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 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. 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 was exaggerating when he said that central banking was one of the three greatest inventions of all time,
but he was right in suggesting 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 10, but it will take several chapters to develop a complete explanation. This
chapter gets us ready. Both the long-run 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. By contrast, economists
use the term “money” in a more specialized way. To an economist, money does not refer 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 countries, pesos, pounds, or yen) in the hands of the public make up the nation’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 is 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 are rising, the amount you can buy with any given quantity of money is
falling. 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 terms in which people 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 (even though it may amount to the same thing). 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 the 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 with 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.

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.

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, they 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 Island of Yap

The economy of Yap, a small island 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. Although the monetary system facilitated
exchange, it did so at great cost.

Eventually, it became common practice for the new owner of the fei not to bother to take 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 is still valued on the island. But it is not the medium of exchange used for most
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,
like 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 $15,000 in 2017. 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 do 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 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 controls 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 some of the
dollars it has 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 accounts 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 admit 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 by 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 July 2017
(billions of dollars)

C Currency $ 1,486

M1 Currency plus demand deposits, traveler’s checks, and other checkable deposits   3,528

M2 M1 plus retail money market mutual fund balances, saving deposits (including  13,602
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 DepositsM=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
We begin by imagining 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—looks like this:

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 original $1,000 creates is

Original Deposit=$1,000Firstbank Lending=(1−rr)×$1,000Secondbank Lending=(1−rr)2×$1,000Thirdbank 
[ 1+(1−rr)+(1−rr)2+(1−rr)3+. . . ]×$1,000=(1/rr)×$1,000.
Each $1 of reserves generates $(1/rr) of money. In our example, rr = 0.2, so the original $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 those households that wish to save some of their income for the future to those
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 also 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, not its wealth.

Bank Capital, Leverage, and Capital

Requirements
The model of the banking system presented so far is simplified. That 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 business strategy relies on 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. This
means that for every dollar of capital that the bank owners have contributed, the bank has $20 of assets and,
thus, $19 of deposits and debts.

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.
Since the depositors and debt holders 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 crisis, many observers
suggested that banks be subject to higher capital requirements.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 12 and 18.
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

MB=C+DC+R.

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

MB=C/D+1C/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

M=cr+1cr+rr×B.

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

m=0.8+10.8+0.1=2.0,
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—B, rr, and cr—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 thereby 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 uses most often. In fact, the Fed conducts open-market operations in New York bond markets almost
every weekday.

The Fed can also alter the monetary base and the money supply 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
regulators, 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.

In response to the financial crisis of 2008–2009, the Federal Reserve set up several new mechanisms for
banks to borrow from it. 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. Changes in reserve requirements are the least frequently used of the Fed’s policy
instruments. Moreover, in recent years, this tool has become less effective because many banks hold more
reserves than are required. Reserves above the minimum required are called excess reserves.

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.
CASE STUDY
Quantitative Easing and the Exploding Monetary Base

Figure 4-1 shows the monetary base from 1960 to 2017. 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 5-fold 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 5-fold. 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 pursued its job
as a lender of last resort 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 keep their prices up and long-term interest rates
down. This policy, called quantitative easing, is a kind of open-market operation. But rather than buying 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 the 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 making 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 had fallen to
such low levels that making loans was not as profitable as it normally is. 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 2014 to 2017, the Fed increased the interest rate it pays 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 12, 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, often defaulting 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. This 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, which might have 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 important, 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 move toward an appreciation of what
central bankers can do to improve the functioning of the economy and, just as important, an appreciation of
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.