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CHAPTER 13
MONEY, BANKS, AND THE FEDERAL RESERVE
MASTERY GOALS
The objectives of this chapter are to:
1. Define money and its functions.
2. Define liquidity.
3. Explain why credit cards, gold bars, and stocks and bonds are not money.
4. List and define the components of M1 and M2.
5. Describe a bank’s balance sheet.
6. Describe the structure and functions of the Federal Reserve System.
7. List the tools that the Fed can use to change the money supply.
8. Explain how the Fed uses open market operations to change the nation’s money supply.
9. Show how the money multiplier is used to calculate the total change in money supply
resulting from an initial change in reserves.
10. Explain how the size of the money multiplier is affected by the public’s desire to hold
cash and banks’ desires to hold excess reserves.
11. Describe how the Fed affect the money supply when it changes the required reserve
ratio or the discount rate, and explain why the Fed seldom uses these two tools.
12. Explain why it is important to prevent bank panics, and why there have been relatively
few bank failures since 1933.
13. Understand the role of regulation in supervising the banking system.
14. (Appendix) Understand the concepts of leverage and deleveraging.
THE CHAPTER IN A NUTSHELL
Money is any asset that is widely acceptable as a means of payment and is highly liquid. An
asset is considered liquid if it can be converted to cash quickly and at li6le cost. Credit limits on
credit cards are not money because the right to borrow is not an asset. Stocks, bonds, and gold
bars are not money because they are not widely acceptable.
M1 is the standard definition of the money stock. It is the sum of cash in the hands of the
public, demand deposits, other checkable deposits, and travelers’ checks. For simplification, this
chapter defines the money supply as cash in the hands of the public plus demand deposits.
Money has several functions including acting as a means of payment, a unit of account, and a
store of value.
Banks are important examples of financial intermediaries—business firms that assemble
loanable funds and channel those funds to borrowers. A bank’s assets include property and
buildings, government and corporate bonds, loans, vault cash, and accounts with the Federal
Reserve. The Federal Reserve requires that banks hold a minimum fraction of their deposits as
vault cash or accounts with the Fed. These are a bank’s required reserves. Total reserves less
required reserves equals excess reserves. Demand deposits are a bank’s liability, because
customers have the right to withdraw these funds from their checking accounts. A bank’s net
worth is equal to total assets minus total liabilities.
Congress established the Federal Reserve System in 1913, as a corporation whose stockholders are
the private banks that it regulates. There are 12 Federal Reserve Banks, each serving a different part
of the United States. The Board of Governors supervises the Federal Reserve System. This board
consists of seven members who are appointed by the President, and confirmed by the Senate for a
14-year term. The most powerful person at the Fed is the Chairman of the Board of Governors, who
is appointed by the President for a four-year term. The Federal Open Market committee consists of
all seven governors of the Fed, along with the 12 district bank presidents. It meets about eight times
per year and sets the general course for the nation’s money supply.
Some of the Fed’s most important responsibilities are supervising and regulating banks, acting
as a bank for banks, issuing paper currency, clearing checks, guiding the macroeconomy, and
dealing with financial crises.
The Fed uses open market operations to control the money supply. It buys government bonds
when it wants to increase the money supply, and sells government bonds when it wants to
decrease the money supply.
When the Fed buys government bonds, it injects reserves into the banking system. This increases
the amount of excess reserves in the banking system, which allows banks to make new loans. When
banks create loans, the total supply of money increases. When the Fed sells government bonds, it
removes reserves from the banking system, and causes the money supply to contract.
The money multiplier is the number by which we multiply an injection of reserves to get the
total change in demand deposits. The size of the money multiplier is negatively related to the
required reserve ratio. The multiplier is weakened by the public’s desire to hold cash and banks’
desires to hold excess reserves.
The Fed can also control the money supply by changing the required reserve ratio or by changing
the discount rate (the rate the Fed charges banks when it lends them reserves). Lowering the
required reserve ratio or the discount rate increases the money supply, and vice versa.
A bank failure occurs when a bank is unable to meet the requests of its depositors to withdraw
their funds. A run on a bank occurs when a bank’s depositors all try to withdraw their funds at
one time. A banking panic occurs when many banks fail simultaneously. The Federal Deposit
Insurance Corporation was created by Congress in 1933, to prevent banking panics by
reimbursing those who lose their deposits when a bank fails. FDIC protection for bank accounts
is not costless—banks must pay insurance premiums to the FDIC, and they pass this cost on to
their depositors and borrowers. Additionally, FDIC insurance weakens bank managers’
incentives to act responsibly, and increases the need for banking regulation. Regulation can
take the form of capital requirements as banks holding a significant percentage of their assets as
capital are encourage to lend responsibly.
In the Using the Theory section, the financial crisis of 2008 is explored and explained with an
emphasis on banks’ balance sheets and the role of the shadow banking system.
The appendix to chapter 25 reinforces the concept of leverage and its importance
In order presented in chapter.
Money: An asset widely accepted as a means of payment.
Means of payment: Anything acceptable as payment for goods and services.
Cash in the hands of the public: Currency and coin held by the non-bank public.
Money supply: The total amount of money (cash, checking deposits, and traveler’s checks)
held by the public.
Store of value: a form in which wealth can be held.
Unit of account: A common unit for measuring how much something is worth.
Federal Reserve System: The monetary authority of the United States, charged with
creating and regulating the nation’s supply of money.
Fiat money: Something that serves as a means of payment by government declaration.
Financial intermediary: A business firm that specializes in brokering between savers and
borrowers.
Balance sheet: A financial statement showing assets, liabilities, and shareholders’ equity at
a point in time.
Bond: A promise to pay back borrowed funds, issued by a corporation or government agency.
Loan: An agreement to pay back borrowed funds, signed by a household or noncorporate
business.
Reserves: Vault cash plus balances held at the Fed.
Required Reserves: The minimum amount of reserves a bank must hold, depending on the
amount of its deposit liabilities.
Required reserve ratio: The minimum fraction of checking account balances that banks
must hold as reserves.
Excess reserves: Reserves in excess of required reserves.
Shareholders’ equity: The difference between total assets and total liabilities.
Central bank: A nation’s principal monetary authority responsible for controlling the money
supply.
Federal Open Market Committee (FOMC): A committee of Federal Reserve oDcials
that establishes U.S. monetary policy.
Discount rate: The interest rate the Fed charges on loans to banks.
Open market operations: Purchases or sales of government bonds by the Federal Reserve
System.
Money multiplier: The multiple by which the money supply changes aEer a change in
reserves.
Fractional reserve system: A system in which banks hold only a fraction of their deposit
liabilities as reserves.
Insolvent: Condition of a firm (e.g., a bank) when total assets are less than total liabilities.
Run on the bank: An a6empt by many of a bank’s depositors to withdraw their funds.
Banking panic: A situation in which fearful depositors a6empt to withdraw funds from
many banks simultaneously.
Bank capital: Another name for shareholders’ equity in a bank.
Capital ratio: A bank’s capital (shareholders’ equity) as a percentage of its total assets.
Shadow banking system: The entire collection of non-bank financial intermediaries.
Non-bank: A financial intermediary less strictly regulated than a bank, and with no
government-guaranteed deposits.
1. Have students explore the Federal Reserve Board’s Web site at www.federalreserve.gov/
. Click on “About the Fed” to access “Purposes and Functions,” “Board Members,” and
“Federal Reserve Bank Presidents.” Click on “Monetary Policy” and then “Federal Open
Market committee” to links to “Meeting calendar, statements, and minutes” and
“members.” Or click on “News and Events” to find Bernanke’s “Monetary Policy Report
to Congress” for his Humphrey-Hawkins testimony about the state of the economy.
2 Emphasize to students that open market operations are the purchase and sale of U.S.
government securities in the secondary market. This is different from the Treasury’s
deficit financing, which consists of selling newly issued government securities in the
primary market.
3. Students enjoy learning how the New York Fed’s Trading Desk implements the FOMC’s
policy directives on a daily basis. A description of what happens at the Trading Desk is
available at h6p://www.ny.frb.org/abou6hefed/fedpoint/fed32.html .
4. Go to h6p://www.frbdiscountwindow.org/ for information about the Fed’s discount
lending system.
5. Explain that the Fed could conduct monetary policy by buying and selling anything (for
instance, corporate bonds or used cars), but that it chooses to conduct monetary policy
by buying and selling U.S. government securities. It chooses to conduct monetary policy
this way because there is a well-developed secondary market for these securities, they
are a standardized product, storage costs are low, and the Fed avoids giving its
imprimatur to private corporations.
DISCUSSION STARTERS
1. M1 and M2 figures and current money multiplier numbers can be found at
h6p://www.stls.frb.org/fred/data/wkly/m1, h6p://www.stls.frb.org/fred/data/wkly/m2,
and h6p://www.stls.frb.org/fred/data/wkly/mult, respectively. Have students use the
current money multiplier to calculate the impact of various open market operations on
the money supply.
2. Information about the current reserve requirement is available at
h6p://www.newyorkfed.org/abou6hefed/fedpoint/fed45.html
3. As stated in the chapter, the FOMC’s deliberations are private. It is interesting to contrast
the United States’ system with the open policies of Tito Mboweni, the president of the
central bank of South Africa. See Roger Thurow, “A New Note: Central-Bank Chief
Foments More Change For South Africans,” The Wall Street Journal, 3/29/2000, p. A1,
for details.
