Source: ECO 201, University of Florida
Tags: money, functions of money, M1, M2, money supply, depository institutions, commercial banks, central bank, Federal Reserve, monetary policy tools, open market operations, discount rate, reserve requirement, money multiplier, monetary base, fractional reserve banking
Difficulty: Intermediate Prerequisites: Understanding of fiscal policy basics and the AD-AS model (see Part 1 of these notes). Familiarity with the concept of interest rates and saving/investment is helpful.
This section moves from the government's budget (fiscal policy) to the central bank's toolkit (monetary policy). Before you can understand how the Fed influences the economy, you need to know what money actually is, how banks create it through lending, and what measures like M1 and M2 capture. The money multiplier connects the central bank's actions to changes in the broader money supply. If you missed earlier lectures, the key thing to know is that money supply changes affect interest rates, which in turn affect investment, aggregate demand, and ultimately output and prices.
Money serves as a medium of exchange, unit of account, and store of value. Banks create money through fractional reserve lending, and the money multiplier shows how a change in reserves ripples into a much larger change in the money supply. The central bank controls this process using open market operations, the discount rate, and reserve requirements.
Money
Any asset that is widely accepted as a medium of exchange for goods and services. In simple terms, money is whatever people agree to use to buy things.
Medium of exchange
The function of money that allows it to be used to buy and sell goods and services, eliminating the need for barter. Think of it as money's primary job: making transactions possible without needing a "double coincidence of wants."
Unit of account
The function of money that provides a common measure for stating prices and recording debts. In simple terms, money gives us a single yardstick for comparing the value of different things.
Store of value
The function of money that allows purchasing power to be held over time. Think of it as money's ability to let you save now and spend later, though inflation erodes this function.
Liquidity
The ease with which an asset can be converted into a medium of exchange without significant loss of value. Cash is perfectly liquid; a house is not.
M1 (narrow money)
The most liquid measure of the money supply. Includes currency in circulation, demand deposits (current/checking accounts), traveller's cheques, and other checkable deposits.
M2 (broad money)
A broader measure that includes everything in M1, plus savings deposits, small-denomination time deposits (CDs under $100,000), and money market mutual fund balances. Think of M2 as M1 plus "near-money" that is easy but not instant to spend.
Depository institution
A financial institution that accepts deposits from the public and makes loans. Commercial banks, savings institutions, and credit unions are all depository institutions.
Fractional reserve banking
A system in which banks hold only a fraction of their deposits as reserves and lend out the rest. This is how banks create money: each loan becomes a new deposit somewhere in the banking system.
Required reserves
The minimum amount of deposits a bank must hold as reserves, set by the central bank as a percentage of deposits (the reserve requirement ratio).
Excess reserves
Reserves held by a bank above the required minimum. Banks can lend out excess reserves to earn interest.
Monetary base (high-powered money)
Currency in circulation plus bank reserves. This is the quantity the central bank controls directly. Sometimes called MB or B.
Money multiplier
The factor by which the money supply changes for a given change in the monetary base. In simple terms, it tells you how much "bang" the central bank gets for each pound or dollar of reserves it injects.
Open market operations (OMOs)
The buying and selling of government securities by the central bank to change the monetary base and, through the multiplier, the money supply. This is the most commonly used monetary policy tool.
Discount rate
The interest rate at which commercial banks can borrow directly from the central bank. A lower discount rate encourages banks to borrow more, increasing reserves and the money supply.
Reserve requirement (reserve ratio)
The fraction of deposits that banks are required to hold as reserves. Raising it reduces the money multiplier; lowering it increases it.
Federal funds rate
The interest rate at which banks lend reserves to each other overnight. The Fed targets this rate through open market operations. It is the primary signal of the Fed's monetary policy stance.
Money performs three core functions. All three must be present for something to qualify as money in the economic sense.
Medium of exchange: Eliminates the inefficiency of barter. Without money, you would need a double coincidence of wants (you have what I want, and I have what you want, at the same time).
Unit of account: Prices are quoted in money terms. With 1,000 goods, you would need roughly 500,000 relative prices under barter. Money reduces this to 1,000 prices.
Store of value: You can earn income today and spend it next month. This function is weakened by inflation, which erodes purchasing power over time.
Anything can serve as money if it is widely accepted. Historically, commodities (gold, silver, shells) served this role. Modern economies use fiat money, which has value because the government declares it legal tender and people trust it.
M1 includes:
Currency in circulation (notes and coins held by the public, not in bank vaults)
Demand deposits (checking/current accounts)
Traveller's cheques
Other checkable deposits
M2 includes:
Everything in M1
Savings deposits
Small time deposits (certificates of deposit under $100,000)
Money market mutual fund balances (retail)
M1 captures the most liquid forms of money, those you can spend immediately. M2 adds near-money assets that require a small step (transferring from savings, waiting for a CD to mature) before spending.
For exam calculations: if given figures for each component, simply add them up. The key is knowing which components belong to which measure.
Commercial banks, savings institutions (thrifts), and credit unions are all depository institutions.
Their core economic function is financial intermediation: they channel funds from savers (depositors) to borrowers (firms and households needing loans).
By accepting deposits and making loans, banks transform short-term liabilities (deposits that can be withdrawn) into long-term assets (loans that are repaid over years). This maturity transformation is essential to the economy but also a source of risk.
Banks earn profit primarily from the spread between the interest rate they charge on loans and the rate they pay on deposits.
Banks do not lend out all their deposits. They hold a fraction as reserves (required by regulation) and lend the rest.
When a bank makes a loan, the borrower typically deposits the funds in another bank. That bank holds a fraction as reserves and lends the rest. The process repeats.
Each round of lending creates new deposits, and therefore new money. The total amount of money created depends on the reserve ratio.
Example: Reserve requirement = 10%. Someone deposits £1,000.
Bank A holds £100 in reserves, lends £900.
Bank B receives the £900 as a deposit, holds £90, lends £810.
Bank C receives £810, holds £81, lends £729.
This continues until the total new deposits equal £10,000 (the original £1,000 times the multiplier of 10).
Formula: Money multiplier = 1 / Reserve requirement ratio
If the reserve ratio (rr) is 0.10, the money multiplier is 1 / 0.10 = 10.
If the reserve ratio is 0.20, the money multiplier is 1 / 0.20 = 5.
Change in money supply = Money multiplier × Change in monetary base
If the Fed buys £50m in government bonds (increasing the monetary base by £50m) and the reserve ratio is 0.10, the money supply increases by 10 × £50m = £500m.
This is the simple multiplier. In practice, the actual multiplier is smaller because:
Banks may hold excess reserves (especially during crises).
Some cash "leaks" out of the banking system as people hold currency rather than depositing it.
The formula assumes every loan becomes a deposit, which does not hold perfectly.
The central bank (the Federal Reserve in the US) has three primary tools:
Open market operations (most important):
To increase the money supply (expansionary): the Fed buys government bonds. It pays for them by crediting banks' reserve accounts, increasing the monetary base. Through the multiplier, the money supply expands.
To decrease the money supply (contractionary): the Fed sells government bonds. Banks pay by having their reserves debited, reducing the monetary base. The money supply contracts.
OMOs are the day-to-day workhorse of monetary policy.
The discount rate:
A lower discount rate makes it cheaper for banks to borrow from the Fed, encouraging borrowing, increasing reserves, and expanding the money supply.
A higher discount rate does the reverse.
In practice, banks are reluctant to use the discount window (it carries a stigma suggesting the bank is in trouble), so this tool is less powerful than OMOs.
Reserve requirements:
Raising the reserve requirement reduces the money multiplier directly. Banks must hold more reserves per deposit, so less is available for lending.
Lowering the requirement increases the multiplier and expands the money supply.
This tool is rarely used because even small changes have large effects, and it disrupts bank portfolio management. (Note: the Fed reduced the reserve requirement to 0% in March 2020.)
The relationship is inverse: a higher reserve requirement means a smaller money multiplier and a smaller money supply for any given monetary base.
The reserve requirement ratio is the denominator of the simple money multiplier formula, so even a small change in the ratio causes a proportionally large change in the multiplier.
Formula | Expression | Notes |
|---|---|---|
Simple money multiplier | 1 / rr | rr = required reserve ratio |
Change in money supply | Multiplier × Change in monetary base | Assumes no excess reserves or cash leakage |
M1 | Currency + demand deposits + traveller's cheques + other checkable deposits | Most liquid measure |
M2 | M1 + savings deposits + small time deposits + retail MMMFs | Broader measure |
When the Fed conducted "quantitative easing" after 2008, it bought trillions of dollars in bonds, massively expanding the monetary base. But banks sat on large excess reserves rather than lending them all out, so the actual money multiplier was much smaller than the simple formula predicted. This is a good example of why the simple multiplier is a useful teaching tool but not a precise forecast.
The reason your bank pays you interest on savings but charges a higher rate on your car loan is financial intermediation in action. The spread is how banks cover costs and earn profit.
"Banks lend out the money depositors put in." Not exactly. Banks lend out a portion and keep the rest as reserves. More importantly, the act of lending itself creates new deposits (and therefore new money) in the banking system. Money creation is a system-level process, not a single-bank process.
"M1 and M2 are completely separate pools of money." M2 includes M1. They are nested measures, not alternatives. Everything in M1 is also in M2.
"The money multiplier is a fixed number." The simple formula treats it as fixed, but in reality it fluctuates because banks' willingness to hold excess reserves and the public's preference for cash both change over time.
"The Fed prints money." The Fed creates reserves (electronic entries on bank balance sheets), which is different from physically printing banknotes. The Treasury's Bureau of Engraving and Printing handles the physical notes.
⚠️ Be able to calculate M1 and M2 from a list of components. Know which items belong to which measure.
⚠️ The money multiplier calculation is a near-certainty on the exam. Given a reserve ratio and a change in the monetary base, calculate the resulting change in the money supply.
⚠️ Know all three monetary policy tools and whether each is used for expansion or contraction. Open market operations are the most commonly tested.
⚠️ Understand the direction of each tool: the Fed buys bonds to expand, sells to contract. Students frequently mix this up.
⚠️ Be able to trace through the money creation process step by step (deposit, reserve, lend, re-deposit) for at least two or three rounds.
True or False: M2 is a subset of M1.
Fill in the blank: The three functions of money are medium of exchange, unit of account, and ______.
True or False: If the reserve requirement is 25%, the simple money multiplier is 4.
Fill in the blank: When the Fed wants to increase the money supply, it ______ government bonds in open market operations.
True or False: Raising the reserve requirement increases the money multiplier.
Answers: 1. False (M1 is a subset of M2). 2. Store of value. 3. True (1/0.25 = 4). 4. Buys. 5. False (it decreases the multiplier).
Q: List the three functions of money and give a one-sentence explanation of each.
A: Medium of exchange (allows goods and services to be bought and sold without barter), unit of account (provides a common standard for measuring value and quoting prices), and store of value (allows purchasing power to be held and transferred over time).
Q: What is the difference between M1 and M2?
A: M1 includes the most liquid forms of money: currency, demand deposits, traveller's cheques, and other checkable deposits. M2 includes everything in M1 plus less liquid near-money assets: savings deposits, small time deposits, and retail money market mutual fund balances.
Q: If the required reserve ratio is 0.05 and the Fed purchases $200 million in government bonds, what is the maximum change in the money supply?
A: Money multiplier = 1 / 0.05 = 20. Maximum change in money supply = 20 × $200m = $4 billion.
Q: Explain how a commercial bank creates money through lending.
A: When a bank receives a deposit, it holds a fraction as required reserves and lends the remainder. The borrower (or the person they pay) deposits the loan proceeds in another bank, which again holds reserves and lends the rest. Each round of lending creates new deposits in the banking system. The cumulative effect is that the initial deposit supports a total volume of deposits equal to the initial amount times the money multiplier.
Q: Why is the actual money multiplier usually smaller than the simple (theoretical) multiplier?
A: Two main reasons. First, banks often hold excess reserves beyond the required minimum, reducing the amount available for lending at each stage. Second, some cash leaks out of the banking system because people hold currency rather than depositing all their funds. Both factors reduce the total expansion of deposits.
The money supply directly affects interest rates, which links monetary policy to the loanable funds market and to investment (covered in the fiscal policy notes, Part 1).
Understanding the monetary base and money multiplier is essential background for the next section on exchange rates, because interest rate differentials between countries drive short-run exchange rate movements.
The AD-AS model from Part 1 reappears here: expansionary monetary policy shifts AD to the right (lower interest rates stimulate investment and consumption), and contractionary policy shifts it left.
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