Introduction to Unit 10 - The Banking System and the Money Multiplier

In this section and the next we will develop our understanding of the Federal Reserve Board and how it uses monetary policy to impact the macroeconomy. We will begin with a look at what we consider to be money. This might be a good time to pull out your wallet and a few scarce bills from it.

In your hand you have some pieces of paper with pictures of well known Americans. Perhaps you are fortunate to hold a few with Ben Franklin's mug on it, but you probably have a few one dollar bills lying around so let's take a look. You will notice that at the top of the bill is written FEDERAL RESERVE NOTE. This tells us that our currency is printed and issued by our nation's central bank, the Federal Reserve. Only the Federal Reserve has the power to legally print money in the United States. This tips us off to the Fed's primary role - to preserve the value of the currency it issues. And also to maintain a strong banking system since the two are complementary to each other.

Flip over the note and take a careful look. There is a pyramid with a floating eye above it. Some kind of symbolism isn't it? My understanding is that this is a symbol of America's early Masonic groups, but I'm not really sure.

The key point being made here is why is this bill worth a dollar and why is a twenty worth $20 of goods and services? Certainly, the bill has no intrinsic value beyond what we give it; the paper it is written on is worthless. What makes money worth more than the paper it is printed on is our faith in our government that issues the money. We trust our money because we believe that the issuing government will maintain the value of that money.

What would you do if you were traveling to a country with hyperinflation where the value of the domestic currency fell by 80% every day? You would avoid holding that currency, preferring to carry out transactions in a more stable currency. This would not be a problem since most merchants would avoid the domestic currency as well. This happens all of the time in countries experiencing severe inflationary problems where the value of the domestic currency falls significantly. Citizens avoid the local currency in favor of a stable one like the dollar or they resort to barter for the exchange of goods and services.

The key to maintaining the value of a currency is to avoid significant inflation. Thus we are willing to make our transactions in dollars as long as we feel its value will be maintained by the presence of minimal inflation rates. The last bout of high inflation in the U.S. was during the 1970s when annual inflation rates reached double digits. Americans responded in several ways. First they tried to spend their earnings as rapidly as possible before prices went up further, and before their money lost part of its value. Savings was reoriented towards inflationary hedges such as gold and real estate that tends to maintain its value when inflation is present. During the 1970s the price of an ounce of gold went from around $100 an ounce to over $800 per ounce.

In contrast, inflation has been low the past decade and the value of gold has stagnated in the $200 to $300 range. The return on savings in gold has been negative during the past decade.

The Money Multiplier

This section will also look at the concept of the money multiplier. The money multiplier implies that when the Fed increases (or decreases) banking reserves by another dollar, the overall increase in the money supply is a multiple of that. This is a result of our fractional banking system where banks are only required to hold 10% of every dollar deposited as reserves. The rest the bank is free to loan out or use to purchase other assets.

In our study of the money multiplier we will look at a hypothetical balance sheet for a bank. On one side of the balance sheet is the bank's liabilities or obligations. This is the source of bank funds and is comprised primarily of deposits by individuals and institutional money managers. Having raised money, a bank seeks to earn a return higher than what it is paying out on its liabilities. Assets comprise what the bank does with its money it raises from depositors. A bank's assets are made up of consumer, business and industrial loans, government debt that it purchases, and required reserves that it must keep with the Federal Reserve. 10% of all deposits must be kept in the form of required reserves by banks.

The Federal Reserve sets the reserve requirement - the portion of bank deposits that must be kept on reserve with the Fed. Currently, the reserve requirement equals 10%. Required reserves are a great deal for the Fed. The Fed pays no interest on the bank reserves that are kept with it. Required reserves also provide the main source of funds for the Fed to conduct monetary policy that we will cover in the next section of this course. As we will see, the Fed routinely uses the reserves that it obtains from a bank to turn around and purchase some of that bank's assets.