Fractional Reserve Banking: Using T-accounts to Illustrate How Banks Create Money

Using T-accounts to Illustrate How Banks Create Money

Suppose the only currency in our simple economy is the 100 dollar-bills that Tracy deposited in the Dolphin Bank. If the required reserve ratio is .10 and all banks choose to hold no excess reserves, how large can the money supply become? If banks hold no excess reserves, then the reserve ratio is the same as the required reserve ratio. The monetary base is the amount of currency in circulation or held as reserves. Thus, this simple economy has a monetary base of $100. The money multiplier is 10 because it is the inverse of the reserve ratio (.10). Since the money supply is the monetary base multiplied by the money multiplier, the money supply in this economy is $1000.

To illustrate how a bank creates money, return to the previous example. Suppose a new bank, the Dolphin Bank, is created. Suppose the first depositor, Tracy, deposits 100 dollar bills in the Dolphin Bank and these are placed in the bank’s vault. At the end of this transaction, Tracy has a $100 deposit at the Dolphin Bank (which are liabilities for the bank) and the Dolphin Bank has $100 of reserves (cash in the vault, which are assets for the bank).

Table 9.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 100
(cash in the bank’s vault)
Deposits $ 100
(owed to Tracy by the bank)


The Dolphin Bank will not earn any profit if it leaves the $100 in its vault. Banks earn profits by creating loans. Suppose the Dolphin Bank keeps $10 as required reserves and lends $90 to Brenda. It takes 90 dollar bills from the vault and gives them to Brenda as a loan. The Dolphin Bank now has $10 cash in the vault and its $90 loan to Brenda as assets.


Table 10.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 10
(cash in the bank’s vault)
Deposits $ 100
(owed to Tracy by the bank)
Loans $ 90
(owed to the bank by Brenda)



When people borrow money, they usually spend it. Suppose Brenda uses the $90 loan to buy a guitar from Carlos. Suppose Carlos deposits the $90 in an account at the Dolphin Bank. The bank now has $190 in deposits, $100 in vault cash, and $90 in loans.


Table 11.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 100
(cash in the bank’s vault)
Deposits $ 190
($100 owed to Tracy by the bank)
($90 owed to Carlos by the bank)
Loans $ 90
(owed to the bank by Brenda)



The Dolphin Bank now has excess reserves that can be used to create more loans. Since the bank is only required to keep $19 as reserves (10% of $190 is $19), it can create an $81 loan. Suppose the Dolphin Bank lends $81 to Jasmine.

Table 12.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 19
(cash in the bank’s vault)
Deposits $ 190
($100 owed to Tracy by the bank)
($90 owed to Carlos by the bank)
Loans $ 171
($90 owed to the bank by Brenda)
($81 owed to the bank by Jasmine)



Suppose Jasmine uses the $81 to buy a painting from Vincent. Suppose Vincent deposits the $81 in an account at the Dolphin Bank. The bank now has $271 is deposits, $100 in vault cash, and $171 in loans.


Table 13.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 100
(cash in the bank’s vault)
Deposits $ 271
($100 owed to Tracy by the bank)
($90 owed to Carlos by the bank)
($81 owed to Vincent by the bank)
Loans $ 171
($90 owed to the bank by Brenda)
($81 owed to the bank by Jasmine)



Once again, the Dolphin Bank has excess reserves that can be used to create additional loans. Since the bank is only required to keep $27.10 as reserves (10% of $271 is $27.10), it can create a $72.90 loan. Suppose the Dolphin Bank lends $72.90 to August.


Table 14.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 27.10
(cash in the bank’s vault)
Deposits $ 271
($100 owed to Tracy by the bank)
($90 owed to Carlos by the bank)
($81 owed to Vincent by the bank)
Loans $ 243.90
($90 owed to the bank by Brenda)
($81 owed to the bank by Jasmine)
($72.90 owed to the bank by August)




Suppose August uses the $72.90 to buy a book from Maya. Suppose Maya deposits the $72.90 in an account at the Dolphin Bank. The bank now has $343.90 in deposits, $100 in vault cash, and $243.90 in loans.


Table 15.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 100
(cash in the bank’s vault)
Deposits $ 343.90
($100 owed to Tracy by the bank)
($90 owed to Carlos by the bank)
($81 owed to Vincent by the bank)
($72.90 owed to Maya by the bank)
Loans $ 243.90
($90 owed to the bank by Brenda)
($81 owed to the bank by Jasmine)
($72.90 owed to the bank by August)



This process can continue until the entire $100 currency becomes required reserves. In this case, $1000 of deposits will have been created by issuing $900 in loans.


Table 16 provides an example of how $100 currency could create $1000 of money in the form of deposits in bank accounts if banks hold 10% of all deposits as reserves and create loans that equal 90% of the value of each deposit.

Fractional Reserve Banking: The Relationships Between the Monetary Base, the Reserve Ratio, and the Money Supply

The Relationships Between the Monetary Base, the Reserve Ratio, and the Money Supply


The total amount of money in an economy depends on two things: the monetary base and the reserve ratio. The monetary base is the amount of currency in circulation or held as reserves. Reserves are the currency commercial banks hold in their vaults plus deposits in their accounts at the Fed.

The reserve ratio (R) is the fraction of deposits that banks hold as reserves. The reserve ratio (R) equals the required reserve ratio (rr) only if banks hold no excess reserves. The reserve ratio (R) is larger than the required reserve ratio (rr) when banks hold excess reserves.

The money multiplier is the amount of money the banking system generates with each dollar of reserves. It is the reciprocal of the reserve ratio.


money multiplier = 1/R where R = reserve ratio


The money supply can be calculated as the monetary base multiplied by the money multiplier. If the reserve ratio is .10, for example, then the money multiplier is (1/.10) = 10. If the monetary base is $1 billion, then the money supply is $10 billion.

Fractional Reserve Banking: How Required Reserves Keep the Banking System Solvent

How Required Reserves Keep the Banking System Solvent


Reserves are deposits that banks have received but not loaned out. Instead they are kept as currency in the vault of the bank (vault cash) or deposited in the bank’s accounts at the Federal Reserve System.

Banks do not earn a rate of return on reserves. Reserves can be divided into two categories: reserves that the Fed requires banks to hold (required reserves) and any additional reserves the banks choose to hold (excess reserves).

The Federal Reserve System established and controls the required reserve ratio. The required reserve ratio (rr) is the fraction or percentage of deposits that commercial banks are required to hold in the form of reserves. This money can be kept in the vault of the commercial banks (as vault cash) or deposited with the regional Federal Reserve Banks that serve the commercial banks. In the absence of a required reserve ratio, commercial banks might not hold enough reserves. This might cause consumers to lose confidence in the banking system.

To illustrate how the required reserve ratio helps maintain the solvency of the banking system, consider the following example. Suppose a new bank, the Dolphin Bank, is created. Suppose the first depositor, Tracy, deposits 100 dollar bills in the Dolphin Bank and these are placed in the bank’s vault. At the end of this transaction, Tracy has a $100 deposit at the Dolphin Bank (which is a liability for the bank) and the Dolphin Bank has $100 of reserves (cash in the vault, which is an asset for the bank).
Table 3.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 100
(cash in the bank’s vault)
Deposits $ 100
(owed to Tracy by the bank)

The Dolphin Bank will not earn any profit if it leaves the $100 in its vault. Banks earn profits by creating loans. Suppose the Dolphin Bank lends the $100 to Brenda. It takes all 100 dollar bills from the vault and gives them to Brenda as a loan. The Dolphin Bank now has no cash in the vault, but its loan to Brenda is an asset for the bank.

Table 4.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves 0
(cash in the bank’s vault)
Deposits $ 100
(owed to Tracy by the bank)
Loans $ 100
(owed to the bank by Brenda)


This is not a good situation, however. Suppose Tracy decides to withdraw $10 from her account. Since the bank has no reserves, it does not have any currency in the vault to give Tracy. The bank is now insolvent. A bank is insolvent if it does not have enough cash to provide to the depositors who wish to withdraw their funds. To avoid this situation, the Federal Reserve System requires banks to keep a fraction of their deposits as reserves (vault cash and deposits at the Fed). If the required reserve ratio is .10 (i.e., 10 percent), then the maximum loan the Dolphin Bank could create from a $100 deposit would be $90. Ten dollars would be required to be kept as reserves. The balance sheet of the Dolphin Bank is now illustrated in Table 5.

Table 5.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 10
(cash in the bank’s vault)
Deposits $ 100
(owed to Tracy by the bank)
Loans $ 90
(owed to the bank by Brenda)


If Tracy goes to withdraw $10 from her account, the bank will have the currency in the vault. If Tracy withdraws $10, the balance sheet of the Dolphin Bank is:

Table 6.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves 0
(cash in the bank’s vault)
Deposits $ 90
(owed to Tracy by the bank)
Loans $ 90
(owed to the bank by Brenda)



In this scenario, the bank is able to give Tracy the $10 she requests, but the bank no longer has 10% of deposits as reserves. Thus it is normal for banks to hold excess reserves.

Consider again the example of Tracy making an initial $100 deposit at the Dolphin Bank. Suppose the bank keeps $30 of this deposit as reserves and creates loans of $70. Of the $30 in reserves, $10 are required reserves (because 10 percent of $100 is $10) and the remaining $20 are excess reserves. In this case, the balance sheet of the Dolphin Bank is:

Table 7.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 30
(cash in the bank’s vault)
Deposits $ 100
(owed to Tracy by the bank)
Loans $ 70
(owed to the bank by Brenda)


Suppose Tracy now withdraws $10 from her account. The bank takes $10 of currency out of the vault and gives it to Tracy and reduces the balance in Tracy’s account to $90. The balance sheet of the Dolphin Bank is now:

Table 8.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 20
(cash in the bank’s vault)
Deposits $ 90
(owed to Tracy by the bank)
Loans $ 70
(owed to the bank by Brenda)


The bank now has $90 of deposits and $20 of reserves. Of the $20, $9 are required reserves (because 10 percent of $90 is $9) and the remaining $11 are excess reserves.

By holding excess reserves, the Dolphin Bank avoided falling short of reserves when Tracy withdrew part of her deposit.

Fractional Reserve Banking - An Introduction

Fractional Reserve Banking

Fractional-reserve banking is a banking system in which banks hold only a fraction of deposits as reserves. Reserves are a commercial bank’s deposits in accounts at a Federal Reserve Bank plus its vault cash. Vault cash is the currency held in the commercial bank’s vault. When banks hold only part of their deposits as reserves, they are able to create money by making loans. If banks held all deposits as reserves, banks would not influence the money supply because they would not be able to issue loans. The money supply increases when banks create new loans. The money supply decreases when banks reduce the amount of money loaned to the public.

Banks are businesses that make profits by accepting deposits of funds and lending a portion of them to businesses and households. Banks pay depositors little or no interest, but charge moderate to high interest rates to borrowers. The difference in the interest rates charged to borrowers and paid to depositors allows banks to cover their costs of operation and make a profit.

When a customer deposits currency in a bank, the bank does not write the customer’s name on it and place it in the vault until the customer returns to withdraw it. Only a small fraction of all the money deposited in banks is kept in the bank's vault or on account with the Fed. The majority of the money deposited in banks is loaned to businesses or households or otherwise invested by the bank.

To illustrate how fractional reserve banking works, it helps to examine a simplified bank balance sheet.



Table 2. A simplified balance sheet for a commercial bank.
Balance Sheet of the First National Bank
Assets
Liabilities & Net Worth
Reserves
(required = $ 1,000,000)
(excess = $ 400,000)
$1,400,000
Deposits
$10,000,000
Loans
$7,500,000


Government Securities
$ 900,000


Property & other assets
$600,000
Net Worth
$ 400,000




Total Assets
$10,400,000
Total Liabilities
& Net Worth
$10,400,000


The left side of the balance sheet lists the assets of the bank. An asset is a financial claim or piece of property that is a store of value. Assets are what the bank owns or is owed. The right side of the balance sheet lists the bank’s liabilities and net worth. Liabilities are debts. Liabilities represent what the bank owes someone else. Net worth is the difference between a firm’s assets and its liabilities. In the sample balance sheet above, the bank’s assets include reserves, loans, government securities, and property & other assets. Reserves are the bank’s deposits in accounts with the Fed plus currency that is held in the bank’s vault. Required reserves are the vault cash and deposits at the Fed that commercial banks hold to meet the Fed’s requirement that for every dollar of deposits at a bank, a certain fraction must be kept as reserves. Excess reserves are the vault cash and deposits at the Fed that commercial banks hold is addition to those held to meet the Fed’s requirement that for every dollar of deposits at a bank, a certain fraction must be kept as reserves. Thus, excess reserves are the reserves that banks hold in excess of the required reserves. U.S. government securities are long-term debt instruments (such as bonds) issued by the U.S. Treasury to finance the budget deficits of the federal government. They are the most widely traded bonds in the United States and are thus the most liquid security. Liquidity is the relative ease and speed with which an asset can be converted into cash. Loans are assets for banks because they represent money that the borrowers owe to the bank. Deposits are liabilities for banks because they represent money that the bank is obligated to pay back to the depositors. By definition, net worth is assets minus liabilities.

Instruments of Monetary Policy

Instruments of Monetary Policy


The Federal Reserve System uses three instruments of monetary policy: (1) the required reserve ratio, (2) the discount and federal funds rates, and (3) open market operations. All three instruments affect the economy by influencing the amount of money commercial banks create through loans.

In order to understand how the Fed uses these monetary policy instruments to influence the economy, it is necessary to understand the fractional reserve banking system.

Structure of the Federal Reserve System

Structure of the Federal Reserve System

The Federal Reserve System is composed of three parts: (1) the Board of Governors (BOG), (2) the Federal Open Market Committee (FOMC), and (3) twelve regional Federal Reserve Banks

The Board of Governors sets policy for the Federal Reserve System. Its seven members are appointed by the President of the United States and confirmed by the Senate. The Federal Reserve governors are given 14-year terms to insulate them from political pressure. The terms are staggered so one term expires every two years. The chairman of the Board of Governors is the most important member of the Fed. The chairman oversees the Fed staff, presides over board meetings, reports regularly to congressional committees, and influences the direction of monetary policy. The President of the United States appoints the Fed chairman to a four-year term. It is not uncommon for a Fed chairman to serve many consecutive terms. For example, Alan Greenspan was originally appointed in 1987 by President Ronald Reagan, and later reappointed by Presidents George H.W. Bush, Bill Clinton, and George W. Bush.

The Federal Open Market Committee (FOMC) conducts open market operations to alter the money supply and influence the economy. Open market operations are the purchases and sales of U.S. government securities by the Federal Reserve System. The FOMC is composed of the seven members of the Board of Governors and five of the 12 regional bank presidents. The president of the New York Fed is always on the FOMC because the purchases and sales of government bonds are conducted at the New York Fed’s trading desk. The other four positions on the FOMC are rotated among the remaining 11 regional bank presidents. Open market operations are the Fed’s primary tool for conducting monetary policy and influencing the economy. The FOMC typically meets every six weeks in Washington, D.C. to discuss the condition of the economy and to consider changes in monetary policy.

The United States is divided into 12 Federal Reserve districts with one regional Federal Reserve Bank headquartered in each district. The 12 regional Federal Reserve Banks oversee the health of the banking system. They are headquartered in Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, St. Louis, and San Francisco. The presidents of the regional banks are chosen from each bank’s board of directors, who are typically leaders of the region’s banking and business community.

The 12 regional Federal Reserve banks perform the following functions:
1. clear checks
2. issue new currency
3. withdraw damaged currency from circulation
4. evaluate some merger applications
5. administer and make discount loans to banks in their districts
6. act as liaisons between the business community and the Federal Reserve System
7. examine state member banks
8. collect data on local business conditions
9. use their large staffs of professional economists to research topics related to the conduct of monetary policy[7]


Figure 2. A map of the twelve Federal Reserve districts, their regional headquarters, and branch offices. Source: The Board of Governors of the Federal Reserve System (http://www.federalreserve.gov/)

Functions of the Federal Reserve System

Functions of the Federal Reserve System

Function #1: Conducting Monetary Policy

The primary function of the Fed is the conduct of monetary policy. Monetary policy is the management of the nation’s money supply, interest rates, and banking system to promote economic growth, low unemployment, and low inflation.

If the Fed thinks the economy needs a stimulus (e.g., to fight unemployment), it will increase the money supply by inducing commercial banks to create more money through loans. Commercial banks are financial institutions, chartered by the federal or state government, that generate income primarily by accepting deposits from the general public and using these funds to create loans. Commercial banks are usually referred to simply as banks. Depositors are paid little or no interest on their deposited funds. Borrowers are charged moderate to high interest rates on their loans from commercial banks, however. Most commercial banks attempt to earn profits for their stockholders (i.e., the owners of the bank). Credit unions are not-for-profit organizations that provide banking services to members. Credit unions usually offer more favorable interest rates than other financial institutions. Many credits unions pay slightly higher rates of return on deposits and charge slightly lower rates of interest on loans than traditional banks.

If the Fed thinks the economy needs to slow down (e.g., to fight inflation), it will decrease the money supply by inducing commercial banks to create less money through loans.

Open market operations are the purchases and sales of government securities by the Fed to or from the general public. Monetary policy is conducted primarily through open market operations by the Federal Open Market Committee (FOMC). The FOMC meets approximately every six weeks to discuss the condition of the economy and consider changing the nation’s money supply. The 12 regional Federal Reserve Banks play an important role in monetary policy by providing economic data and research to the FOMC for its consideration. After each meeting, the FOMC directs the Open Market Desk at the Federal Reserve Bank of New York to increase, decrease or maintain the growth rate of the nation’s money supply. To increase the money supply, the Open Market Desk buys Treasury securities each day from the general public (i.e., in the open market). These transactions are open market purchases. To decrease the money supply, the Open Market Desk sells Treasury securities each day to the general public (i.e., in the open market). These transactions are open market sales.

If the Board of Governors thinks the economy needs more influence than is provided by the open market operations, it can change the discount and federal funds rates, which are the interest rates charged on loans to commercial banks. Low interest rates provide an incentive for commercial banks to create more money in the form of loans to the general public. The discount rate is the interest rate charged on loans from the regional Federal Reserve Banks to commercial banks. Loans from regional Federal Reserve Banks to commercial banks are called discount loans. The federal funds rate is the interest rate charged on loans from commercial banks to other commercial banks. The federal funds rate is one half of a percentage point less than the discount rate. Federal funds are reserves that are loaned overnight from a commercial bank with excess reserves to a commercial bank with a shortage of reserves. Reserves are explained later in this chapter.

If the Board of Governors wants to make a major adjustment to the economy, it might change the required reserve ratio. Decreasing the required reserve ratio allows commercial banks to create more money in the form of loans to the general public. Increasing the required reserve ratio causes commercial banks to create less money in the form of loans to the general public.


Function #2: Supervising and Regulating Banks

The Federal Reserve System maintains the stability of the financial system and protects the credit rights of consumers. Prior to the creation of the Federal Reserve System in 1913, the United States endured many banking panics. So to stabilize the banking system, Congress gave the Fed the responsibility to supervise and regulate banks. The Board of Governors develops the written rules that define acceptable behavior for financial institutions. The 12 regional Federal Reserve Banks supervise the enforcement of these rules by overseeing state-chartered member banks, the companies that own banks (bank holding companies) and international organizations that do banking business in the United States. The Federal Reserve System also ensures the stability of the banking system by acting as a lender of last resort. This means that if a commercial bank is in danger of going bankrupt, the Fed will provide the bank with enough funds to keep it solvent. A bank is solvent if it is able to meet its financial obligations, such as providing money to all depositors who wish to wish to withdraw their funds.






Function #3: Providing Financial Services[6]

The Federal Reserve System provides financial services to the U.S. government, the public, financial institutions, and foreign official institutions.

The Federal Reserve Banks and their branches provide a safe and efficient method of transferring funds throughout the banking system by offering banking services to all financial institutions in the United States.

Each Federal Reserve Bank provides banking services to all financial institutions in its geographic region. These services include the provision of currency as needed by the area’s financial institutions and the processing of commercial checks and other electronic payments.

The electronic payment services provided by the Fed are funds transfers and the automated clearinghouse (ACH). Funds transfers occur between financial institutions or government agencies. ACH transactions include payroll deposits, electronic bill payments, insurance payments, and Social Security distributions.

Because the Federal Reserve System provides banking services to financial institutions, such as commercial banks, the Fed is sometimes called the bankers’ bank. The Federal Reserve also provides banking services to the U.S. government. These services include the maintenance of U.S. Treasury accounts, the processing of government checks, the sale, service, and redemption of U.S. Treasury securities, savings bonds and postal money orders, and the collection of federal tax deposits.

Overview of the Federal Reserve System

Overview of the Federal Reserve System

Monetary policy is the management of the nation’s money supply, interest rates, and banking system to promote economic growth, low unemployment, and low inflation.

The Federal Reserve System (the Fed), the central bank of the United States, conducts U.S. monetary policy. The Fed is a quasi-government agency that was created in 1913, after a series of bank failures, to ensure the health of the banking system of the United States.

The Federal Reserve System is composed of a Board of Governors (BOG), the Federal Open Market Committee (FOMC), and twelve regional Federal Reserve Banks. These three parts work together to accomplish the Fed’s three main responsibilities:

(1) conducting monetary policy to promote economic growth, low unemployment, and low inflation;
(2) supervising and regulating banks to maintain the stability of the financial system; and
(3) providing financial services to the U.S. government, the public, financial institutions, and foreign official institutions.

The Federal Reserve System does not print currency. U.S. currency is printed by the Bureau of Engraving and Printing, which is part of the U.S. Department of the Treasury.

Definitions of the U.S. Money Supply

In the United States, the money supply has several definitions.

M1 = currency[1] + travelers checks[2] + demand deposits[3] and other checkable deposits[4],[5]


A traveler’s check is a draft, available in various denominations, that must be signed at the time of purchase and which can be redeemed only when countersigned with a matching signature at the time of redemption.

A demand deposit is the balance in a checking account at a commercial bank. Depositors may withdraw these funds on demand using a check or debit card.

M2 = everything in M1 + savings accounts + money market accounts + money market mutual funds + small denomination certificates of deposit

M3 = everything in M2 + large denomination certificates of deposit



U.S. Money Stock Measures


Table 1. Money Stock Measures.

Totals for the week ending
March 14, 2005
(in billions of dollars)
Currency[1]
703.2
Travelers checks[2]
7.5
Demand deposits[3]
320.8
Other checkable deposits at commercial banks[4]
182.2
Other checkable deposits at thrift institutions[5]
137.4
M1
1,351.1
M2
6,407.5
M3
9,477.4
Source: Federal Reserve System (http://www.federalreserve.gov/releases/H6/Current/)

Types of Money

Types of Money

Currency is paper bills and coins. Paper bills are paper or cloth notes with markings that indicate their monetary denominations. Paper bills are an example of fiat money. Coins are hard materials, typically metals, with markings that indicate their monetary denominations. Coins are an example of commodity money.

Fiat money is money that does not have intrinsic value. It generally cannot be used except as money. “Fiat” is Latin for “let it be done.” In English, a fiat is an arbitrary order or degree. Thus, fiat money is money because the government has declared it to be so. The Jacksonville University motto is “fiat lux,” which translates as “let there be light” or “let the light shine.” The goal of the university is to enlighten its students.

Commodity money is money that has intrinsic value. It can be used as something other than money. Gold and silver coins are commodity money because they can be melted down and used to make jewelry or other goods.

Money and its Functions

Money is anything that is generally accepted to serve as a medium of exchange, store of value, and unit of account.

Functions of Money

· Money is a medium of exchange when it is used to facilitate trade. In the absence of money, trade is done by barter. Barter is the exchange of a good or service for another good or service. Barter is often difficult because it requires a double coincidence of wants, which is the need for a trader to find a partner who has a product he wants and who wants what he is offering to trade. Buying food from the grocery store with a twenty-dollar bill is an example of using money as a medium of exchange.

· Money is a store of value when it is used to hold purchasing power for use at a later time. Putting coins in a piggy bank is an example of using money as a store of value.

· Money is a unit of account when it is used to measure the prices of things. In the United States, items are priced in dollars and cents.

Many things have been used as money throughout history. In Colonial Virginia, bundles of tobacco were used as money. In World War II, soldiers used cigarettes as money. On the Pacific island of Yap, giant circular stones with holes in the center are used as money.

How Monetary Policy Affects the Economy

How Monetary Policy Affects the Economy

Monetary policy is conducted in the United States by the Federal Reserve System (the Fed), which is the U.S. central bank. A central bank is an institution that oversees the banking system and regulates the quantity of money in an economy. The Fed influences the economy by changing the money supply and interest rates to either increase or decrease aggregate demand (AD), which is overall spending on newly produced goods and services. When the Federal Reserve conducts monetary policy, it may increase or decrease the money supply depending on the condition of the economy.

Expansionary monetary policy occurs when the Federal Reserve System induces commercial banks to increase the amount of money they create through loans. Thus, expansionary monetary policy increases the money supply. If the economy needs stimulation (e.g., to fight unemployment), then the Fed usually conducts expansionary monetary policy to increase the money supply, reduce interest rates, and encourage more consumption and investment spending. Low interest rates encourage households and businesses to borrow money. If they use this borrowed money to increase spending on consumer products (C) and investment (I) in capital equipment, inventories, and structures, then aggregate demand increases. Aggregate demand is composed of consumption spending (C), investment spending (I), government purchases (G), and net exports (X-M).


AD = C + I + G + X - M


Contractionary monetary policy occurs when the Federal Reserve System induces commercial banks to decrease the amount of money they create through loans. Thus, contractionary monetary policy decreases the money supply. If the economy needs dampening (e.g., to fight inflation), then the Fed usually conducts contractionary monetary policy to decrease the money supply, increase interest rates, and discourage consumption and investment spending. High interest rates discourage households and businesses from borrowing money. If higher interest costs reduce spending on consumer products (C) and investment (I) in capital equipment, inventories, and structures, then aggregate demand decreases.

Macroeconomic Policy Tools

Macroeconomic Policy Tools

Monetary and fiscal policies are two tools that are used to manage the economy in attempts to achieve macroeconomic policy goals. Monetary policy is used more frequently to manage the economy because it has a smaller political bias than fiscal policy.

Monetary policy is the management of the nation’s money supply, interest rates, and banking system to promote economic growth, low unemployment, and low inflation.

Fiscal policy is taxing and spending by the government.

Monetary Policy - Learning Objectives

After studying the portion of this blog devoted to monetary policy (the primary macroeconomic policy tool), you should be able to:

· define monetary policy.
· define fiscal policy.
· explain how expansionary monetary policy influences the economy.
· explain how contractionary monetary policy influences the economy.
· define money.
· explain the three functions of money and provide examples of money used in each of these functions.
· define barter, double coincidence of wants, and the relationship between the two concepts.
· explain the difference between currency, paper bills, and coins.
· explain the difference between fiat money and commodity money.
· recite, translate, and explain the Jacksonville University motto.
· explain the difference between the M1, M2, and M3 definitions of the money supply.
· define a central bank.
· explain when and why the Federal Reserve System was created.
· list and explain the functions of the Federal Reserve System.
· explain the structure of the Federal Reserve System and describe the duties performed by each part.
· list the cities in which the 12 regional Federal Reserve Bank are headquartered.
· list and explain the three instruments of monetary policy.
· define and explain fractional-reserve banking.
· define reserves and explain the difference between required reserves and excess reserves.
· explain the difference between the reserve ratio (R) and the required reserve ratio (rr).
· define and explain the money multiplier.
· define and explain the monetary base.
· explain the relationship between assets, liabilities, and net worth.
· define U.S. government securities.
· define liquidity.
· use T-accounts to illustrate how required reserves help make the banking system solvent.
· explain the difference between the discount rate and the federal funds rate.
· define open market operations
· explain how the Federal Reserve System uses the required reserve ratio to influence the economy.
· explain how the Federal Reserve System uses the discount and federal funds rates to influence the economy.
· explain how the Federal Reserve System uses open market operations to influence the economy.
· define a commercial bank.

Monetary Policy - Topics

The primary macroeconomic policy goals are economic growth, low unemployment, and low inflation. The main tools to achieve these goals are monetary policy and fiscal policy.

Monetary policy is the central bank's use of the money supply, interest rates, and the loans generated by the banking system to influence the overall level of spending in the economy. The U.S. central bank is the Federal Reserve System (the Fed).

Click on the hyperlinks below to take you to a portion of the blog devoted to that topic:

Monetary Policy - Learning Objectives
Macroeconomic Policy Tools
How Monetary Policy Affects the Economy
Money and its Functions
Types of Money
Definitions of the U.S. Money Supply
Overview of the Federal Reserve System
Functions of the Federal Reserve System
Structure of the Federal Reserve System
Membership of the Board of Governors of the Federal Reserve System, 1914 to present
Instruments of Monetary Policy
Fractional Reserve Banking - An Introduction
Fractional Reserve Banking: How Required Reserves Keep the Banking System Solvent
Fractional Reserve Banking: The Relationships Between the Monetary Base, the Reserve Ratio, and the Money Supply
Fractional Reserve Banking: Using T-accounts to Illustrate How Banks Create Money
An example of how $100 of currency could create $1000 of money in the form of deposits in bank accounts if banks hold 10% of all deposits as reserves
How the Instruments of Monetary Policy Affect the Economy
Monetary Policy Instrument #1: the Required Reserve Ratio
Monetary Policy Instrument #2: the federal funds rate
Monetary Policy Instrument #3: open market operations
Example of How the Fed Uses an Open Market Purchase to Increase the Money Supply in a Fractional Reserve Banking System with 10% Required Reserves.
Example of Fractional Reserve Banking with 20% Required Reserves
Important Definitions Related to Monetary Policy
Monetary Policy - Questions for Further Study
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