The Monetary System

Subhashree Banerjee
 What Money Is, and Why It’s
Important
• Without money, trade would require barter, the exchange of one
good or service for another.
• Every transaction would require a double coincidence of wants –
the unlikely occurrence that two people each have a good the
other wants.
• “Double coincidence of wants” simply means that two people
have to want each other’s stuff.
• Most people would have to spend time searching for others to
trade with – a huge waste of resources.
• This searching is unnecessary with money, the set of assets that
people regularly use to buy g&s from other people.
 The Functions of Money
• Money has three functions in the economy:
• Medium of exchange
• Unit of account
• Store of value
The Functions of Money
• Medium of Exchange
• A medium of exchange is an item that buyers give to
sellers when they want to purchase goods and services.
• A medium of exchange is anything that is readily
acceptable as payment.
• That just means you use money to buy stuff.
 The Functions of Money
• Unit of Account
• A unit of account is the yardstick people use to post prices and record debts.
• The price or monetary value of virtually everything is measured in the same units – Rupees.
• Imagine how hard it would be to plan your budget or comparison shop if sellers each used
their own system of measuring prices.

• Store of Value
• A store of value is an item that people can use to transfer purchasing power from the
present to the future.
• Money holds its value over time, so you don’t have to spend it immediately upon receiving
it.
The Functions of Money
• Liquidity is the ease with which an asset can be converted into the
economy’s medium of exchange.
 The 2 Kinds of Money
Commodity money:
takes the form of a commodity with intrinsic value
Examples: gold coins, cigarettes
• Intrinsic value means the commodity would have value even if it
weren’t being used as money.
• In the film “The Shawshank Redemption,” prisoners use cigarettes as
money.

Fiat money:
money without intrinsic value, used as money
because of govt decree
• It does not have intrinsic value.
• Examples: Coins, currency, check
deposits.
 The Money Supply
• The money supply (or money stock): the quantity of money
available in the economy
• What assets should be considered part of the money supply?
Here are two candidates:
• Currency: the paper bills and coins in the hands of the (non-
bank) public
• Demand deposits: balances in bank accounts that depositors
can access on demand by writing a check
 Measures of the U.S. Money Supply
• M1: currency, demand deposits, traveler’s checks, and other checkable
deposits. M1 = $1.4 trillion (October 2005)
• M2: everything in M1 plus savings deposits, small time deposits, money
market mutual funds, and a few minor categories. M2 = $6.6 trillion
(October 2005)

The distinction between M1 and M2

will usually not matter when we talk about
“the money supply” in this course.

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Two Measures of the Money Stock for
the U.S. Economy
Billions
of Dollars
M2
$6,398
•Savings deposits
•Small time deposits
•Money market
mutual funds
•A few minor categories
($5,035 billion)

M1
$1,363
• Demand deposits
•Everything in M1
• Traveler ’s checks
($1,363 billion)
• Other checkable deposits
($664 billion)
• Currency
($699 billion)
0
Central Banks & Monetary Policy
• Central bank: an institution that oversees the banking system and
regulates the money supply
• Monetary policy: the setting of the money supply by policymakers
in the central bank
• Federal Reserve (Fed): the central bank of the U.S. (RBI)
THE FEDERAL RESERVE SYSTEM
• The Federal Reserve (Fed) serves as the nation’s
central bank.
• It is designed to oversee the banking system.
• It regulates the quantity of money in the economy.
THE FEDERAL RESERVE SYSTEM
• The Fed was created in 1913 after a series of bank
failures convinced Congress that the United States
needed a central bank to ensure the health of the
nation’s banking system.
THE FEDERAL RESERVE SYSTEM
• The primary elements in the Federal Reserve System
are:
• The Board of Governors
• The Regional Federal Reserve Banks
• The Federal Open Market Committee
The Fed’s Organization
• The Fed is run by a Board of Governors, which has seven
members appointed by the president and confirmed by the
Senate.
• Among the seven members, the most important is the
chairman.
• The chairman directs the Fed staff, presides over board meetings,
and testifies about Fed policy in front of Congressional
Committees.
The Fed’s Organization
• The Board of Governors
• Serve staggered 14-year terms so that one comes vacant
every two years.
• President appoints a member as chairman to serve a four-
year term.
The Fed’s Organization
• Three Primary Functions of the Fed
• Regulates banks to ensure they follow federal laws
intended to promote safe and sound banking practices.
• Acts as a banker’s bank, making loans to banks and as a
lender of last resort.
• Conducts monetary policy by controlling the money
supply.
The Federal Open Market
Committee (FOMC)
• Serves as the main policy-making organ of the Federal
Reserve System.
• Meets approximately every six weeks to review the
economy.
The Federal Open Market
Committee (FOMC)
• The Federal Open Market Committee (FOMC) is made up of
the following voting members:
• The chairman and the other six members of the Board of
Governors.
• The president of the Federal Reserve Bank of New York.
• The presidents of the other regional Federal Reserve banks (four
vote on a yearly rotating basis).
The Federal Open Market
Committee (FOMC)
• Monetary policy is conducted by the Federal Open
Market Committee.
• The money supply refers to the quantity of money
available in the economy.
• Monetary policy is the setting of the money supply by
policymakers in the central bank.
The Federal Open Market
Committee
• Open-Market Operations
• The money supply is the quantity of money available in
the economy.
• The primary way in which the Fed changes the money
supply is through open-market operations.
• The Fed purchases and sells U.S. government bonds.
The Federal Open Market
Committee
• Open-Market Operations
• To increase the money supply, the Fed buys government
bonds from the public.
• To decrease the money supply, the Fed sells government
bonds to the public.
BANKS AND THE MONEY SUPPLY

• Banks can influence

the quantity of
demand deposits in
the economy and
the money supply.
 Bank Reserves
• Reserves are deposits that banks have received but have not
loaned out.
• In a fractional reserve banking system, banks keep a fraction of
deposits as reserves, and use the rest to make loans.
• The Fed establishes reserve requirements, regulations on the
minimum amount of reserves that banks must hold against
deposits.
• Banks may hold more than this minimum amount if they choose.
• The reserve ratio, R
= fraction of deposits that banks hold as reserves
= total reserves as a percentage of total deposits
 Bank T-account
• T-account: a simplified accounting statement that shows a bank’s assets &
liabilities.
• Example:
FIRST NATIONAL BANK
Assets Liabilities
Reserves $ 10 Deposits $100
Loans $ 90

 Banks’ liabilities include deposits, assets include

loans & reserves.
 In this example, notice that R = $10/$100 = 10%.
 Banks and the Money Supply: An
Example
Suppose $100 of currency is in circulation.
To determine banks’ impact on money supply, we calculate the money
supply in 3 different cases:
1. No banking system
2. 100% reserve banking system: banks hold 100% of deposits as
reserves, make no loans
3. Fractional reserve banking system
 Banks and the Money Supply: An
Example
CASE 1: no banking system
Public holds the $100 as currency.
Money supply = $100.
 Banks and the Money Supply: An
Example
CASE 2: 100% reserve banking system
Public deposits the $100 at First National Bank (FNB).

FNB holds
100% of FIRST NATIONAL BANK
deposit Assets Liabilities
as reserves: Reserves $100 Deposits $100
Loans $ 0
Money supply
= currency + deposits = $0 + $100 = $100
In a 100% reserve banking system,
banks do not affect size of money supply.
Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system

Suppose R = 10%. FNB loans all but 10%

of the deposit:
FIRST NATIONAL BANK
Assets Liabilities
Reserves $100
10 Deposits $100
Loans $ 90
0

Money supply = $190 (!!!)

depositors have $100 in deposits,
borrowers have $90 in currency.
 Banks and the Money Supply: An
Example
CASE 3: fractional reserve banking system
How did the money supply suddenly grow?
When banks make loans, they create money.
The borrower gets
• $90 in currency (an asset counted in the
money supply)
• $90 in new debt (a liability)

A fractional reserve banking system creates

money, but not wealth.
 Banks and the Money Supply: An
Example
CASE 3: fractional reserve banking system
Suppose borrower deposits the $90 at Second National
Bank (SNB).

Initially, SNB’s SECOND NATIONAL BANK

T-account looks Assets Liabilities
like this: Reserves $ 909 Deposits $ 90
Loans $ 81
0

If R = 10% for SNB, it will loan all but 10% of the

deposit.
Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system
The borrower deposits the $81 at Third National Bank
(TNB).

Initially, TNB’s THIRD NATIONAL BANK

T-account looks Assets Liabilities
like this: Reserves $$8.10
81 Deposits $ 81
Loans $ 0
$72.90

If R = 10% for TNB, it will loan all but 10% of the

deposit.
The Money Multiplier
Increase in the Money Supply = $190.00!
First National Bank Second National Bank
Assets Liabilities Assets Liabilities

Reserves Deposits Reserves Deposits

$10.00 $100.00 $9.00 $90.00

Loans Loans
$90.00 $81.00

Total Assets Total Liabilities Total Assets Total Liabilities

$100.00 $100.00 $90.00 $90.00
 Banks and the Money Supply: An
Example
CASE 3: fractional reserve banking system
The process continues, and money is created with each
new loan.

$ In
In this
this
example,
example,
100.00 $100
$100 ofof
$ reserves
reserves
Original deposit = generate
generate
FNB lending = 90.00 $1000
$1000 of of
SNB lending = $ money.
money.
TNB lending =
.. 81.00
.
 The Money Multiplier
• Money multiplier: the amount of money the banking system
generates with each dollar of reserves
• The money multiplier equals 1/R.
• In our example,
R = 10%
money multiplier = 1/R = 10
$100 of reserves creates $1000 of money
The Money Multiplier
• The money multiplier is the reciprocal of the reserve ratio:
M = 1/R
• Example:
• With a reserve requirement, R = 20% or .2:
• The money multiplier is 1/.2 = 5.
 A C T I V E L E A R N I N G 1:
Exercise
While cleaning your apartment, you look under the sofa cushion find
a $50 bill (and a half-eaten taco). You deposit the bill in your
checking account.
The Fed’s reserve requirement is 20% of deposits.

A. What is the maximum amount that the money supply could

increase?
B. What is the minimum amount that the money supply could
increase?
 A C T I V E L E A R N I N G 1:
Answers
You deposit $50 in your checking account.
A. What is the maximum amount that the money supply could
increase?
If banks hold no excess reserves, then
money multiplier = 1/R = 1/0.2 = 5
The maximum possible increase in deposits is
5 x $50 = $250
But money supply also includes currency, which falls by $50.
Hence, max increase in money supply = $200.

38
 A C T I V E L E A R N I N G 1:
Answers
You deposit $50 in your checking account.
A. What is the maximum amount that the money supply could
increase?
Answer: $200
B. What is the minimum amount that the money supply could
increase?
Answer: $0
If your bank makes no loans from your deposit, currency falls
by $50, deposits increase by $50, money supply remains
unchanged.

39
The Fed’s 3 Tools of Monetary Control
1. Open-Market Operations (OMOs): the purchase and
sale of U.S. government bonds by the Fed.
 To increase money supply, Fed buys govt bonds,
paying with new dollars.
…which are deposited in banks, increasing reserves
…which banks use to make loans, causing the
money supply to expand.
 To reduce money supply, Fed sells govt bonds,
taking dollars out of circulation, and the process
works in reverse.
The Fed’s 3 Tools of Monetary Control
1. Open-Market Operations (OMOs): the purchase and
sale of U.S. government bonds by the Fed.
 OMOs are easy to conduct, and are the Fed’s
monetary policy tool of choice.
The Fed’s 3 Tools of Monetary Control
2. Reserve Requirements (RR).
Affect how much money banks can create by making
loans.

 To increase money supply, Fed reduces RR.

Banks make more loans from each dollar of reserves,
which increases money multiplier and money supply.
 To reduce money supply, Fed raises RR,
and the process works in reverse.
 Fed rarely uses reserve requirements to control
money supply: Frequent changes would disrupt
banking.
The Fed’s 3 Tools of Monetary Control
3. The Discount Rate:
the interest rate on loans the Fed makes to banks

 When banks are running low on reserves,

they may borrow reserves from the Fed.
 To increase money supply,
Fed can lower discount rate, which encourages
banks to borrow more reserves from Fed.
 Banks can then make more loans, which increases
the money supply.
 To reduce money supply, Fed can raise discount rate.
The Fed’s 3 Tools of Monetary Control
3. The Discount Rate:
the interest rate on loans the Fed makes to banks

 The Fed often uses discount lending to provide extra

liquidity when financial institutions are in trouble,
such as after the stock market crash of Oct. 1987.
The Federal Funds Rate
• On any given day, banks with insufficient reserves can
borrow from banks with excess reserves.
• The interest rate on these loans is the federal funds
rate.
• Many interest rates are highly correlated,
so changes in the fed funds rate cause changes in other
rates and have a big impact in the economy.
• The FOMC uses OMOs to target the fed funds rate.
• So fed funds rate policy & monetary policy are
connected.
 The Federal Funds Rate
To raise fed funds The Federal
rate, Fed sells federal rff Funds market
govt bonds (OMO). funds rate S2 S1
This removes
reserves from the 3.75%
banking system,
reduces the supply 3.50%
of fed funds,
causes rff to rise.
D1
F
F2 F1
quantity of
federal funds
• The demand for federal funds comes from banks that find themselves with insufficient reserves,
perhaps because they made too many loans or had higher-than-expected withdrawals.

• The supply of federal funds comes from banks that find themselves with more reserves than they want,
perhaps because they had lower-than-expected withdrawals, or because few customers took out loans.

• The federal funds rate adjusts to balance the supply of and demand for federal funds.

• The Federal Reserve can use OMOs to target the fed funds rate.

• Whenever the rate starts to fall below the Fed’s target, the Fed sells government bonds in the open
market in order to pull reserves out of the banking system, which raises the rate as shown in this
diagram.

• If the rate rises above the Fed’s target, the Fed buys govt bonds in the open market, injecting reserves
into the banking system, and pushing the rate down.

• For the Fed, OMOs are quick, easy, and effective, so the Fed can keep the fed funds rate very close to
the target. THE MONETARY SYSTEM 47
 Problems Controlling the Money
Supply
• If households hold more of their money as currency, banks have fewer
reserves, make fewer loans, & money supply falls.
• If banks hold more reserves than required, they make fewer loans, &
money supply falls.
• Yet, Fed can compensate for household & bank behavior to retain fairly
precise control over the money supply.
 Bank Runs and the Money Supply
• A run on banks:
When people suspect their banks are in trouble, they may “run” to the
bank to withdraw their funds, holding more currency and less deposits.
• Under fractional-reserve banking, banks don’t have enough reserves to
pay off ALL depositors, hence banks may have to close.
• Also, banks may make fewer loans & hold more reserves to satisfy
depositors.
• These events increase R, reverse the process of money creation, cause
money supply to fall.
Bank Runs and the Money Supply

• During 1929-1933, a wave of bank runs and bank

closings caused money supply to fall 28%.
• Many economists believe this contributed to the
severity of the Great Depression.
• Bank runs not a problem today due to federal deposit
insurance.
 Reserve Bank of India
• Established on April 1, 1935 in accordance with the provisions of the Reserve Bank of
India Act, 1934.
• Initially established in Kolkata but was permanently moved to Mumbai in 1937. The
Central Office is where the Governor sits and where policies are formulated.
• The Reserve Bank's affairs are governed by a central board of directors. The board is
appointed by the Government of India in keeping with the Reserve Bank of India Act.
• Constitution:
• Official Directors
• Full-time : Governor and not more than four Deputy Governors
• Non-Official Directors
• Nominated by Government: ten Directors from various fields and two government Official
• Others: four Directors - one each from four local boards
THE MONETARY SYSTEM 51
Assignment to be submitted on 6th
March, 2023 by 3:30 PM
• Write a short note on RBI, a brief history, its structure and its
operations.

• Details are available in RBI website

THE MONETARY SYSTEM 52

Thank you

THE MONETARY SYSTEM 53