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264
WHAT’S NEW IN THE SEVENTH EDITION:
There is a new
In the News
box on “Why Gold?”
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.
CONTEXT AND PURPOSE:
Chapter 16 is the first chapter in a two-chapter sequence dealing with money and prices in the long run.
Chapter 16 describes what money is and develops how the Federal Reserve controls the quantity of
money. Because the quantity of money influences the rate of inflation in the long run, the following
chapter concentrates on the causes and costs of inflation.
The purpose of Chapter 16 is to help students develop an understanding of what money is, what
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 in which prices and other economic values are recorded. As a
store of value, it offers a way to transfer purchasing power from the present to the future.
16
THE MONETARY SYSTEM
Chapter 16/The Monetary System ❖ 265
• 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 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 influences the money supply in this
way, the Fed’s control of the money supply is imperfect.
CHAPTER OUTLINE:
I. The Meaning of Money
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 would prefer and why.
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 offers a free, 13-
minute video entitled “The Fed Today” that discusses the history and operations of
the Fed.
266 ❖ Chapter 16/The Monetary System
A. Definition 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. Definition of medium of exchange: an item that buyers give to sellers when they
want to purchase goods and services.
2. Definition 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.
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. Definition of commodity money: money that takes the form of a commodity with
intrinsic value.
2. Definition of fiat money: money without intrinsic value that is used as money
because of government decree.
3.
In the News: Why Gold?
a. Historically, societies have used gold, rather than other commodities, for commodity
money.
b. This article from
NPR Morning Edition
describes why gold is the best choice for
commodity money.
D. Money in the U.S. Economy
1. The quantity of money circulating in the United States is sometimes called the
money stock
.
Chapter 16/The Monetary System ❖ 267
3. Figure 1 shows the monetary assets included in two important measures of the money
supply, M1 and M2.
4.
FYI: Why Credit Cards Aren’t Money
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 find that the average adult should have approximately $4,490 in currency.
II. The Federal Reserve System
A. Definition of Federal Reserve (Fed): the central bank of the United States.
B. Definition of central bank: An institution designed to oversee the banking system and
regulate the quantity of money in the economy.
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 vault.
Make sure that students realize that the assets included in M1 and M2 differ 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 large time deposits.
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 a month.
268 ❖ Chapter 16/The Monetary System
C. The Fed’s Organization
1. The Fed is run by a Board of Governors with 7 members who serve 14-year terms.
a. The Board of Governors has a chairman who is appointed for a four-year term.
b. The current chairman is Ben Bernanke.
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
Information about the structure of the Federal Reserve can be found in the seal to the left of
Washington’s portrait. The writing around the seal says “Federal Reserve Bank of
___________.”
If the class is big enough, all 12 Federal Reserve Banks will be represented: Boston, New
York, Philadelphia, Richmond, Atlanta, Cleveland, Chicago, St. Louis, Minneapolis, Kansas City,
Dallas, and San Francisco.
This is a good place to introduce the Federal Reserve Districts, and the Banks’ roles in those
regions. These include check clearing, holding commercial bank reserves, supplying currency,
lending to commercial banks, and collecting and analyzing regional economic data.
Chapter 16/The Monetary System ❖ 269
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.
4. The second job of the Fed is to control the quantity of money available in the economy.
a. Definition of money supply: the quantity of money available in the economy.
b. Definition 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.
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.
III. Banks and the Money Supply
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.
The process of money creation in the banking system is one of the more difficult
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 deposits and giving out loans.
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 off dollar bills and not
just guessing the names of large cities.
270 ❖ Chapter 16/The Monetary System
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.
3. The financial 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 influence the supply of
money.
B. Money Creation with Fractional-Reserve Banking
1. Definition of fractional-reserve banking: a banking system in which banks hold only
a fraction of deposits as reserves.
4. The bank’s T-account would look like this:
FIRST NATIONAL BANK
Assets
Liabilities
Reserves
$10.00
Deposits
$100.00
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.
Chapter 16/The Monetary System ❖ 271
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.
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.
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. Definition 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.
money multiplier 1/reserve ratio=
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 difficult for them.
ALTERNATIVE CLASSROOM EXAMPLE:
Reserve ratio = 12.5%
Money multiplier = 1/0.125 = 8
272 ❖ Chapter 16/The Monetary System
D. Bank Capital, Leverage, and the Financial Crisis of 2008–2009
1. In reality, banks also get funds from issuing debt and equity.
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. Definition of leverage: the use of borrowed money to supplement existing funds for
purposes of investment.
5. Definition of leverage ratio: the ratio of assets to bank capital.
a. The leverage ratio is $1,000/$50 = 20.
6. Definition of capital requirement: a government regulation specifying a minimum
amount of bank capital.
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 Influences the Quantity of Reserves
1. Open-Market Operations
a. Definition 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.
Chapter 16/The Monetary System ❖ 273
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
a. The Fed can also lend reserves to banks.
b. Definition of discount rate: the interest rate on the loans that the Fed makes to
banks.
B. How the Fed Influences the Reserve Ratio
1. Reserve Requirements
a. Definition of reserve requirements: regulations on the minimum amount of
reserves that banks must hold against deposits.
2. Paying Interest on Reserves
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.
You may wish to use T-accounts to show the effects of an open market purchase or
sale. This way, students can see that the effect of an open market operation can be
quite large because of the money multiplier.
274 ❖ Chapter 16/The Monetary System
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.
D.
Case Study: Bank Runs and the Money Supply
1. Bank runs create a large problem under fractional-reserve banking.
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.
Instructions
The two volunteers are bankers. Have each of them draw a balance sheet on the board.
BankTwo AmerBankCorp
Assets Liabilities Assets Liabilities
0 0 0 0
Chapter 16/The Monetary System ❖ 275
E. The Federal Funds Rate
1. Definition of federal funds rate: the short-term interest rate that banks charge one
another for loans.
F.
In the News: Bernanke on the Fed’s Toolbox
1. During the financial crisis of 2008 and 2009, the Fed expanded reserves to help struggling
banks.
2. This is an article written by Fed chairman, Ben Bernanke, discussing the Fed’s options for
reversing this policy once the economy recovers from this deep recession.
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.)
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.
Continue this process for a few more iterations.
At the end, ask everyone who has money in the bank to stand. The total deposits in the bank
will far exceed the initial $1,000 that the Fed put into the economy.
Show the final balance sheet for each bank.
Points for Discussion
Banks are important to the process of money creation. The banking system, as a whole,
literally expands the money supply.
If the process is carried on far enough, you can derive the money multiplier.
276 ❖ Chapter 16/The Monetary System
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. The three functions of money are: (1) medium of exchange; (2) unit of account; and (3)
Questions for Review
1. Money is different from other assets in the economy because it is the most liquid asset
3. Demand deposits are balances in bank accounts that depositors can access on demand
Chapter 16/The Monetary System ❖ 277
8. The discount rate is the interest rate on loans that the Federal Reserve makes to banks. If
Quick Check Multiple Choice
1. c
Problems and Applications
1. a. A U.S. penny is considered money in the U.S. economy because it is used as a medium
278 ❖ Chapter 16/The Monetary System
2. When your uncle repays a $100 loan from Tenth National Bank (TNB) by writing a check
from his TNB checking account, the result is a change in the assets and liabilities of both
your uncle and TNB, as shown in these T-accounts:
Your Uncle
Assets
Liabilities
3. a. Here is BSB's T-account:
Beleaguered State Bank
Assets
Liabilities
4. If you take $100 that you held as currency and put it into the banking system, then the total
Chapter 16/The Monetary System ❖ 279
5. a.
Happy Bank
Assets
Liabilities
c.
Happy Bank
Assets
Liabilities
6. With a required reserve ratio of 10%, the money multiplier could be as high as 1/0.10 = 10,
8. a. With a required reserve ratio of 10% and no excess reserves, the money multiplier is
280 ❖ Chapter 16/The Monetary System
e. If people hold equal amounts of currency (
C
) and demand deposits (
D
) and the money
