Money, Banking, and Monetary Policy
Core concepts
Money serves as medium of exchange, unit of account, and store of value. M1 includes currency and checkable deposits; M2 adds savings deposits, small time deposits, and money market funds. Banks create money through lending; the money multiplier is approximately 1 divided by the reserve ratio, so a 10% reserve requirement supports about $10 of deposits per $1 of reserves. The Federal Reserve conducts monetary policy. To expand the money supply it buys securities, lowers the discount rate, or lowers reserve requirements; to contract it does the reverse. Expansionary policy lowers interest rates, raising investment and aggregate demand. The money demand curve reflects transactions, precautionary, and speculative motives. The quantity theory links money growth to inflation. Monetary policy faces lags and liquidity-trap limits. The Fed's goals include price stability and maximum employment.
Traps to watch
- Reversing open-market operations - buying expands reserves, selling contracts them.
- Using the multiplier as exact rather than a maximum, ignoring currency holding and excess reserves.
- Confusing the discount rate with the federal funds rate.
- Assuming bond prices and interest rates move together; they move inversely.
Worked example
A $1,000 open-market purchase with a 20% reserve ratio supports up to $1,000 × (1/0.20) = $5,000 in new deposits. Rule of thumb: multiplier = 1 ÷ reserve ratio; higher reserves mean less money creation.