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73
CHAPTER 4
The Monetary System: What It Is,
and How It Works
Notes to the Instructor
Chapter Summary
This chapter presents standard material defining what money is and explaining how the money
supply process works. The chapter begins by describing the functions and types of money along
Comments
The material in this chapter can be covered in one or two lectures. Students sometimes confuse
the money multiplier with the concept of aggregate demand multipliers presented in Chapter 11
(and which they may have studied in a principles of economics course). I find it useful to
highlight the difference between these multipliers.
Use of the Web Site
The data plotter can provide students the opportunity to explore the relative importance of
currency compared with demand deposits in measuring the money supply.
Use of the Dismal Scientist Web Site
Go to the Dismal Scientist Web site and download monthly data over the past two years for the
money supply (M1) and the monetary base (currency held by the public plus reserves held by
Chapter Supplements
This chapter includes the following supplements:
4-2 If You Think the Island of Yap Has Problems… (Case Study)
4-4 Financial Innovation, Near Money, and the Demise of Monetary Aggregates
4-6 Additional Readings
74 | CHAPTER 4 The Monetary System: What It Is, and How It Works
!Supplement 3-5,
“Economist’s
Terminology”
Lecture Notes
Introduction
This chapter introduces the concept of money and discusses how the money supply is
determined, highlighting the role of commercial banks in the monetary system. The chapter also
describes how central banks influence the money supply and considers problems of monetary
4-1 What Is Money?
Economists make a sharp distinction between money and income. Money, to an economist,
represents the stock of assets that are used to carry out transactions. Most important, money
includes currency—dollar bills and coins—as well as other assets, such as bank accounts.
Understanding money would seem to be central to understanding macroeconomics, but this task
is not straightforward. The mystery of money is the following: We carry around little pieces of
paper that are intrinsically worthless, yet we can go into a store, give up some of these pieces of
The Functions of Money
The traditional starting point for an analysis of money is in terms of the different functions that
money can serve. To develop an understanding of money, economists focus on three aspects, or
functions, of money: medium of exchange, store of value, and unit of account.
The medium-of-exchange function of money emphasizes that money makes exchange
easier. In an economy without money (a barter economy), people would spend a lot of time
carrying out exchanges. In such an economy, an economics professor who wanted a beer might
have to hunt around a long time for a bar that was willing to give her a beer in exchange for a
lecture on economics or an offprint of one of her articles. But in a monetary economy, she can
accept little green pieces of paper from her employer and use these to buy beer. The bar will
accept these pieces of paper because it, in turn, believes that others will accept the pieces of
paper, and so on. From this perspective, money has value because people expect it to have value.
This sounds tenuous, and it is. Monetary systems have often collapsed through
Lecture Notes | 75
!
Supplement 4-2,
“If You Think the
Island of Yap Has
Problems…”
The Types of Money
Historically, many different things have performed the roles of money, including seashells,
cigarettes, and precious metals such as gold, as well as little pieces of paper. The use of pieces of
paper was a gradual development as the government took a greater and greater interest in the
monetary system. Today, other pieces of paper— checks—also serve to facilitate payments, and
many transactions take place without any paper changing hands at all, in the form of electronic
transfers.
Case Study: Money in a POW Camp
In prisoner of war camps during World War II, cigarettes evolved as a form of commodity
money. Prisoners used cigarettes to trade the goods they received in Red Cross parcels because
this eliminated the need for a coincidence of wants before trade could take place.
The Development of Fiat Money
Case Study: Money and Social Conventions on the Island of Yap
The island of Yap in the Pacific used large stone wheels for money. Since these were difficult to
transport, transactions often took place without these stone wheels actually being moved at all;
instead, islanders simply traded claims to the stones for goods.
FYI: Bitcoin: The Strange Case of a Virtual Money
Bitcoin is a type of money that exists only in electronic form. Created in 2009 by anonymous
computer expert(s), bitcoin is not commodity money, since it has no intrinsic value, nor fiat
money, since it is not issued by government action. It is a medium of exchange that relies on
people’s accepting it in exchange. In this way, it is similar to the primitive money used on the
How the Quantity of Money Is Controlled
For a commodity money system, the supply of money is determined simply by the amount of the
commodity in existence, whereas for a fiat money system, the supply of money is controlled by
the government. The government’s control over the money supply is referred to as monetary
policy. In many countries, monetary policy is managed by an institution known as a central
76 | CHAPTER 4 The Monetary System: What It Is, and How It Works
!Table 4-1
!Supplement 4-3,
“More on Credit
Cards”
!Supplement 4-4,
“Financial
Innovation, Near
Money, and the
Demise of
Monetary
Aggregates.
rotate annually among the remaining eleven bank presidents. Nonvoting regional bank
presidents attend FOMC meetings and contribute to the discussion about policy. Although
members of the Board of Governors are appointed by the President of the United States and
confirmed by Congress, they have a 14-year tenure, so the Board is not completely under the
control of the current administration. The presidents of the regional Fed banks are chosen by the
How the Quantity of Money Is Measured
There are many different assets that have some money-like characteristics, such as currency,
checking accounts, savings accounts, money market funds, and other assets. Some of these serve
principally as a means of payment; others serve principally as a store of value; most fulfill both
M2 (M1 plus saving deposits, money market funds, and small time deposits).
FYI: How Do Credit Cards and Debit Cards Fit into the
Monetary System?
Although credit cards are used to make purchases, they are not really a method of “payment” but
instead a method of “deferring payment.” In effect, the credit card company is making a loan to
you. When you pay off the credit card bill at the end of the month by writing a check against
your checking account, you finally are making a payment. The balance in your checking account
is part of the money supply, but the outstanding debt on your credit card is not. A payment with
4-2 The Role of Banks in the Monetary System
The definition of the money supply that we generally use in macroeconomics is
100-Percent-Reserve Banking
If there were no banks in the economy, there would be no demand deposits, and so the money
!
Supplement 4-5,
“Checks without
and coin would be held as reserves—but there would instead be demand deposits equal to the
amount of currency. This can be illustrated in terms of the balance sheet of the banking sector,
which we assume consists of one bank. This bank has assets equal to the reserves it holds and
liabilities equal to the deposits of its customers. Under 100-percent-reserve banking, banks have
no influence on the money supply.
Fractional-Reserve Banking
In the real world, banks also make loans. Since banks do not anticipate that all their depositors
will want to withdraw all their money at once, they do not need to hold reserves equal to the
amount of deposits. Instead, they only hold a fraction of their deposits as reserves and loan out
the rest. This is known as fractional-reserve banking.
Suppose that, as before, the public deposits all its currency in the banking system. Thus,
there is no currency in the hands of the public. But now suppose that banks adopt a reserve–
deposit ratio (rr) of 20 percent, so that for every $1 of deposits, the banks hold $0.20 in reserves
Bank Capital, Leverage, and Capital Requirements
The model of the banking system presented above ignores the need for bank owners to have
some financial resources, known as bank capital, representing their equity stake in the bank. A
more realistic balance sheet for a bank would account for bank capital on the liability side and
would also include the debt issued by the bank in addition to deposits as liability items. The
asset side of the balance sheet would include bank investments in securities of the government
and private sector in addition to reserves and loans. Banks will allocate resources to these assets
require banks to hold sufficient capital, under what are known as capital requirements, to ensure
that they can pay off their depositors. Many banks ended up with too little capital during 2008
and 2009 as a result of losses on investments they had made in mortgage loans and mortgage-
backed securities. This capital shortage in turn led banks to reduce lending, contributing to the
downturn in the economy. To counteract this, the Treasury and Federal Reserve began to put
public funds into banks in an attempt to recapitalize the banking system.
4-3 How Central Banks Influence the Money Supply
Having described the functions of money, how it is measured, and the way in which the banking
system affects the amount of money in the economy, we now analyze how a central bank
influences the money supply. This role of the central bank is the key element of monetary policy.
78 | CHAPTER 4 The Monetary System: What It Is, and How It Works
A Model of the Money Supply
We now examine fractional-reserve banking more carefully, taking into account the interactions
among the central bank (Federal Reserve), households, and commercial banks. Some of the
economy’s notes and coin—the monetary base—is in general held by the public (C) and some is
held by banks as reserves (R). Letting B denote the monetary base, we have, by definition,
The currency–deposit ratio and the reserve–deposit ratio describe the behavior of the
public and of banks, respectively. We can now use these equations to find how the money
supply depends upon these two variables and on the monetary base. First, divide the second
equation by the first to get
M
B=C+D
C+R
The term (cr + 1)/(cr + rr) is known as the money multiplier, since it shows how each dollar of
the monetary base is multiplied up to give a larger value for the money supply. For example, if
the reserve–deposit ratio is 10 percent and the currency–deposit ratio is 40 percent, then the
The Instruments of Monetary Policy
This chapter makes the simplifying assumption that the Federal Reserve controls the money
supply directly. But in reality, the Fed has only indirect control over the money supply using a
variety of instruments. These instruments can be categorized as those that affect the monetary
base and those that affect the reserve–deposit ratio and thereby the money multiplier.
Lecture Notes | 79
!Figure 4-1
!
Table 4-2
including the Term Auction Facility. Under this facility, the Fed sets the quantity of reserves it
desires to lend and banks then bid for the funds. The last auction under this facility was held in
2010.
Case Study: Quantitative Easing and the Exploding Monetary
Base
The monetary base has typically grown gradually over time, but from 2007–2014 it expanded
rapidly, increasing about fivefold in size. This explosion in the monetary base resulted from the
Federal Reserve acting boldly during the financial crisis and economic recession as a lender of
last resort. Initially, the Fed purchased mortgage-backed securities to help stabilize the mortgage
market so that potential homeowners could borrow. Later, the Fed purchased long-term
government bonds with the goal of keeping long-term interest rates low. This policy of
quantitative easing is similar to an open-market operation, except that long-term, somewhat
riskier securities are purchased rather than short-term Treasury bills.
Problems in Monetary Control
By using its various instruments, the Fed can powerfully influence the money supply. But it does
not have perfect control. Bank decisions to increase holdings of excess reserves will increase the
reserve–deposit ratio and lower the money supply. The Fed also cannot fully control the amount
that banks borrow from the discount window. If banks reduce their borrowing, the monetary
base and money supply will decrease.
Case Study: Bank Failures and the Money Supply in the 1930s
Chapter 12 discusses how some economists believe that a large decline in the money supply
during the early 1930s was the main cause of the Great Depression. But exactly why did the
money supply fall so dramatically? Interestingly, between August 1929 and March 1933 the
4-4 Conclusion
This chapter has explained the nature of money and how central banks influence its supply. The
81
LECTURE SUPPLEMENT
4-1 Money as a Medium of Exchange: The Search Model
Nobuhiro Kiyotaki and Randall Wright have developed a theory of money that explicitly recognizes how
fiat monies may evolve to facilitate transactions.1 That is, they show how a generally accepted money can
alleviate the “double coincidence of wants” problem that arises in a barter economy.
Kiyotaki and Wright imagine a world in which individuals must search for one another to carry out
trades. Think of a world with lots of different commodities, which we can think of as fruit. Suppose for
simplicity that everyone owns a fruit tree. Unfortunately, nobody likes the fruit of their own tree, and
everyone likes only some fraction of the other fruits in the economy. (For example, you might own a
banana tree but like only apples and pears, while your neighbor has a cherry tree but eats only mangoes
and papaya.) Suppose also that trading involves a transaction cost.
CASE STUDY EXTENSION
4-2 If You Think the Island of Yap Has Problems….
“[T]here are three freely convertible currencies in the Galaxy, but none of them counts. The Altairian
dollar has recently collapsed, the Flainian Pobble Bead is only exchangeable for other Flainian Pobble
83
LECTURE SUPPLEMENT
4-3 More on Credit Cards
As discussed in the text, although credit cards are used to make transactions, they are not a method of
payment but instead are a mechanism for deferring payment. Unlike a check or debit card, a credit card
does not represent a claim on funds in a deposit account. Accordingly, measures of the money supply,
such as M1 and M2, which are defined to include deposits in checking and saving accounts, do not include
84 | CHAPTER 4 The Monetary System: What It Is, and How It Works
84
LECTURE SUPPLEMENT
4-4 Financial Innovation, Near Money, and the Demise of the Monetary
Aggregates
The distinction between monetary and nonmonetary assets is becoming more blurred over time, largely as
a result of rapid financial innovation in recent years. Assets included in a narrow definition of money, such
as checking accounts, were once a good medium of exchange but a poor store of value. But now that
checking accounts pay interest, they are a better store of value. Assets such as mutual funds were once a
good store of value but a poor medium of exchange. Now depositors often can write checks on these
accounts, so they also serve as a medium of exchange. Such assets are often called near money.
A consequence is that the velocity of money, by any given definition, is likely to be unstable, because
near money assets are good substitutes. This makes policymaking difficult for the Federal Reserve. In
ADDITIONAL CASE STUDY
4-5 Checks Without Banks: The Irish Banking Strike
Since banks create money under fractional-reserve banking, we would expect the closure of banks to
severely disrupt the functioning of an economy. The Irish experience in 1970 (studied by the Irish
economist Antoin Murphy) provides an interesting counterexample.1 In that year, a major strike closed all
Irish banks for six and a half months. All the indications from the start, moreover, were that this would be
According to Murphy, it was the small size of the Irish economy (the population of Ireland was about
3 million at that time) and the high degree of personal contact that allowed the system to function. Stores
and pubs took over some of the functions of the banking system. “It appears that the managers of these
retail outlets and public houses had a high degree of information about their customers—one does not after
all serve drink to someone for years without discovering something of his liquid resources. This
LECTURE SUPPLEMENT
4-6 Additional Readings
Two general interest books on the Federal Reserve under Alan Greenspan are Steven K. Beckner, Back
