the supply of money by $800 when it

makes this loan. Before the loan is made, the money supply is
$1,000, equaling the deposits in Firstbank. After the loan is made,
the money supply is $1,800: The depositor still has a demand deposit
of $1,000, but now the borrower holds $800 in currency. Thus, in a
system of fractional-reserve banking, banks create money.

The creation of money does not stop with Firstbank. If the borrower
deposits the $800 in another bank (or if the borrower uses the $800
to pay someone who then deposits it), the process of money creation
continues. Here is the balance sheet of Secondbank:

Secondbank’s Balance Sheet

Assets Liabilities

Reserves $160 Deposits $800

Loans $640

Secondbank receives the $800 in deposits, keeps 20 percent, or $160,

in reserve, and then lends $640. Thus, Secondbank creates $640 of
money. If this $640 is eventually deposited in Thirdbank, this bank
keeps 20 percent, or $128, in reserve and lends $512, resulting in this
balance sheet:

Thirdbank’s Balance Sheet

Assets Liabilities

Reserves $128 Deposits $640

Loans $512
The process goes on and on. With each deposit and loan, more
money is created.

This process of money creation can continue forever, but it does not
create an infinite amount of money. Letting rr denote the reserve–
deposit ratio, the amount of money that the initial $1,000 creates is

Initial Deposit = $1,000

Firstbank Lending = (1 − rr) × $1,000

2
Secondbank Lending = (1 − rr) × $1,000

3
Thirdbank Lending = (1 − rr) × $1,000

2 3
Total Money Supply = [1 + (1 − rr) +(1 − rr) + (1 − rr) + . . .

= (1/rr) × $1,000.

Each $1 of reserves generates $(1/rr) of money. In our example,

rr = 0.2 , so the initial $1,000 generates $5,000 of money.4

The banking system’s ability to create money is the main difference

between banks and other financial institutions. As we first discussed
in Chapter 3, financial markets have the important function of
transferring the economy’s resources from households that wish to
save some of their income for the future to households and firms
that wish to borrow to buy investment goods to be used in future
production. The process of transferring funds from savers to
borrowers is called financial intermediation. Many institutions act
as financial intermediaries: The most prominent examples are the
stock market, the bond market, and the banking system. Yet, of
these financial institutions, only banks have the legal authority to
create assets (such as checking accounts) that are part of the money
supply. Therefore, banks are the only financial institutions that
directly influence the money supply.

Note that although the system of fractional-reserve banking creates

money, it does not create wealth. When a bank lends some of its
reserves, it gives borrowers the ability to make transactions and
therefore increases the money supply. The borrowers are
undertaking debt obligations to the bank, however, so the loans do
not make them wealthier. In other words, the creation of money by
the banking system increases the economy’s liquidity but not its
wealth.

Bank Capital, Leverage, and Capital

Requirements
The model of the banking system presented so far is simplified. This
is not necessarily a problem; after all, all models are simplified. But
one particular simplifying assumption is noteworthy.

In the bank balance sheets we just examined, a bank takes in

deposits and either uses them to make loans or holds them as
reserves. Based on this discussion, you might think that it does not
take any resources to open a bank. That is, however, not true.
Opening a bank requires some capital. That is, the bank owners
must start with some financial resources to get the business going.
Those resources are called bank capital or, equivalently, the equity
of the bank’s owners.

Here is what a more realistic balance sheet for a bank would look
like:

Realbank’s Balance Sheet

Assets Liabilities and Owners’ Equity

Reserves $200 Deposits $750

Loans $500 Debt $200

Securities $300 Capital (owners’ equity) $50

The bank obtains resources from its owners who provide capital,
from customers by taking in deposits, and from investors by issuing
debt. It uses these resources in three ways. Some funds are held as
reserves; some are used to make bank loans; and some are used to
buy financial securities, such as government or corporate bonds.
The bank allocates its resources among these asset classes,
considering the risk and return that each offers and any regulations
that restrict its choices. The reserves, loans, and securities on the
left side of the balance sheet must equal, in total, the deposits, debt,
and capital on the right side of the balance sheet. This equality
results from the fact that the value of the owners’ equity is, by
definition, the value of the bank’s assets (reserves, loans, and
securities) minus the value of its liabilities (deposits and debt).

Fundamental to the banking system is a phenomenon called

leverage, which is the use of borrowed money to supplement
existing funds for purposes of investment. The leverage ratio is the
ratio of the bank’s total assets (the sum of the left side of the balance
sheet) to the bank’s capital (the one item on the right side of the
balance sheet that represents the owners’ equity). In this example,
the leverage ratio is $1000/$50, or 20. A leverage ratio of 20 means
that for every dollar of capital that the bank owners have
contributed, the bank has $20 of assets. Of the $20 of assets, $19 are
financed with borrowed money — either by accepting deposits or
issuing debt.

Because of leverage, a bank can lose capital quickly in tough times.

To see how, let’s continue with this example. If the bank’s assets fall
in value by just 5 percent, then the $1,000 of assets is now worth
only $950. Because the bank owes $950 to depositors and debt
holders (and they have the legal right to be paid first), the owners’
equity falls to zero. That is, when the leverage ratio is 20, a 5 percent
fall in the value of the bank assets causes a 100 percent fall in bank
capital. If the value of the assets declines by more than 5 percent,
assets fall below liabilities, sending bank capital below zero. The
bank is said to be insolvent. The fear that bank capital may run out,
and thus that depositors might not be repaid in full, is what
generates bank runs when there is no deposit insurance.

Bank regulators require that banks hold sufficient capital. The goal
of a capital requirement is to ensure that banks will be able to pay
off their depositors and other creditors. The amount of capital
required depends on the kind of assets a bank holds. If the bank
holds safe assets such as government bonds, regulators require less
capital than if the bank holds risky assets such as loans to borrowers
whose credit is of dubious quality.

The arcane issues of bank capital and leverage are usually left to
bankers, regulators, and financial experts, but they became
prominent topics of public debate during and after the financial
crisis of 2008–2009. During this period, declining house prices
caused many banks and other financial institutions to incur losses
on mortgage-backed securities. Because of leverage, the losses to
bank capital were proportionately much larger than the losses to
bank assets. Some institutions became insolvent. These events had
repercussions not only within the financial system but throughout
the economy. In the aftermath of the financial crisis, legislative and
regulatory changes imposed higher and increasingly complex
capital requirements for many banks with the goal of reducing the
likelihood of future crises.5

For now, we can put aside the issues of bank capital and leverage.
But they will resurface when we discuss financial crises in Chapters
13 and 19.
4-3 How Central Banks Influence
the Money Supply
Having seen what money is and how the banking system affects the
amount of money in the economy, we are ready to examine how the
central bank influences the banking system and the money supply.
This influence is the essence of monetary policy.

A Model of the Money Supply

If the Federal Reserve adds a dollar to the economy and that dollar is
held as currency, the money supply increases by exactly one dollar.
But as we have seen, if that dollar is deposited in a bank, and banks
hold only a fraction of their deposits in reserve, the money supply
increases by more than one dollar. As a result, to understand what
determines the money supply under fractional-reserve banking, we
need to take account of the interactions among (1) the Fed’s decision
about how many dollars to create, (2) banks’ decisions about
whether to hold deposits as reserves or to lend them out, and (3)
households’ decisions about whether to hold their money in the
form of currency or demand deposits. This section develops a model
of the money supply that includes all these factors.

The model has three exogenous variables:

 The monetary base B is the total number of dollars held by the
public as currency C and by the banks as reserves R. It is
directly controlled by the Federal Reserve.
The reserve–deposit ratio rr is the fraction of deposits that
banks hold in reserve. It is determined by the business policies
of banks and the laws regulating banks.
The currency–deposit ratio cr is the amount of currency C
people hold as a fraction of their holdings of demand deposits
D. It reflects the preferences of households about the form of
money they wish to hold.

By showing how the money supply depends on the monetary base,

the reserve–deposit ratio, and the currency–deposit ratio, this model
is useful for understanding how Fed policy and the choices of banks
and households influence the money supply.

We begin with the definitions of the money supply and the monetary
base:

M = C + D,

B = C + R.

The first equation states that the money supply is the sum of
currency and demand deposits. The second equation states that the
monetary base is the sum of currency and bank reserves. To solve
for the money supply as a function of the three exogenous variables
(B, rr, and cr), we divide the first equation by the second to obtain

M C + D
= .
B C + R

We then divide both the top and bottom of the expression on the
right by D:

M C/D + 1
= .
B C/D + R/D

Note that C/D is the currency–deposit ratio cr and that R/D is the
reserve–deposit ratio rr. Making these substitutions, and bringing
the B from the left to the right side of the equation, we obtain

cr + 1
M = × B.
cr + rr

This equation shows how the money supply depends on the three
exogenous variables.

We can now see that the money supply is proportional to the

monetary base. The factor of proportionality, (cr + 1) /(cr + rr) , is
denoted m and is called the money multiplier. We can write

M = m × B.

Each dollar of the monetary base produces m dollars of money.

Because the monetary base has a multiplied effect on the money
supply, the monetary base is sometimes called high-powered money.

Here’s a numerical example. Suppose that the monetary base B is

$800 billion, the reserve–deposit ratio rr is 0.1, and the currency–
deposit ratio cr is 0.8. In this case, the money multiplier is

0.8 + 1
m = = 2.0,
0.8 + 0.1

and the money supply is

M = 2.0 × $800 billion = $1,600 billion.

Each dollar of the monetary base generates two dollars of money, so

the total money supply is $1,600 billion.

We can now see how changes in the three exogenous variables — the
monetary base, the reserve–deposit ratio, and the currency–deposit
ratio — cause the money supply to change:

1. The money supply is proportional to the monetary base. Thus,

an increase in the monetary base increases the money supply
by the same percentage.
2. The lower the reserve–deposit ratio, the more loans banks make
and the more money banks create from every dollar of reserves.
Thus, a decrease in the reserve–deposit ratio raises the money
multiplier and the money supply.
3. The lower the currency–deposit ratio, the fewer dollars of the
monetary base the public holds as currency, the more base
dollars banks hold as reserves, and the more money banks can
create. Thus, a decrease in the currency–deposit ratio raises the
money multiplier and the money supply.

With this model in mind, we can discuss the ways in which the Fed
influences the money supply.

The Instruments of Monetary Policy

Although it is often convenient to make the simplifying assumption
that the Federal Reserve controls the money supply directly, in fact
the Fed controls the money supply indirectly using various
instruments. These instruments can be classified into two broad
groups: those that influence the monetary base and those that
influence the reserve–deposit ratio and in turn the money
multiplier.
How the Fed Changes the Monetary Base
As we discussed earlier, open-market operations are the purchases and
sales of government bonds by the Fed. When the Fed buys bonds
from the public, the dollars it pays for the bonds increase the
monetary base and thereby increase the money supply. When the
Fed sells bonds to the public, the dollars it receives reduce the
monetary base and thus decrease the money supply. Open-market
operations are the policy instrument that the Fed has traditionally
used most often (though, in recent years, some of the other
instruments have taken larger roles).

The Fed can also alter the monetary base by lending reserves to
banks. Banks borrow from the Fed when they think they do not have
enough reserves on hand, either to satisfy bank regulations, meet
depositor withdrawals, make new loans, or satisfy some other
business requirement. When the Fed lends to a bank that is having
trouble obtaining funds from elsewhere, it is said to act as the lender
of last resort.

Banks can borrow from the Fed in various ways. Traditionally, banks
have borrowed at the Fed’s so-called discount window. The discount
rate is the interest rate that the Fed charges on these loans. The
lower the discount rate, the cheaper are borrowed reserves, and the
more banks borrow at the Fed’s discount window. Hence, a
reduction in the discount rate raises the monetary base and the
money supply.
During the financial crisis of 2008–2009, distressed banks were
reluctant to borrow from the discount window for fear that doing so
would signal weakness to the public. In response, the Federal
Reserve set up several new mechanisms through which banks could
borrow. For example, under the Term Auction Facility, the Fed set a
quantity of funds it wanted to lend to banks, and eligible banks then
bid to borrow those funds. The loans went to the highest eligible
bidders — that is, to the banks that had acceptable collateral and
offered to pay the highest interest rate. Unlike at the discount
window, where the Fed sets the price of a loan and the banks
determine the quantity of borrowing, at the Term Auction Facility
the Fed set the quantity of borrowing, and a competitive bidding
process among banks determined the price. The last Term Auction
Facility auction was conducted in 2010, but this policy illustrates that
the Federal Reserve has various ways to alter the monetary base and
the money supply.

How the Fed Changes the Reserve–Deposit Ratio

As our model of the money supply shows, the money multiplier is
the link between the monetary base and the money supply. The
money multiplier depends on the reserve–deposit ratio, which in
turn is influenced by various Fed policy instruments.

Reserve requirements are Fed regulations that impose a minimum

reserve–deposit ratio on banks. An increase in reserve requirements
tends to raise the reserve–deposit ratio and thus lower the money
multiplier and the money supply. Banks may, however, hold excess
reserves, which are reserves above the minimum required. Changes
in reserve requirements have historically been the least frequently
used of the Fed’s policy instruments. In March 2020, the Fed
eliminated reserve requirements entirely.

In October 2008, the Fed started paying interest on reserves. That

is, when a bank holds reserves on deposit at the Fed, the Fed now
pays the bank interest on those deposits. This change gives the Fed
another tool with which to influence the economy. The higher the
interest rate on reserves, the more reserves banks will choose to
hold. Thus, an increase in the interest rate on reserves will tend to
increase the reserve–deposit ratio, lower the money multiplier, and
lower the money supply. The interest rate paid on reserves has
arguably been the most important instrument of monetary policy in
recent years.

CASE STUDY
Quantitative Easing and the Exploding Monetary Base
Figure 4-1 shows the monetary base from 1960 to 2020. You can see that something
extraordinary happened after 2007. From 1960 to 2007 the monetary base grew gradually
over time. But then from 2007 to 2014 it spiked up substantially, increasing about fivefold
over just a few years.
 FIGURE 4-1

The Monetary Base The monetary base has historically grown relatively smoothly over
time, but from 2007 to 2014 it increased approximately fivefold. The huge expansion in
the monetary base, however, was not accompanied by similar increases in M1 and M2.

Data from: U.S. Federal Reserve.

This huge increase in the monetary base is attributable to actions the Federal Reserve took
during the financial crisis and economic downturn of this period. With the financial markets
in turmoil, the Fed responded with historic vigor. It began by buying large quantities of
mortgage-backed securities. Its goal was to restore order to the mortgage market so that
would-be homeowners could borrow. Later, the Fed pursued a policy of buying long-term
government bonds to push up their prices and to push down long-term interest rates. This
policy, called quantitative easing, was a kind of open-market operation. But rather than buy
short-term Treasury bills, as the Fed normally does in an open-market operation, it bought
longer-term and somewhat riskier securities. These open-market purchases led to a
substantial increase in the monetary base.

The huge expansion in the monetary base, however, did not lead to a similar increase in
broader measures of the money supply. While the monetary base increased about 400
percent from 2007 to 2014, M1 increased by only 100 percent and M2 by only 55 percent.
These figures show that the tremendous expansion in the monetary base was accompanied
by a large decline in the money multiplier. Why did this decline occur?
 The model of the money supply presented earlier in this chapter shows that a key
determinant of the money multiplier is the reserve ratio rr. From 2007 to 2014, the reserve
ratio increased substantially because banks chose to hold substantial quantities of excess
reserves. That is, rather than make loans, the banks kept much of their available funds in
reserve. (Excess reserves rose from about $1.5 billion in 2007 to about $2.5 trillion in 2014.)
This decision prevented the normal process of money creation that occurs in a system of
fractional-reserve banking.

Why did banks choose to hold so much in excess reserves? Part of the reason is that banks
had made many bad loans leading up to the financial crisis; when this fact became
apparent, bankers tried to tighten their credit standards and make loans only to those they
were confident could repay. In addition, interest rates fell to such low levels that making
loans was not as profitable as it had been. Banks did not lose much by leaving their financial
resources idle as excess reserves.

Although the explosion in the monetary base did not lead to a similar explosion in the
money supply, some observers feared that it still might. As the economy recovered from the
downturn and interest rates rose to normal levels, they argued, banks could reduce their
holdings of excess reserves by making loans. The money supply would start growing —
perhaps too quickly.

Policymakers at the Federal Reserve, however, were aware of this potential problem and
were ready to handle it. From 2015 to 2017, the Fed increased the interest rate it paid on
reserves from 0.25 to 1.50 percent. A higher interest rate on reserves makes holding reserves
more profitable for banks, thereby discouraging bank lending and keeping the money
multiplier low.6

Problems in Monetary Control

The Fed has substantial power to influence the money supply, but it
cannot control the money supply perfectly. Banks’ discretion in how
they conduct their businesses, as well as households’ decisions
about their personal financial affairs, can cause the money supply to
change in ways the Fed did not anticipate. For example, if banks
choose to hold more excess reserves, the reserve–deposit ratio
increases and the money supply falls. Similarly, if households decide
to hold more of their money in the form of currency, the currency–
deposit ratio increases and the money supply falls. Hence, the
money supply sometimes moves in ways the Fed does not intend.

CASE STUDY
Bank Failures and the Money Supply in the 1930s
Between August 1929 and March 1933, the money supply fell 28 percent. As we will discuss
in Chapter 13, some economists believe that this large decline in the money supply was the
main cause of the Great Depression of the 1930s, when unemployment reached
unprecedented levels, prices fell precipitously, and economic hardship was widespread. In
light of this hypothesis, one is drawn to ask why the money supply fell so dramatically.

The three variables that determine the money supply — the monetary base, the reserve–
deposit ratio, and the currency–deposit ratio — are shown in Table 4-2 for 1929 and 1933.
You can see that the fall in the money supply cannot be attributed to a fall in the monetary
base: In fact, the monetary base rose 18 percent over this period. Instead, the money supply
fell because the money multiplier fell 38 percent. The money multiplier fell because the
currency–deposit and reserve–deposit ratios both rose substantially.

TABLE 4-2 The Money Supply and Its Determinants: 1929 and
1933
August 1929 March 1933

Money Supply 26.5 19.0

Currency 3.9 5.5

Demand deposits 22.6 13.5

Monetary Base 7.1 8.4

 Currency 3.9 5.5

Reserves 3.2 2.9

Money Multiplier 3.7 2.3

Reserve–deposit ratio 0.14 0.21

Currency–deposit ratio 0.17 0.41

Data from: Milton Friedman and Anna Schwartz, A Monetary History of the United States,
1867–1960 (Princeton, NJ: Princeton University Press, 1963), Appendix A.

Most economists attribute the fall in the money multiplier to the large number of bank
failures in the early 1930s. From 1930 to 1933, more than 9,000 banks suspended operations,
and many of them defaulted on their depositors. The bank failures caused the money supply
to fall by altering the behavior of both depositors and bankers.

Bank failures raised the currency–deposit ratio by reducing public confidence in the banking
system. People feared that bank failures would continue, and they began to view currency
as a more desirable form of money than demand deposits. When they withdrew their
deposits, they drained the banks of reserves. The process of money creation reversed itself,
as banks responded to lower reserves by reducing their outstanding balance of loans.

In addition, the bank failures raised the reserve–deposit ratio by making bankers more
cautious. Having just observed many bank runs, bankers became apprehensive about
operating with a small amount of reserves. They therefore increased their holdings of
reserves to well above the legal minimum. Just as households responded to the banking
crisis by holding more currency relative to deposits, bankers responded by holding more
reserves relative to loans. Together these changes caused a large fall in the money
multiplier.

Although it is easy to explain why the money supply fell, it is more difficult to decide whether
to blame the Federal Reserve. One might argue that the monetary base did not fall, so the
Fed should not be blamed. Critics of Fed policy during this period make two
counterarguments. First, they claim that the Fed should have taken a more vigorous role in
preventing bank failures by acting as a lender of last resort when banks needed cash during
bank runs. Doing so would have helped maintain confidence in the banking system and
prevented the large fall in the money multiplier. Second, they point out that the Fed could
have responded to the fall in the money multiplier by increasing the monetary base even
more than it did. Either of these actions would likely have prevented such a large fall in the
money supply and reduced the severity of the Great Depression.

Since the 1930s, many policies have been enacted that make such a large and sudden fall in
the money supply less likely today. Most importantly, the system of federal deposit
insurance protects depositors when a bank fails. This policy is designed to maintain public
confidence in the banking system and thus prevents large swings in the currency–deposit
ratio. Deposit insurance has a cost: In the late 1980s and early 1990s, for example, the
federal government incurred the large expense of bailing out many insolvent savings-and-
loan institutions. Yet deposit insurance helps stabilize the banking system and the money
supply. That is why, during the financial crisis of 2008–2009, the Federal Deposit Insurance
Corporation raised the amount guaranteed from $100,000 to $250,000 per depositor.
4-4 Conclusion
You should now understand what money is and how central banks
affect its supply. Yet this accomplishment, valuable as it is, is only
the first step toward understanding monetary policy. The next and
more interesting step is to see how changes in the money supply
influence the economy. We begin our study of that question in the
next chapter. As we examine the effects of monetary policy, we can
start to appreciate what central bankers can do to improve the
functioning of the economy and, just as important, what they cannot
do. But be forewarned: You will have to wait until the end of the
book to see all the pieces of the puzzle fall into place.

QUICK QUIZ
1. Which of the following is not part of the money supply?
a. the metal coins in your pocket
b. the paper currency in your wallet
c. the balances in your retirement account
d. the funds in your checking account
2. In a system of fractional-reserve banking, bank lending
increases the
a. monetary base.
b. money supply.
c. amount of excess reserves.
 d. economy’s net worth.
3. If a central bank wants to increase the money supply, it can
bonds in open-market operations or
reserve requirements.
a. buy, increase
b. buy, decrease
c. sell, increase
d. sell, decrease
4. When the Federal Reserve reduces the interest rate it pays
on reserves, this tends to the money
multiplier and the money supply.
a. increase, increase
b. increase, decrease
c. decrease, increase
d. decrease, decrease
5. Because of leverage, a 5 percent decline in the value of a
bank’s assets causes the value of the bank’s
to fall by than 5 percent.
a. capital, more
b. capital, less
c. deposits, more
d. deposits, less
6. Suppose that a change in transaction technology reduces
the amount of currency people want to hold relative to
demand deposits. If the Fed does nothing, the money
supply tends to . But the Fed can hold the
money supply constant by bonds in open-
market operations.
a. increase, buying
b. increase, selling
c. decrease, buying
d. decrease, selling

Answers at end of chapter.

SUMMARY
1. Money is the stock of assets used for transactions. It serves as a
store of value, a unit of account, and a medium of exchange.
Various assets are used as money: Commodity money systems
use an asset with intrinsic value, whereas fiat money systems
use an asset whose sole function is to serve as money. In
modern economies, a central bank such as the Federal Reserve
is responsible for controlling the supply of money.
2. The system of fractional-reserve banking creates money
because each dollar of reserves generates more than one dollar
of demand deposits.
3. To start a bank, the owners must contribute some of their own
financial resources, which become the bank’s capital. Because
banks employ leverage, a change in the value of a bank’s assets
has a proportionately larger impact on the value of its capital.
Bank regulators require that banks hold sufficient capital to
ensure that depositors can be repaid.
4. The supply of money depends on the monetary base, the
reserve–deposit ratio, and the currency–deposit ratio. An
increase in the monetary base leads to a proportionate increase
in the money supply. A decrease in the reserve–deposit ratio or
currency–deposit ratio increases the money multiplier and in
turn the money supply.
 5. The Federal Reserve influences the money supply either by
changing the monetary base or by changing the reserve ratio
and thus the money multiplier. It can change the monetary base
through open-market operations or by making loans to banks. It
can influence the reserve ratio by altering reserve requirements
or by changing the interest rate it pays banks for reserves they
hold.

KEY CONCEPTS
Money
Store of value
Unit of account
Medium of exchange
Fiat money
Commodity money
Gold standard
Money supply
Monetary policy
Central bank
Federal Reserve
Open-market operations
Currency
Demand deposits
Reserves
100-percent-reserve banking
Balance sheet
Fractional-reserve banking
Financial intermediation
Bank capital
Leverage
Capital requirement
Monetary base
Reserve–deposit ratio
Currency–deposit ratio
Money multiplier
Discount rate
Reserve requirements
Excess reserves
Interest on reserves

QUESTIONS FOR REVIEW

1. Describe the functions of money.
2. What is fiat money? What is commodity money?
3. What are open-market operations, and how do they
influence the money supply?
4. Explain how banks create money.
5. What are the various ways in which the Federal Reserve
can influence the money supply?
6. Why might a banking crisis lead to a decrease in the money
supply?

PROBLEMS AND APPLICATIONS

1. What are the three functions of money? Which of the
functions do the following items satisfy? Which do they not
satisfy?
a. A credit card
b. A painting by Rembrandt
c. A Starbucks gift card
2. Explain how each of the following events affects the
monetary base, the money multiplier, and the money
supply.
a. The Federal Reserve buys bonds in an open-market
operation.
b. The Fed increases the interest rate it pays banks for
holding reserves.
c. The Fed reduces its lending to banks through its Term
Auction Facility.
d. Rumors about a computer virus attack on ATMs increase
the amount of money people hold as currency rather
than demand deposits.
e. The Fed flies a helicopter over 5th Avenue in New York
City and drops newly printed $100 bills.
3. An economy has a monetary base of 1,000 $1 bills.
Calculate the money supply in scenarios (a)–(d) and then
answer part (e).
a. All money is held as currency.
b. All money is held as demand deposits. Banks hold 100
percent of deposits as reserves.
c. All money is held as demand deposits. Banks hold 20
percent of deposits as reserves.
d. People hold equal amounts of currency and demand
deposits. Banks hold 20 percent of deposits as reserves.
e. The central bank wants to increase the money supply by
10 percent. In each of the above four scenarios, by how
much must it increase the monetary base?
4. • In the nation of Wiknam, people hold $1,000
of currency and $4,000 of demand deposits in the only
bank, Wikbank. The reserve–deposit ratio is 0.25.
a. What are the money supply, the monetary base, and the
money multiplier?
b. Assume that Wikbank is a simple bank: It takes in
deposits, makes loans, and has no capital. Show
Wikbank’s balance sheet. What value of loans does the
bank have outstanding?
c. Wiknam’s central bank wants to increase the money
supply by 10 percent. Should it buy or sell government
bonds in open-market operations? Assuming no change
in the money multiplier, calculate, in dollars, how much
the central bank needs to transact.
5. • In the economy of Panicia, the monetary base
is $1,000. People hold one-third of their money in the form
of currency (and thus two-thirds as bank deposits). Banks
hold one-third of their deposits in reserve.
a. What are the reserve–deposit ratio, the currency–
deposit ratio, the money multiplier, and the money
supply?
b. One day, fear about the banking system strikes the
population, and people now want to hold half their
money in the form of currency. If the central bank does
nothing, what is the new money supply?
c. If, in the face of this panic, the central bank wants to
conduct an open-market operation to keep the money
supply at its original level, does it buy or sell
government bonds? Calculate, in dollars, how much the
central bank needs to transact.
6. As a case study in the chapter discusses, the money supply
fell from 1929 to 1933 because both the currency–deposit
ratio and the reserve–deposit ratio increased. Use the
model of the money supply and the data in Table 4-2 to
answer the following hypothetical questions about this
episode.
a. What would have happened to the money supply if the
currency–deposit ratio had risen but the reserve–deposit
ratio had remained the same?
b. What would have happened to the money supply if the
reserve–deposit ratio had risen but the currency–deposit
 ratio had remained the same?
c. Which of the two changes was more responsible for the
fall in the money supply?
7. To increase tax revenue, the U.S. government in 1932
imposed a 2-cent tax on checks written on bank account
deposits. (In today’s dollars, this tax would amount to about
40 cents per check.)
a. How do you think the check tax affected the currency–
deposit ratio? Explain.
b. Use the model of the money supply under fractional-
reserve banking to discuss how this tax affected the
money supply.
c. Many economists believe that a falling money supply
was in part responsible for the severity of the Great
Depression of the 1930s. From this perspective, was the
check tax a good policy to implement in the middle of
the Great Depression?
8. Give an example of a bank balance sheet with a leverage
ratio of 20. If the value of the bank’s assets rises by 2
percent, what happens to the value of the owners’ equity in
this bank? How large would the decline in the value of bank
assets need to be to reduce this bank’s capital to zero?
9. • Jimmy Paul Miller starts his own bank, called
JPM. As owner, Jimmy puts in $2,000 of his own money.
JPM then borrows $4,000 in a long-term loan from Jimmy’s
uncle, accepts $14,000 in demand deposits from his
neighbors, buys $7,000 of U.S. Treasury bonds, lends
 $10,000 to local businesses to finance new investments, and
keeps the remainder of the bank’s assets as reserves at the
Fed.
a. Show JPM’s balance sheet. What is JPM’s leverage ratio?
b. An economic downturn causes 5 percent of the local
businesses to declare bankruptcy and default on their
loans. Show JPM’s new balance sheet. By what
percentage does the value of JPM’s assets fall? By what
percentage does JPM’s capital fall?

For any problem marked with this icon , there is a worked-out solution
and tutorial online for a similar problem. To access these solutions and other learning
resources, visit Achieve for Macroeconomics, 11e:
https://achieve.macmillanlearning.com.

ANSWERS TO QUICK QUIZ

1. c
2. b
3. b
4. a
5. a
6. b