Macroeconomics

N. Gregory Mankiw

The Monetary
System: What it
Is and How It
Works

Presentation Slides

© 2019 Worth Publishers, all rights reserved

 IN THIS CHAPTER, YOU WILL LEARN:

The definition, functions, and

types of money
How banks “create” money
What a central bank is and
how it controls the money
supply

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 Macroeconomic Concerns

Three of the major concerns of macroeconomics are

Output growth

Unemployment

Inflation and deflation

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  FIGURE 5.3 The Circular Flow of Payments

Households receive income from firms

and the government, purchase goods
and services from firms, and pay taxes
to the government.
They also purchase foreign-made
goods and services (imports).
Firms receive payments from
households and the government for
goods and services; they pay wages,
dividends, interest, and rents to
households and taxes to the
government.
The government receives taxes from
firms and households, pays firms and
households for goods and services—
including wages to government
workers—and pays interest and
transfers to households.
Finally, people in other countries
purchase goods and services
produced domestically (exports).
Note: Although not shown in this
diagram, firms and governments also
purchase imports.
© 2014 Pearson Education, Inc. 4 of 23
Money: Definition

Money is the stock of assets that can be readily used to

make transactions.
Money: Functions

• Medium of exchange
we use it to buy stuff

• Store of value
transfers purchasing power from the present to the future

• Unit of account
the common unit by which everyone measures prices and
values
Money: Types

1. Fiat money
• has no intrinsic value
• example: the paper currency we use
2. Commodity money
• has intrinsic value
• examples:
gold coins,
cigarettes in POW camps
NOW YOU TRY Discussion question

Which of these are money?

a. Currency
b. Checks
c. Deposits in checking accounts (“demand deposits”)
d. Credit cards
e. Certificates of deposit (“time deposits”)
Money: Examples, part 1

• Deposits in checking accounts (“demand deposits”)

• Yes, the funds in a checking account serve the three
purposes
• Checks
• The check itself is not money, but the funds in the
checking account are money
• Currency
• Yes; U.S. dollar bills, Mexican pesos, and other
currencies are all money
Money: Examples, part 2

• Certificates of deposit (“time deposits”), or CDs

• Depends on the length of time; they are a store of
value and are measured in money units (dollars, for
example) but are not easily spent (medium of
exchange)
• As you’ll see in a few slides, there are multiple
measures of the money supply
• Credit cards
• No, they are a means of deferred payment
• For credit card purchases, you agree to pay back your
credit card company in the future
Two definitions

• The money supply is the quantity of

money available in the economy.

• Monetary policy is control over the money

supply.
The central bank and monetary control

• Monetary policy is conducted by a country’s central

bank.

• The U.S. central bank is called the Federal Reserve (“the

Fed”).

• To control the money supply, the Fed uses

open-market operations, the purchase and sale of
government bonds.
 Money supply measures, July 2017

Amount in July 2017

Symbol Assets Included
(billions of dollars)
C Currency $ 1,486
M1 Currency plus demand deposits, 3,528
traveler’s checks, and other
checkable deposits
M2 M1 plus retail money market 13,602
mutual fund balances, saving
deposits (including money
market deposit accounts), and
small time deposits
Banks’ role in the monetary system, part 1

The money supply equals currency plus demand (checking

account) deposits

M=C+D

Since the money supply includes demand

deposits, the banking system plays an
important role.
A few preliminaries

• Reserves (R ): the portion of deposits that banks have

not lent.
• A bank’s liabilities include deposits; assets include
reserves and outstanding loans.
• 100-percent-reserve banking: a system in which banks
hold all deposits as reserves.
• Fractional-reserve banking:
a system in which banks hold a fraction of their deposits
as reserves.
Banks’ role in the monetary system, part 2

• To understand the role of banks, we will consider three

scenarios:
1. No banks
2. 100-percent-reserve banking (banks hold all deposits
as reserves)
3. Fractional-reserve banking (banks hold a fraction of
deposits as reserves, use the rest to make loans)
• In each scenario, we assume C = $1,000.
Scenario 1: No banks

With no banks,
D = 0 and M = C = $1,000.
Scenario 2: 100-percent-reserve banking

 Initially C = $1000, D = $0, M = $1,000

 Now suppose households deposit the $1,000 at
“Firstbank.

After the deposit:

C = $0,
FIRSTBANK’S balance sheet
D = $1,000,
M = $1,000
Assets Liabilities
LESSON:
Reserves $1,000 Deposits $1,000
100%-reserve
banking has no
impact on size of
money supply.
Scenario 3: Fractional-reserve banking (1 of 4)

• Suppose banks hold 20% of deposits in reserve, making

loans with the rest.
• Firstbank will make $800 in loans.
The money supply
FIRSTBANK’S balance sheet now equals $1,800:
• Depositor has
Assets Liabilities
$1,000 in
Reserves $200 Deposits $1,000 demand
Loans $800
deposits.
• Borrower
holds $800 in
currency.
Scenario 3: Fractional-reserve banking (2 of 4)

• Suppose banks hold 20% of deposits in reserve, making

loans with the rest.
• Firstbank will make $800 in loans.
The money supply
FIRSTBANK’S balance sheet now equals $1,800:
• Depositor has
Assets Liabilities
$1,000 in
Reserves $200 Deposits $1,000 demand
Loans $800
deposits.
• Borrower
holds $800 in
LESSON: In a fractional-reserve
currency.
banking system, banks create money.
Scenario 3: Fractional-reserve banking (3 of 4)

• Suppose the borrower deposits the $800 in Secondbank.

• Initially, Secondbank’s balance sheet is:

FIRSTBANK’S balance sheet

Assets Liabilities Secondbank will

Reserves $160 Deposits $800 loan 80% of this
Loans $640 deposit.
Scenario 3: Fractional-reserve banking (4 of 4)

• If this $640 is eventually deposited in Thirdbank,

• Then Thirdbank will keep 20% of it in reserve
and loan out the rest:

FIRSTBANK’S balance sheet

Assets Liabilities
Reserves $128 Deposits $640
Loans $512
Finding the total amount of money

Original deposit = $1000

+ Firstbank lending = $ 800
+ Secondbank lending = $ 640
+ Thirdbank lending = $ 512
+ other lending…

Total money supply = (1/rr ) × $1,000

where rr = ratio of reserves to deposits

In our example, rr = 0.2, so M = $5,000

Money creation in the banking system

A fractional-reserve banking system creates

money, but it doesn’t create wealth.
Bank loans give borrowers some new money
and an equal amount of new debt.
Bank capital, leverage, and capital requirements, part 1

• Bank capital: the resources a bank’s owners have

put into the bank
• A more realistic balance sheet:

Liabilities and Liabilities and

Assets Assets owners’ equity owners’ equity
Reserves $200 Deposits $750

Loans 500 Debt 200

Capital
Securities 300 (owners’ equity) 50
Bank capital, leverage, and capital requirements, part 2

Leverage: the use of borrowed money to supplement

existing funds for purposes of investment
Leverage ratio = Assets/Capital
= $(200 + 500 + 300)/$50 = 20
Liabilities and Liabilities and
Assets Assets owners’ equity owners’ equity
Reserves $200 Deposits $750

Loans 500 Debt 200

Capital
Securities 300 (owners’ equity) 50
Bank capital, leverage, and capital requirements, part 3

• Being highly leveraged makes banks vulnerable.

• Example: Suppose a recession causes our bank’s
assets to fall by 5%, to $950.
• Then, capital = assets – liabilities = 950 – 950 = 0
Liabilities and Liabilities and
Assets Assets owners’ equity owners’ equity
Reserves $200 Deposits $750

Loans 500 Debt 200

Capital
Securities 300 (owners’ equity) 50
 How the Federal Reserve Controls the Money Supply

The money supply is equal to the sum of deposits inside banks and the
currency in circulation outside banks.

If the Fed wants to increase the supply of money, it creates more reserves,
thereby freeing banks to create additional deposits by making more loans. If it
wants to decrease the money supply, it reduces reserves.

Three tools are available to the Fed for changing the money supply:

(1) Changing the required reserve ratio.

(2) Changing the discount rate.

(3) Engaging in open market operations.

© 2014 Pearson Education, Inc. 28 of 23

Bank capital, leverage, and capital requirements, part 4

Capital requirement:
• minimum amount of capital mandated by regulators
• intended to ensure that banks will be able to pay off
depositors
• higher for banks that hold more risky assets
2008–2009 financial crisis:
• Losses on mortgages shrank bank capital, slowed
lending, exacerbated the recession.
• Govt injected billions of dollars of capital into banks to
ease the crisis and encourage more lending.
A model of the money supply

Exogenous variables
• Monetary base, B = C + R
controlled by the central bank
• Reserve-deposit ratio, rr = R/D
depends on regulations and bank policies
• Currency-deposit ratio, cr = C/D
depends on households’ preferences
Solving for the money supply (1 of 2)

C +D
M =C +D = ×B = m×B
B
where :
C +D
m=
B
C + D C D  + D D  cr + 1
= = =
C + R C D  + R D  cr + rr
Solving for the money supply (2 of 2)

cr + 1
M = m × B, where m =
cr + rr

• If rr < 1, then m > 1

• If monetary base changes by ΔB, then ΔM = m × ΔB
• m is the money multiplier, the increase in the money
supply resulting from a one-dollar increase in the
monetary base.
NOW YOU TRY
The money multiplier

cr + 1
M = m × B, where m =
cr + rr

Suppose households decide to hold more of their money as

currency and less in the form of demand deposits.
1. Determine the impact on the money supply.

2. Explain the intuition for your result.

NOW YOU TRY
The money multiplier, solution
Impact of an increase in the currency-deposit ratio
Δcr > 0.
1. An increase in cr increases the denominator of m
proportionally more than the numerator. So m falls,
causing M to fall.
2. If households deposit less of their money, then banks
can’t make as many loans, so the banking system
won’t be able to create as much money.
The instruments of monetary policy, part 1

The Fed can change the monetary base by using:

• open market operations (the Fed’s preferred method
of monetary control)
• To increase the base, the Fed could buy
government bonds, paying with new dollars.
• the discount rate: the interest rate the Fed charges
on loans to banks
• To increase the base, the Fed could lower the
discount rate, encouraging banks to borrow more
reserves.
The instruments of monetary policy, part 2

The Fed can change the reserve–deposit ratio by using:

• reserve requirements: Fed regulations impose a
minimum reserve–deposit ratio.
• To reduce the reserve–deposit ratio, the Fed could
reduce reserve requirements.
• interest on reserves: The Fed pays interest on bank
reserves deposited with the Fed.
• To reduce the reserve–deposit ratio, the Fed could
pay a lower interest rate on reserves.
Why the Fed can’t precisely control M

cr + 1
M = m × B, where m =
cr + rr

• Households can change cr, causing m and M to change.

• Banks often hold excess reserves (reserves above the
reserve requirement).
If banks change their excess reserves, then rr, m, and M
change.
 CASE STUDY: Quantitative easing (1 of 2)

Monetary base
From 8/2008 to 8/2011,
the monetary base tripled,
but M1 grew only about 40%.
CASE STUDY: Quantitative easing (2 of 2)

• Quantitative easing: The Fed bought long-term govt

bonds instead of T-bills to reduce long-term rates.
• The Fed also bought mortgage-backed securities to help
the housing market.
• But after losses on bad loans, banks tightened lending
standards and increased excess reserves, causing the
money multiplier to fall.
• If banks start lending more as the economy recovers,
rapid money growth may cause inflation. To prevent
this, the Fed is considering various “exit strategies.”
CASE STUDY: Bank failures in the 1930s, part 1

• From 1929 to 1933:

• more than 9,000 banks closed
• the money supply fell 28%
• This drop in the money supply may not have caused the
Great Depression, but it certainly contributed to its
severity.
CASE STUDY: Bank failures in the 1930s, part 2

cr + 1
M = m × B, where m =
cr + rr

• Loss of confidence in banks:

increases cr, reduces m
• Banks became more cautious:
increases rr, reduces m
CASE STUDY: Bank failures in the 1930s, part 3

August 1929 March 1933 % change

M 26.5 19.0 −28.3%
C 3.9 5.5 41.0
D 22.6 13.5 −40.3
B 7.1 8.4 18.3
C 3.9 5.5 41.0
R 3.2 2.9 −9.4
m 3.7 2.3 −37.8
rr 0.14 0.21 50.0
cr 0.17 0.41 141.2
Could this happen again?

• Many policies have been implemented since the 1930s to

prevent such widespread bank failures.
• An example is federal deposit insurance to prevent bank
runs and large swings in the currency–deposit ratio.
 CHAPTER SUMMARY (1 of 3)
Money
• Definition: the stock of assets used for transactions
• Functions: medium of exchange, store of value, unit of
account
• Types: commodity money (has intrinsic value),
fiat money (no intrinsic value)
• Money supply controlled by the central bank

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 CHAPTER SUMMARY (2 of 3)
Fractional reserve banking creates money because each
dollar of reserves generates many dollars of demand
deposits.
The money supply depends on the:
• monetary base
• currency–deposit ratio
• reserve ratio
The Fed can control the money supply with:
 open market operations
 the reserve requirement
 the discount rate
 interest on reserves
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 CHAPTER SUMMARY (3 of 3)
Bank capital, leverage, and capital requirements
• Bank capital is the owners’ equity in the bank.
• Because banks are highly leveraged, a small decline in
the value of bank assets can have a huge impact on bank
capital.
• Bank regulators require that banks hold sufficient capital
to ensure that depositors can be repaid.

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