Source: Mankiw, Principles of Macroeconomics, 8th ed., Chs. 16, 17, 20, 21, 22
Tags: money, banking, Federal Reserve, monetary policy, money supply, money creation, reserve requirement, discount rate, open market operations, federal funds rate, barter, comparative advantage, international trade, exchange rates, tariffs, trade barriers, Bretton Woods, gold standard, GATT, WTO, NAFTA, balance of payments
Difficulty: Intermediate to Advanced | Prerequisites: Chapters 1–4 (supply and demand) and Chapters 10–15 (AD/AS model, fiscal policy). You will need to combine supply-and-demand reasoning with the AD/AS framework.
This unit covers two distinct but related areas. First, how money and the banking system work, and how the Federal Reserve uses monetary policy to influence the economy. Second, how and why countries trade with each other, what determines exchange rates, and what institutions govern international commerce. These topics connect because monetary policy affects interest rates, which affect capital flows, which affect exchange rates, which affect trade. If you are comfortable with the AD/AS model from the previous unit, you have the tools you need. This unit applies them to money markets and the global economy.
Money serves as a medium of exchange, unit of account, and store of value. Banks create money through lending, and the Federal Reserve controls the money supply using open market operations, the discount rate, and reserve requirements. Internationally, countries trade based on comparative advantage, but governments often intervene with tariffs and quotas. Exchange rates are determined by supply and demand in currency markets, and institutions like the WTO, IMF, and World Bank provide a framework for international economic cooperation.
Money
Anything widely accepted as a medium of exchange. Money has three functions: medium of exchange (you use it to buy things), unit of account (you use it to measure value), and store of value (you can hold it and spend it later). In simple terms, money is whatever people agree to treat as money.
Barter
The direct exchange of goods and services without money. Barter requires a "double coincidence of wants" (both parties must want what the other has), which makes it deeply inefficient for complex economies.
Commodity money
Money that has intrinsic value, such as gold or silver coins. The material itself is valuable even apart from its use as money.
Fiat money
Money without intrinsic value, declared legal tender by government decree. Modern banknotes and coins are fiat money. They work because people trust that others will accept them.
M1 money supply
The narrowest definition of the money supply: currency in circulation, demand deposits (current accounts), traveller's cheques, and other checkable deposits. This is the most liquid measure.
M2 money supply
A broader measure that includes everything in M1 plus savings deposits, small time deposits (CDs under $100,000), and money market mutual funds. Think of M2 as M1 plus "near-money" that can be converted to cash fairly easily.
Fractional reserve banking
A system where banks hold only a fraction of deposits as reserves and lend out the rest. This is how the modern banking system works and how banks create money.
Reserve ratio (reserve requirement)
The fraction of deposits that a bank must hold in reserve and not lend out. Set by the Federal Reserve. A lower reserve requirement allows banks to lend more and expands the money supply.
Money multiplier
The maximum amount of money the banking system can create from each pound of reserves. Formula: 1 / reserve ratio. If the reserve ratio is 10% (0.10), the money multiplier is 10: each pound of new reserves can support up to ten pounds of deposits.
Federal Reserve System (the Fed)
The central bank of the United States. It has a dual mandate: to promote maximum employment and stable prices. The Fed sets monetary policy and supervises the banking system.
Federal funds rate
The interest rate at which banks lend reserves to each other overnight. It is the primary target of Fed monetary policy. When you hear "the Fed raised rates", this is the rate they are talking about.
Open market operations (OMOs)
The Fed's primary tool for controlling the money supply. The Fed buys or sells government bonds on the open market. Buying bonds injects money into the economy (expansionary); selling bonds pulls money out (contractionary).
Discount rate
The interest rate the Fed charges commercial banks for short-term loans from the Fed's "discount window". Lowering it encourages banks to borrow and lend more; raising it discourages borrowing.
Expansionary monetary policy
Policy aimed at increasing the money supply and lowering interest rates to stimulate economic activity. Used during recessions.
Contractionary monetary policy
Policy aimed at decreasing the money supply and raising interest rates to slow economic activity and reduce inflation. Used when the economy is overheating.
Quantity theory of money
The theory that the price level is proportional to the money supply in the long run. Expressed as MV = PY, where M is the money supply, V is the velocity of money, P is the price level, and Y is real output.
Monetarism
The school of thought, associated with Milton Friedman, that emphasises the role of the money supply in determining inflation and economic activity. Monetarists advocate steady, predictable growth in the money supply rather than active intervention.
Comparative advantage (international context)
A country has a comparative advantage in producing a good if it can produce that good at a lower opportunity cost than other countries. This is the fundamental reason countries trade.
Tariff
A tax on imported goods. It raises the domestic price, benefits domestic producers, generates government revenue, but harms consumers and reduces the total gains from trade.
Quota
A limit on the quantity of a good that can be imported. Like a tariff, it raises domestic prices and benefits domestic producers at the expense of consumers, but unlike a tariff, it does not generate government revenue (the profit goes to whoever holds the import licence).
Trade deficit
When a country's imports exceed its exports (negative net exports). The US has run a trade deficit for decades.
Trade surplus
When a country's exports exceed its imports (positive net exports).
Exchange rate
The price of one country's currency expressed in terms of another country's currency. For example, if $1 = 0.85 euros, the exchange rate is 0.85 euros per dollar.
Appreciation
An increase in the value of a currency relative to other currencies. A stronger currency makes imports cheaper and exports more expensive.
Depreciation
A decrease in the value of a currency relative to other currencies. A weaker currency makes exports cheaper and imports more expensive.
Gold standard
A monetary system where a country's currency is directly convertible into gold at a fixed rate. It limits the government's ability to expand the money supply but provides exchange rate stability. Most countries abandoned it during the 20th century.
Bretton Woods system
The international monetary system established in 1944. Currencies were pegged to the US dollar, which was convertible to gold. It created the IMF and the World Bank. The system collapsed in 1971 when the US suspended dollar-to-gold convertibility.
International Monetary Fund (IMF)
An international organisation that monitors exchange rates, lends to countries facing balance-of-payments difficulties, and provides technical assistance. Created at Bretton Woods.
World Bank
An international organisation that provides loans and grants to developing countries for projects aimed at reducing poverty and promoting development. Also created at Bretton Woods.
General Agreement on Tariffs and Trade (GATT)
A series of international agreements (starting 1947) aimed at reducing trade barriers. It was replaced by the WTO in 1995.
World Trade Organization (WTO)
The international body that oversees trade rules, resolves trade disputes, and provides a forum for trade negotiations. It succeeded GATT.
NAFTA (North American Free Trade Agreement)
A trade agreement among the US, Canada, and Mexico that eliminated most tariffs between the three countries. It took effect in 1994.
Adjustable peg exchange system
An exchange rate system where a country fixes (pegs) its currency to another currency or basket of currencies but retains the ability to adjust the peg. The Bretton Woods system operated this way.
A barter economy requires a double coincidence of wants, which becomes impractical as an economy grows and specialises.
Money solves this by serving as: a medium of exchange (accepted in transactions), a unit of account (a yardstick for value), and a store of value (holds purchasing power over time).
For money to function well, it should be durable, portable, divisible, uniform, limited in supply, and widely accepted.
The evolution from commodity money (gold, silver) to fiat money (paper currency) reflects growing trust in institutions and the need for a flexible money supply.
Banks accept deposits and make loans. Under fractional reserve banking, they keep a fraction of deposits as reserves and lend out the rest.
When a bank makes a loan, it creates a new deposit in the borrower's account. This is how the banking system creates money.
The process is cumulative: the initial deposit generates a loan, which generates a new deposit at another bank, which generates another loan, and so on.
Example of the money multiplier:
Suppose the reserve ratio is 20% and someone deposits $1,000.
The bank keeps $200 in reserves and lends $800.
That $800 is deposited elsewhere. The second bank keeps $160 (20%) and lends $640.
This continues until the total money created = $1,000 x (1/0.20) = $5,000.
Money multiplier = 1 / reserve ratio = 1 / 0.20 = 5.
In practice, the actual multiplier is smaller than the theoretical maximum because banks may hold excess reserves and borrowers may hold some cash rather than depositing it all.
Structure:
The Board of Governors (7 members, appointed by the President, based in Washington).
12 regional Federal Reserve Banks across the country.
The Federal Open Market Committee (FOMC), which sets monetary policy. It includes the Board of Governors plus 5 of the 12 regional bank presidents on a rotating basis.
Responsibilities:
Conducts monetary policy (the main focus of this course).
Supervises and regulates banks.
Provides financial services (clearing cheques, acting as "lender of last resort").
Issues currency.
Open market operations (primary tool):
The Fed buys government bonds to increase the money supply (expansionary). This puts cash into banks' hands, lowers interest rates, and encourages lending.
The Fed sells government bonds to decrease the money supply (contractionary). This pulls cash out of the banking system, raises interest rates, and discourages lending.
Discount rate:
A higher discount rate discourages banks from borrowing from the Fed, tightening the money supply.
A lower discount rate encourages borrowing, easing the money supply.
Reserve requirement:
Lowering the reserve requirement means banks can lend a larger fraction of deposits, expanding the money supply.
Raising it means banks must hold more in reserve, contracting the money supply.
The Fed changes reserve requirements rarely because even small changes have large effects.
The transmission mechanism works through a chain:
The Fed changes the money supply (e.g. buys bonds).
Interest rates change (money supply up, interest rate down).
Investment and consumption respond (lower rates encourage borrowing and spending).
Aggregate demand shifts (AD shifts right with expansionary policy).
Output and the price level change.
Expansionary monetary policy (used during a recession):
Fed buys bonds, money supply increases, interest rates fall, AD shifts right, output rises.
Contractionary monetary policy (used during inflation):
Fed sells bonds, money supply decreases, interest rates rise, AD shifts left, price level stabilises.
MV = PY
M = money supply.
V = velocity of money (how many times a pound changes hands in a year).
P = price level.
Y = real output.
If V and Y are relatively stable (as monetarists assume), then changes in M lead directly to changes in P. This is the theoretical basis for the claim that "inflation is always and everywhere a monetary phenomenon."
Countries trade because of differences in opportunity costs (comparative advantage).
Even a country that is better at producing everything (absolute advantage in all goods) benefits from specialisation and trade.
Trade allows a country to consume beyond its own PPF.
The main arguments for trade restrictions (protecting infant industries, national security, unfair foreign competition) are controversial. Economists broadly agree that the gains from trade outweigh the losses, though the losses fall unevenly.
Tariffs:
Raise the domestic price of imports.
Benefit domestic producers (who face less competition) and the government (which collects revenue).
Harm consumers (who pay higher prices) and reduce overall economic efficiency.
Quotas:
Limit the quantity of imports.
Have similar price and distributional effects to tariffs, but the "rents" go to import licence holders rather than the government.
Other barriers: subsidies to domestic producers, regulatory requirements, anti-dumping rules, voluntary export restraints.
Exchange rates are determined by supply and demand in currency markets.
Demand for a currency comes from foreigners wanting to buy the country's goods, services, or assets.
Supply of a currency comes from domestic residents wanting to buy foreign goods, services, or assets.
A country with high interest rates tends to attract foreign capital, increasing demand for its currency and causing appreciation.
A country running a trade deficit is supplying more of its currency (to pay for imports) than foreigners demand for its exports, which tends to cause depreciation.
Fixed vs. floating exchange rates:
Under a fixed (pegged) system, the government or central bank intervenes to maintain the exchange rate at a target level.
Under a floating system, the exchange rate is determined by market forces.
Most major currencies today float, though some countries still peg their currencies.
Pre-WWII: the gold standard
Currencies were defined in terms of gold, providing stable exchange rates.
The system limited monetary policy flexibility because the money supply was tied to gold reserves.
Countries on the gold standard could not easily run expansionary monetary policy during a downturn.
Post-WWII: Bretton Woods (1944–1971)
The dollar was pegged to gold ($35/oz); other currencies were pegged to the dollar.
Created the IMF (to oversee exchange rates and provide emergency lending) and the World Bank (to finance development).
The system collapsed when the US could no longer maintain the gold-dollar link due to inflation and trade deficits.
Post-1971: managed floating
Major currencies float, but central banks sometimes intervene to smooth extreme fluctuations.
GATT (later the WTO) provided a framework for reducing trade barriers through multilateral negotiations.
Regional agreements like NAFTA further reduced barriers between specific trading partners.
Money multiplier:
Money multiplier = 1 / Reserve ratio
Total deposits created from an initial deposit:
Total deposits = Initial deposit x (1 / Reserve ratio)
Quantity theory of money:
MV = PY
Rearranged for the price level: P = MV / Y
Exchange rate calculation (cross rate):
If $1 = 110 yen and $1 = 0.85 euros, then 1 euro = 110 / 0.85 ≈ 129.4 yen.
The 2008 financial crisis saw the Fed reduce the federal funds rate to near zero and engage in "quantitative easing" (large-scale bond purchases) to inject liquidity into the banking system. This is expansionary monetary policy taken to its extreme.
Currency depreciation is why a holiday abroad becomes more expensive when your home currency weakens. It is also why export-heavy economies sometimes prefer a weaker currency.
NAFTA transformed supply chains across North America, with car manufacturers sourcing parts from all three member countries. The economic debate around NAFTA (and its 2020 successor, the USMCA) illustrates the tension between overall gains from trade and the concentrated losses in specific industries and regions.
Students often think the government "prints money" directly when it wants to spend. In practice, the Fed creates money through open market operations, and money creation in the wider economy happens primarily through the banking system's lending activities.
The money multiplier gives a theoretical maximum. In practice, banks hold excess reserves and borrowers do not always redeposit the full amount, so the actual expansion is smaller.
A trade deficit is not inherently "bad". It can reflect strong domestic demand and foreign willingness to invest in the country. The US has run persistent trade deficits while remaining the world's largest economy.
"Fixing" the exchange rate is not free. A country that pegs its currency must hold large foreign exchange reserves and may have to sacrifice control over domestic monetary policy.
⚠️ Be able to trace through the money creation process with a specific reserve ratio and an initial deposit. Know the money multiplier formula.
⚠️ Know the three tools of monetary policy, how each one works, and which direction (expansionary or contractionary) results from each action.
⚠️ Understand the transmission mechanism: from the Fed's action to interest rates to investment to aggregate demand to output and prices.
⚠️ Comparative advantage questions may reappear here in an international context. Be ready to calculate opportunity costs and identify which country should export which good.
⚠️ Know the effects of tariffs and quotas on price, domestic quantity, imports, consumer surplus, and producer surplus.
⚠️ Be able to explain the Bretton Woods system and why it collapsed.
⚠️ Understand the difference between currency appreciation and depreciation, and how each affects exports, imports, and the trade balance.
1. True or False: Under fractional reserve banking, banks lend out all of their deposits.
Answer: False. Banks keep a fraction (the reserve ratio) and lend out the rest.
2. Fill in the blank: If the reserve ratio is 10%, the money multiplier is __________.
Answer: 10 (calculated as 1 / 0.10).
3. True or False: When the Fed buys government bonds, the money supply decreases.
Answer: False. Buying bonds injects money into the economy, increasing the money supply.
4. Fill in the blank: A tariff is a __________ on imported goods.
Answer: Tax.
5. True or False: Under the Bretton Woods system, all currencies were pegged directly to gold.
Answer: False. Currencies were pegged to the US dollar, which was pegged to gold.
Q: A bank receives a new deposit of $10,000. The reserve requirement is 20%. How much can this bank lend from this deposit? What is the maximum total money creation across the entire banking system?
A: The bank keeps $2,000 (20%) in reserves and can lend $8,000. Across the entire banking system, maximum total deposits = $10,000 x (1/0.20) = $50,000. So up to $40,000 of new money is created on top of the original deposit.
Q: The economy is in a recession. Describe what the Fed would do using open market operations and explain the chain of effects.
A: The Fed buys government bonds, which increases bank reserves and the money supply. This drives down interest rates. Lower interest rates encourage borrowing, increasing investment and consumption. Aggregate demand shifts to the right, raising output and reducing unemployment.
Q: Why does a tariff reduce total economic efficiency even though it helps domestic producers?
A: The tariff raises the domestic price above the world price. Consumers pay more and buy less. Some goods that were produced more cheaply abroad are now produced domestically at higher cost. The loss to consumers exceeds the gains to producers and the government, creating a deadweight loss.
Q: Explain the double coincidence of wants and why it makes barter inefficient.
A: In a barter system, for a trade to occur, each party must want exactly what the other offers. A baker who wants shoes must find a cobbler who wants bread. As economies grow and specialise, finding these matches becomes increasingly impractical. Money eliminates this problem by serving as a universally accepted medium of exchange.
Q: Country X pegs its currency to the US dollar. What happens if Country X experiences higher inflation than the US?
A: Country X's goods become relatively more expensive. Its exports fall and imports rise, creating a trade deficit. Maintaining the peg becomes increasingly costly because the central bank must use foreign reserves to buy its own currency. Eventually, the peg may become unsustainable and collapse (devaluation).
Q: What is the quantity theory of money, and what does it predict about inflation?
A: The quantity theory states that MV = PY. If velocity (V) and real output (Y) are stable, then an increase in the money supply (M) leads proportionally to an increase in the price level (P). It predicts that excessive money supply growth is the primary cause of inflation.
Monetary policy and fiscal policy (Chapters 13–15) are complementary tools. In practice, a recession often triggers both lower interest rates from the Fed and stimulus spending from Congress.
Exchange rates connect directly to aggregate demand through the net exports component. A depreciating currency boosts exports and shifts AD to the right, a mechanism the AD/AS model from the previous unit captures.
The comparative advantage principle introduced in the trade chapters is the same concept from Chapter 3, now applied to nations rather than individuals.
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