Lecture slides for an undergraduate course on Basic Macroeconomics that I taught in the Fall of 2007. This lecture focuses on (US-centric) monetary policy.

1. GOVernment in the economy
Part IIa: Money, the Financial System, and the Money Supply

2. Show Me the Money!
• In economic terms, “money” refers to a generally accepted
medium of exchange.
• It serves three purposes:
• Medium of Exchange. It overcomes the need for a
“double coincidence of wants” to make trade (barter)
possible.
• Store of Value. It is preserves its value until used in
exchange.
• Unit of Account. It is a numeraire: a standardized unit in
which prices can be quoted.
Conceptualizing “Money”.

3. Types of Monetary Systems
• Commodity Money
• A monetary system in which money is actually a
commodity with intrinsic value, such as precious metals
(e.g. gold or silver).
• Fiat Money
• A monetary system where money has no intrinisic value
but is considered legal tender by government decree.
Based on the “kind” of money being used...

4. Monetary Aggregates
M1:
Publicly Held Currency + Sight Deposits
M2:
M1 + Savings and Money Market Accounts
M3:
M2 + Larger Fixed-Term Deposits + Nonbank Accounts
Measuring the money supply.

5. The Federal Reserve System
• The Federal Reserve is the central bank of the United
States.
• Functions:
• Banking regulation.
• Clearing interbank transactions.
• Lender of last resort.
• Conduct monetary policy.
The functions of the Federal Reserve.

6. Federal Reserve
Open Market Committee (FMOC)
The Federal Reserve SystemThe structure of the Federal Reserve.
Board of Governors Federal Reserve Banks
(Chairman + 6 Members) (12 Presidents)
- Board of Governors
- President of NY Fed
- 4 Fed Bank Presidents

7. The Federal Reserve SystemThe structure of the Federal Reserve.
Source: http://www.federalreserve.gov/otherfrb.htm

8. Monetary Policy
1. Setting the reserve requirement.
2. Engaging in open market operations.
3. Adjusting the discount rate.
How the Fed controls the money supply.

9. Money Creation: Banks
• In effect, banks create money through their borrowing and
lending activity.
• Banks can only loan money depending on its amount of
reserves.
• Required reserves: the specific fraction of deposits that
a bank is required by law to have on hand (often stated
as a required reserve ratio).
• Excess reserves: Total reserves less required reserves.
Some perspective (and terms).

10. Money Creation: BanksA bank’s simplified balance sheet.
ASSETS LIABILITIES
Deposits
These represent funds that
have to be paid back to
customers in the future.
Reserves and Loans
Reserves are there in
case anyone calls on their
deposits, and banks
generally make money
from interest paid on funds
they lend out.

11. The Reserve RequirementThe supply of money grows as it flows through the financial system.
BANK OF AMERICA
Assets Liabilities
100 100
CHASE
Assets Liabilities
CITIBANK
Assets Liabilities

12. The Reserve RequirementThe supply of money grows as it flows through the financial system.
BANK OF AMERICA
Assets Liabilities
20
80
100
CHASE
Assets Liabilities
80 80
CITIBANK
Assets Liabilities

13. The Reserve RequirementThe supply of money grows as it flows through the financial system.
BANK OF AMERICA
Assets Liabilities
20
80
100
CHASE
Assets Liabilities
16
64
80
CITIBANK
Assets Liabilities
64 64

14. The Reserve RequirementThe supply of money grows as it flows through the financial system.
BANK OF AMERICA
Assets Liabilities
20
80
100
CHASE
Assets Liabilities
16
64
80
CITIBANK
Assets Liabilities
12.80
51.20
64
And so on throughout
the economy...

15. The Reserve RequirementThe supply of money grows as it flows through the financial system.
BANK OF AMERICA
Assets Liabilities
20
80
100
CHASE
Assets Liabilities
16
64
80
CITIBANK
Assets Liabilities
12.80
51.20
64
1
2
3
4
5
6
And so on throughout
the economy...
7

16. The Money MultiplierThe relationship between the reserve requirement and the money supply.
Note: This is not a multiplier in the sense of GDP multipliers.
Adding up all the new deposits in the economy:
Deposit 1 100.00
Deposit 2 80.00
Deposit 3 64.00
Deposit 4 51.20
.
.
.
.
.
.
TOTAL 500.00
The Money Multiplier:
The amount of new dollars created
by each new dollar deposited in the
financial system.
1
Reserve Requirement
Mathematically:

17. The Discount Rate
• It is possible for a bank to fall short of its reserve
requirement, in which case it must borrow to make up for
the difference.
• There are two interest rates relevant to banks when they
borrow:
• Federal Funds Rate: The inter-bank loan rate.
(e.g. Bank of America borrowing from Chase Manhattan)
• The Discount Rate: The borrowing rate of the Fed.
(e.g. Bank of America borrowing from the Fed)
Part of monetary policy is setting the rates at which banks borrow.

18. The Discount Rate
• An increase in the discount rate should contract the money
supply: banks will be inclined to borrow less.
• A decrease in the discount rate should expand the money
supply: banks will be inclined to borrow more.
• Note, however, that the discount rate is seldom used as an
instrument of monetary policy in this way.
• It is usually just used to signal how well the economy is
doing.
• Even if the discount rate is relatively low, the Fed (and
central banks in general) use moral suasion to
discourage borrowing from the discount window.
Part of monetary policy is setting the rates at which banks borrow.

19. Open Market Operations
• The Treasury can finance a budget deficit (G > T) by
borrowing from the public.
• This is accomplished by issuing government bonds.
• There are two “open markets” for government debt (bonds):
• Primary Market: When the bonds are first issued. The
Fed does not participate in this market.
• Secondary Market: Where bonds already issued are
bought and sold. The Fed participates in these trades.
• By buying (selling) government securities, the Fed
effectively decreases (increases) the money supply.
The Fed controls the money supply by trading in government securities.

20. Open Market OperationsAn illustration.
The Fed
Suppose the yellow circle
represents the supply of
money in the economy.
If the Fed sells its own
holdings of government
bonds, money flows from
the public to the Fed.
This will cause the
money supply to
contract.

21. Open Market OperationsAn illustration.
The Fed
Suppose the yellow circle
represents the supply of
money in the economy.
If the Fed sells its own
holdings of government
bonds, money flows from
the public to the Fed.
This will cause the
money supply to
contract.

22. Open Market OperationsAn illustration.
The Fed
Conversely, the Fed can
also buy government
bonds back from the
public.
This will cause money to
flow from the Fed to the
economy.
As a result, the money
supply will expand.

23. Open Market OperationsAn illustration.
The Fed
Conversely, the Fed can
also buy government
bonds back from the
public.
As a result, the money
supply will expand.
This will cause money to
flow from the Fed to the
economy.

24. The Money Supply CurveMoney supply independent of interest rates.
Interest Rate (r)
Money (M)
Ms