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WHAT’S NEW IN THE EIGHTH EDITION:
There is a new In the News feature on “A Trip to Jekyll Island” and a new question in the
Problems and Applications section.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
what money is and what functions money has in the economy.
what the Federal Reserve System is.
how the banking system helps determine the supply of money.
what tools the Federal Reserve uses to alter the supply of money.
468
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
29
THE MONETARY
SYSTEM
469 ❖ Chapter 29/The Monetary System
CONTEXT AND PURPOSE:
Chapter 29 is the <rst chapter in a two-chapter sequence dealing with money and prices in
the long run. Chapter 29 describes what money is and develops how the Federal Reserve
controls the quantity of money. Because the quantity of money in>uences the rate of
in>ation in the long run, the following chapter concentrates on the causes and costs of
in>ation.
The purpose of Chapter 29 is to help students develop an understanding of what money
is, what forms money takes, how the banking system helps create money, and how the
Federal Reserve controls the quantity of money. An understanding of money is important
because the quantity of money a?ects in>ation and interest rates in the long run, and
production and employment in the short run.
KEY POINTS:
The term money refers to assets that people regularly use to buy goods and services.
Money serves three functions. As a medium of exchange, it is the item used to make
transactions. As a unit of account, it provides the way to record prices and other
economic values. As a store of value, it o?ers a way to transfer purchasing power from
the present to the future.
Commodity money, such as gold, is money that has intrinsic value: It would be valued
even if it were not used as money. Fiat money, such as paper dollars, is money without
intrinsic value: It would be worthless if it were not used as money.
In the U.S. economy, money takes the form of currency and various types of bank
deposits, such as checking accounts.
The Federal Reserve, the central bank of the United States, is responsible for regulating
the U.S. monetary system. The Fed chair is appointed by the president and con<rmed by
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Chapter 29/The Monetary System ❖ 470
Congress every four years. The chair is the lead member of the Federal Open Market
Committee, which meets about every six weeks to consider changes in monetary policy.
Bank depositors provide resources to banks by depositing their funds into bank accounts.
These deposits are part of a bank’s liabilities. Bank owners also provide resources (called
bank capital) for the bank. Because of leverage (the use of borrowed funds for
investment), a small change in the value of a bank’s assets can lead to a large change in
the value of the bank’s capital. To protect depositors, bank regulators require banks to
hold a certain minimum amount of capital.
The Fed controls the money supply primarily through open-market operations. The
purchase of government bonds increases the money supply, and the sale of government
bonds decreases the money supply. The Fed also uses other tools to control the money
supply. It can expand the money supply by decreasing the discount rate, increasing its
lending to banks, lowering reserve requirements, or decreasing the interest rate on
reserves. It can contract the money supply by increasing the discount rate, decreasing
its lending to banks, raising reserve requirements or increasing the interest rate on
reserves.
When individuals deposit money in banks and banks loan out some of these deposits, the
quantity of money in the economy increases. Because the banking system in>uences the
money supply in this way, the Fed’s control of the money supply is imperfect.
The Federal Reserve has in recent years set monetary policy by choosing a target for the
federal funds rate, a short-term interest rate at which banks make loans to one another. As
the Fed achieves its target, it adjusts the money supply.
CHAPTER OUTLINE:
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
This is a good chapter to “win back” the students who were bored with
national income accounting. Students are generally interested in learning
more about the banking system and the Federal Reserve. The Federal
Reserve o?ers a free, 13-minute video entitled “The Fed Today” that
discusses the history and operations of the Fed.
471 ❖ Chapter 29/The Monetary System
I. The Meaning of Money
A. De<nition of money: the set of assets in an economy that people regularly
use to buy goods and services from other people.
B. The Functions of Money
1. Money serves three functions in our economy.
a. De<nition of medium of exchange: an item that buyers give to sellers
when they want to purchase goods and services.
b. De<nition of unit of account: the yardstick people use to post prices
and record debts.
c. De<nition of store of value: an item that people can use to transfer
purchasing power from the present to the future.
2. De<nition of liquidity: the ease with which an asset can be converted into
the economy’s medium of exchange.
a. Money is the most liquid asset available.
b. Other assets (such as stocks, bonds, and real estate) vary in their liquidity.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Begin the analysis by asking students, “What is money?” Students will
likely want to start right in with a discussion of the functions that money
serves. Stop them. Ask them instead to describe money. Hold up a dollar
bill and a piece of paper cut to the same size. Ask the students which they
Chapter 29/The Monetary System ❖ 472
c. When people decide how to allocate their wealth, they must balance the
liquidity of each possible asset against the asset’s usefulness as a store of
value.
C. The Kinds of Money
1. De<nition of commodity money: money that takes the form of a
commodity with intrinsic value.
2. De<nition of 3at money: money without intrinsic value that is used as
money because of government decree.
D. Money in the U.S. Economy
1. The quantity of money circulating in the United States is sometimes called the
money stock.
2. Included in the measure of the money supply are currency, demand deposits, and
other monetary assets.
a. De<nition of currency: the paper bills and coins in the hands of the
public.
b. De<nition of demand deposits: balances in bank accounts that
depositors can access on demand by writing a check.
3. Figure 1 shows the monetary assets included in two important measures of the
money supply, M1 and M2.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Figure 1
Point out to students that currency only makes up about 30% of the value
of M1, with the remaining 70% in the form of checking deposits. Students
need to understand that the majority of the money in the economy is
actually made up of account balances rather than stacks of currency in a
473 ❖ Chapter 29/The Monetary System
4. FYI: Why Credit Cards Aren’t Money
a. Credit cards are not a form of money; when a person uses a credit card, he or
she is simply deferring payment for the item.
b. Because using a debit card is like writing a check, the account balances that
lie behind debit cards are included in the measures of money.
5. Case Study: Where Is All the Currency?
a. If we divide the amount of outstanding currency in the United States by the
adult population, we <nd that the average adult holds over $5,500 in currency.
b. Of course, most adults carry a much smaller amount.
c. One explanation is that a great deal of U.S. currency may be held in other
countries.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Students are quite curious about whether credit cards are considered
money. You can satisfy their curiosity in part by pointing out that credit
cards actually lead to a drop in the quantity of money people need to
carry because they allow households to consolidate bills for payment once
Make sure that students realize that the assets included in M1 and M2
di?er in terms of their liquidity. Also note that there are other measures of
the money supply (M3 and MZM), which include less liquid assets like time
Chapter 29/The Monetary System ❖ 474
d. Another explanation is that large amounts of currency may be held by
criminals because transactions that use currency leave no paper trail.
II. The Federal Reserve System
A. De<nition of Federal Reserve (Fed): the central bank of the United States.
B. De<nition of central bank: An institution designed to oversee the banking
system and regulate the quantity of money in the economy.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
475 ❖ Chapter 29/The Monetary System
Activity 1—What Can Be Learned from a Dollar?
Type: In-class demonstration
Topics: Money, Federal Reserve
Materials needed: None
Time: 5 minutes
Class limitations: Works in any size class
Purpose
This activity introduces the role of the Federal Reserve in controlling the money
supply.
Instructions
Ask the class to take a dollar bill from wallets (or a $5, $10, $20, or $100).
Students without any currency can share with someone who does. Ask the class to
read the bill.
After a minute, ask them what they have learned.
Common Answers and Points for Discussion
Most students focus on the statement “This note is legal tender for all debts,
public and private.” This statement is the only “backing” U.S. currency has—the
note is not convertible into gold or silver. This can be used to introduce the
di?erence between <at money and commodity money.
C. The Fed’s Organization
1. The Fed was created in 1913 after a series of bank failures.
1. The Fed is run by a Board of Governors with 7 members who serve 14-year terms.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Highlight the Federal Reserve’s independence from the federal
government. Students are surprised to <nd that the Fed actually earns
more than enough to <nance its operations without being funded by
Chapter 29/The Monetary System ❖ 476
a. The Board of Governors has a chair who is appointed for a four-year term.
b. The current chair is Janet Yellen.
2. The Federal Reserve System is made up of 12 regional Federal Reserve Banks
located in major cities around the country.
3. One job performed by the Fed is the regulation of banks to ensure the health of
the nation’s banking system.
a. The Fed monitors each bank's <nancial condition and facilitates bank
transactions by clearing checks.
b. The Fed also makes loans to banks when they want to borrow.
4. The second job of the Fed is to control the quantity of money available in the
economy.
a. De<nition of money supply: the quantity of money available in the
economy.
b. De<nition of monetary policy: the setting of the money supply by
policymakers in the central bank.
D. The Federal Open Market Committee
1. The Federal Open Market Committee (FOMC) consists of the 7 members of the
Board of Governors and 5 of the 12 regional bank presidents.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Have students pull out dollar bills and read the name of the city of the
district bank on the bill. However, make sure that they are actually
reading o? dollar bills and not just guessing the names of large cities.
Introduce students to the idea of open market operations here, but do not
be surprised if they do not catch on quickly. You can return to this topic
later in the chapter.
477 ❖ Chapter 29/The Monetary System
2. The primary way in which the Fed increases or decreases the number of dollars in
the economy is through open market operations (which involve the purchase or
sale of U.S. government bonds).
a. If the Fed wants to increase the supply of money, it creates dollars and uses
them to purchase government bonds from the public through the nation's
bond markets.
b. If the Fed wants to reduce the supply of money, it sells government bonds
from its portfolio to the public. Money is then taken out of the hands of the
public and the supply of money falls.
III. Banks and the Money Supply
A. The Simple Case of 100-Percent-Reserve Banking
1. Example: Suppose that currency is the only form of money and the total amount
of currency is $100.
2. A bank is created as a safe place to store currency; all deposits are kept in the
vault until the depositor withdraws them.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
The process of money creation in the banking system is one of the more
diUcult things to teach at the Principles level. Nearly every aspect of the
process will be new to students and nothing is obvious or intuitive.
Therefore, it is extremely important that each step in the process is shown
through T-accounts so that students can see how the banking system
creates money as banks carry out their normal functions of accepting
Chapter 29/The Monetary System ❖ 478
a. De<nition of reserves: deposits that banks have received but have not
loaned out.
b. Under the example described above, we have 100-percent-reserve banking.
3. The <nancial position of the bank can be described with a T-account:
FIRST NATIONAL BANK
Assets Liabilities
Reserves $100.00 Deposits $100.00
4. The money supply in this economy is unchanged by the creation of a bank.
a. Before the bank was created, the money supply consisted of $100 worth of
currency.
b. Now, with the bank, the money supply consists of $100 worth of deposits.
5. This means that, if banks hold all deposits in reserve, banks do not in>uence the
supply of money.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Students will either catch on to T-accounts immediately or be completely
confused. It is a good idea to explain them and then let students work
together in small groups of two or three. You can check each group to
identify the students who will require individualized attention.
Make sure that you explain why bank reserves are an asset from the
bank’s perspective, but customer deposits are a liability.
479 ❖ Chapter 29/The Monetary System
B. Money Creation with Fractional-Reserve Banking
1. De<nition of fractional-reserve banking: a banking system in which banks
hold only a fraction of deposits as reserves.
2. De<nition of reserve ratio: the fraction of deposits that banks hold as
reserves.
3. Example: Same as before, but First National decides to set its reserve ratio equal
to 10% and lend the remainder of the deposits.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Chapter 29/The Monetary System ❖ 480
4. The bank’s T-account would look like this:
FIRST NATIONAL BANK
Assets Liabilities
Reserves $10.00 Deposits $100.00
Loans $90.00
5. When the bank makes these loans, the money supply changes.
a. Before the bank made any loans, the money supply was equal to the $100
worth of deposits.
b. Now, after the loans, deposits are still equal to $100, but borrowers now also
hold $90 worth of currency from the loans.
c. Therefore, when banks hold only a fraction of deposits in reserve, banks
create money.
6. Note that, while new money has been created, so has debt. There is no new
wealth created by this process.
C. The Money Multiplier
1. The creation of money does not stop at this point.
2. Borrowers usually borrow money to purchase something and then the money
likely becomes redeposited at a bank.
3. Suppose a person borrowed the $90 to purchase something and the funds then
get redeposited in Second National Bank. Here is this bank’s T-account (assuming
that it also sets its reserve ratio to 10%):
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
481 ❖ Chapter 29/The Monetary System
SECOND NATIONAL BANK
Assets Liabilities
Reserves $9.00 Deposits $90.00
Loans $81.00
4. If the $81 in loans becomes redeposited in another bank, this process will go on
and on.
5. Each time the money is deposited and a bank loan is created, more money is
created.
6. De<nition of money multiplier: the amount of money the banking system
generates with each dollar of reserves.
7. In our example, the money supply increased from $100 to $1,000 after the
establishment of fractional-reserve banking.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
ALTERNATIVE CLASSROOM EXAMPLE:
Reserve ratio = 12.5%
Spend some time showing students how the multiplier changes as reserve
requirements change. Make sure that you explain why the multiplier
changes when the reserve ratio changes. Students will catch on to the
math fairly quickly; it is the intuition that is most diUcult for them.
money multiplier 1/reserve ratio=
Chapter 29/The Monetary System ❖ 482
D. Bank Capital, Leverage, and the Financial Crisis of 2008–2009
1. In reality, banks also get funds from issuing debt and equity.
2. De<nition of bank capital: the resources a bank’s owners have put into
the institution.
3. A more realistic balance sheet for a bank:
MORE REALISTIC NATIONAL BANK
Assets Liabilities and Owners' Equity
Reserves $200.00 Deposits $800.00
Loans $700.00 Debt $150.00
Securities $100.00 Capital (owner’s
equity)
$50.00
4. De<nition of leverage: the use of borrowed money to supplement existing
funds for purposes of investment.
5. De<nition of leverage ratio: the ratio of assets to bank capital.
a. The leverage ratio is $1,000/$50 = 20.
b. A leverage ratio of 20 means that, for every dollar of capital that has been
contributed by the owners, the bank has $20 of assets.
c. Because of leverage, a small change in assets can lead to a large change in
owner’s equity.
6. De<nition of capital requirement: a government regulation specifying a
minimum amount of bank capital.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
483 ❖ Chapter 29/The Monetary System
7. In 2008 and 2009, many banks realized they had incurred sizable losses on some
of their assets.
IV. The Fed’s Tools of Monetary Control
A. How the Fed In>uences the Quantity of Reserves
1. Open-Market Operations
a. De<nition of open-market operations: the purchase and sale of U.S.
government bonds by the Fed.
b. If the Fed wants to increase the supply of money, it creates dollars and uses
them to purchase government bonds from the public in the nation's bond
markets.
c. If the Fed wants to lower the supply of money, it sells government bonds from
its portfolio to the public in the nation's bond markets. Money is then taken
out of the hands of the public and the supply of money falls.
d. If the sale or purchase of government bonds a?ects the amount of deposits in
the banking system, the e?ect will be made larger by the money multiplier.
e. Open market operations are easy for the Fed to conduct and are therefore the
tool of monetary policy that the Fed uses most often.
2. Fed Lending to Banks
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
You may wish to use T-accounts to show the e?ects of an open market
purchase or sale. This way, students can see that the e?ect of an open
market operation can be quite large because of the money multiplier.
Chapter 29/The Monetary System ❖ 484
a. The Fed can also lend reserves to banks.
b. De<nition of discount rate: the interest rate on the loans that the Fed
makes to banks.
c. A higher discount rate discourages banks from borrowing from the Fed and
likely encourages banks to hold onto larger amounts of reserves. This in turn
lowers the money supply.
d. A lower discount rate encourages banks to lend their reserves (and borrow
from the Fed). This will increase the money supply.
e. In recent years, the Fed has set up new mechanisms for banks to borrow from
the Fed.
B. How the Fed In>uences the Reserve Ratio
1. Reserve Requirements
a. De<nition of reserve requirements: regulations on the minimum
amount of reserves that banks must hold against deposits.
b. This can a?ect the size of the money supply through changes in the money
multiplier.
c. The Fed rarely uses this tool because of the disruptions in the banking
industry that would be caused by frequent alterations of reserve
requirements. (It is also not e?ective when banks hold a lot of excess
reserves.)
2. Paying Interest on Reserves
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
485 ❖ Chapter 29/The Monetary System
a. In October of 2008, the Fed began paying banks interest on reserves.
b. The higher the interest rate, the more reserves a bank will want to hold. This
will reduce the money multiplier and the money supply.
C. Problems in Controlling the Money Supply
1. The Fed does not control the amount of money that consumers choose to deposit
in banks.
a. The more money that households deposit, the more reserves the banks have,
and the more money the banking system can create.
b. The less money that households deposit, the less reserves banks have, and
the less money the banking system can create.
2. The Fed does not control the amount that bankers choose to lend.
a. The amount of money created by the banking system depends on loans being
made.
b. If banks choose to hold onto a greater level of reserves than required by the
Fed (called excess reserves), the money supply will fall.
3. Therefore, in a system of fractional-reserve banking, the amount of money in the
economy depends in part on the behavior of depositors and bankers.
4. Because the Fed cannot control or perfectly predict this behavior, it cannot
perfectly control the money supply.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Chapter 29/The Monetary System ❖ 486
D. Case Study: Bank Runs and the Money Supply
1. Bank runs create a large problem under fractional-reserve banking.
2. Because the bank only holds a fraction of its deposits in reserve, it will not have
the funds to satisfy all of the withdrawal requests from its depositors.
3. Today, deposits are guaranteed through the Federal Depository Insurance
Corporation (FDIC).
Activity 2—Money Creation
Type: In-class demonstration
Topics: The banking system and deposit expansion
Materials needed: two volunteers, a paper with “$1,000” written on it
Time: 25 minutes
Class limitations: Works in any size class
Purpose:
This activity demonstrates the role of the banking system in expanding the money
supply.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
487 ❖ Chapter 29/The Monetary System
The Federal Reserve also conducts open-market operations. Use the $1,000 paper
to buy a baseball cap from a student. (Explain that the Fed actually buys
government bonds from the public because the market for used baseball caps is
small.)
The capless student now has $1,000 to spend with any other member of the class.
This student receives $1,000 and puts it in the bank of his or her choice.
The bank now has $1,000 in deposits (a liability) and $1,000 in cash (an asset).
The bank needs to keep $200 in reserve (20%) but can loan the other $800. Have
the banker tear o? 20% of the bill and give the rest to another student.
Revise the banks' balance sheets.
Now the borrower spends the $800 and the recipient deposits it in a bank. This
bank now has $800 in deposits and $800 in cash. Of that, $160 needs to be kept
in reserve and $640 can be lent. Have the banker save 20% of the paper and give
the rest to another eager borrower.
Revise the banks' balance sheets.
E. The Federal Funds Rate
1. De<nition of federal funds rate: the short-term interest rate that banks
charge one another for loans.
2. When the federal funds rate rises or falls, other interest rates often move in the
same direction.
3. In recent years, the Fed has set a target for the federal funds rate.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Chapter 29/The Monetary System ❖ 488
F. In the News: A Trip to Jekyll Island
1. In spite of many examples of its positive e?ects on the economy, the Fed still
faces public scorn and mistrust.
2. This Los Angeles Times article describes the story of the creation of the Fed and
the public’s paranoia associated with the central bank.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
