• Unit 5: Money, Banking, and Monetary Policy

    Monetary policy includes the methods government agencies, such as the U.S. Federal Reserve, engage in to encourage banks, businesses, and individuals to change their interest rates, the supply of money, and the demand for money. Money serves as a medium of exchange, a store of value, and a unit of account. These three functions enable individuals to avoid a bartering system (we pay a business money for providing a service, rather than with a goat or loaf of bread). The ways we use to define and measure money are important to managing an economy. Savings and investment are key elements within the circular flow model and are a function of interest rates.

    Completing this unit should take you approximately 11 hours.


    • Upon successful completion of this unit, you will be able to:

      • define money and identify its functions;
      • show how money is measured and explain the role of banks in the money creation process;
      • apply the money multiplier formula to calculate the change in money supply in a fractional reserve banking system;
      • explain the structure, functions, and goals of the U.S. Federal Reserve;
      • show the importance of the Fed's independence from the government and explain the way independence is achieved through the Fed's structure and decision making process;
      • identify the three tools of monetary policy and the ways in which they are used to change the money supply in the economy;
      • explain and illustrate how the bond market works, and discuss the relationship between bond prices and interest rates;
      • explain and illustrate how the foreign exchange market works and how a change in the interest rate affects the exchange rate for a country's currency;
      • graphically represent the money demand and the money supply functions and determine the equilibrium interest rate and quantity of money in the money market;
      • use graphs to analyze the effect of changes in the bonds and money markets on the equilibrium real GDP and the price level;
      • identify the main goals of monetary policy and apply the monetary policy tools to achieve a particular outcome; and
      • Use AD-AS model to illustrate the impact of monetary policy on the price level and real GDP.

    • 5.1: Money and the Money Creation Process

      • The Nature and Creation of Money Book

        Read these sections, "What is Money?" and "The Banking System and Money Creation", to examine money and its impact on real GDP and the price level.  Specifically, learn about what money is and its three functions. Distinguish between the M1 and M2 definitions of money. Also, learn about the money creation process and role of banks in it in a fractional reserve banking system. You will revisit certain sections of the chapter later in this unit.

      • The Federal Reserve: "Federal Reserve Statistical Release" File

        Read this report to find out specific values of the different measures of money – M1 and M2. Also learn about the growth of the U.S. economy overtime.

      • What is Money? Page

        The following videos discuss the definition of money and the money creation process in a fractional reserve banking system. Understanding the money creation process is key to understanding how to control the economy through changes in the money supply.

      • Fractional Reserve Banking Page

        Watch these videos, which explain fractional reserve banking. Be mindful that total reserves are the checkable deposits that the public has placed in a commercial bank. Required reserves are a percentage of the checkable deposits that must remain in a commercial bank as required by the Federal Reserve. Required reserves are set by the Federal Reserve to protect banks from customers running on the bank, i.e., reserves protects a bank from customer panic. Excess reserves are a percentage of checkable deposits that a bank is authorized by the Federal Bank to lend out. Consequently, required reserves are deposits from which the banks earn a profit through the loan and repayment process.

      • Weaknesses of Fractional Reserve Lending Page

        As banks are only required to keep a fraction of all deposits as reserves, the risk is there for depositors asking to withdraw their deposits in droves in the event of unfavorable market conditions. How can a bank operating in this system ensure that it can fulfil its obligations to its customers? Watch this lecture about the weaknesses of fractional reserve lending.

      • Fractional Reserve Banking and Money Creation Quiz
        Receive a grade

        Take this quiz to check your understanding of fractional reserve banking, the reserve requirement, money creation, and the role of the Fed in these processes.

        • This assessment does not count towards your grade. It is just for practice!
        • You will see the correct answers when you submit your answers. Use this to help you study for the final exam!
        • You can take this assessment as many times as you want, whenever you want.

    • 5.2: Structure and Powers of the Federal Reserve System

      • The Federal Reserve System Book
        Read these sections to learn about the Federal Reserve System's structure, functions, and goals. Also, identify and explain the tools of monetary policy and way money is created or destroyed through the purchase and sale of government bonds.
      • The Fed Page
        Watch this video to learn about the Federal Reserve system of banks. As you learn about the Fed's structure, think about how this structure helps insulate this insitution and its decision making authority from the political processes in the country.
      • The Fed Today Page

        This video walks through the history of the Federal Reserve from its creation in through present day banking. It explores the structure of the Fed, its role in banking supervision and financial services, as well as its primary role in designing and carrying out monetary policy.

      • The Federal Reserve: "Everyday Economics" Book

        Read this article on the inception of the Federal Reserve system. Also learn about how this institution evolved over time to become one of the most important decision makers in our economy.

    • 5.3: Financial Markets

      • Financial Markets and the Economy Book

        Read this chapter to build a foundation for understanding financial markets. The first section discusses the bonds and foreign exchange markets and the way they are connected through the interest rate. The second section builds the model of the money market and connects it to the other financial markets. Pay attention to how the connection is made between the financial markets and the overall economy by showing the effects on the equilibrium real GDP and the price level, using the model of aggregate demand and supply.

      • Overview of Bonds Page

        Read this article about bonds and some factors related to their prices. Like stocks, an objective is to sell at a higher price than that at time of purchase. Part of this effort entails focusing on current and anticipated interest rates. Unlike stocks, bonds take the form of loans. You will learn about a specific relationship that exists between bond prices and interest rates.

      • Exchange Rates Page

        Watch this video to learn about the foreign exchange market and the way the value of currency is determined through the demand and supply of currency. Also learn about how and why a country may manipulate its currency value.

      • Interest as Rent for Money Page

        Watch this lecture, which discusses interest as rent for money. Be mindful that equilibrium interest rates are the balance or combination of the market for money plus the investment demand for money. Consequently, equilibrium real GDP and the price level will determine the equilibrium based on transactional demand and investment demand.

      • Money Supply and Demand Impacting Interest Rates Page

        Watch this lecture about money supply and demand impacting interest rates. Note that the interest rate is the price of money (as it is money's opportunity cost). As individuals consider the interest rate when deciding how much of their income to save and how much to spend, they effectively make the choice of how much money to hold (for the purpose of spending).

      • Financial Speculation Page

        Read this article about the stock market and how expectations play a role in terms of changes in the price of a stock. Speculators tend to focus on changes in prices and attempt to sell at a price higher than they bought the stock. You will learn that a stock is a share of ownership in an organization, and its price is determined largely by the supply of and the demand for stocks in the stock market.

    • 5.4: Monetary Policy and the Interest Rates

      • Monetary Policy and the Fed Book

        Read this chapter to understand in more detail the monetary policy tools, process, and impacts on the U.S. economy. Review specific monetary policies and their effects from our recent history.

      • Monetary Policy Page

        Watch this video for an overview and explanation of the three tools of monetary policy: Open Market Operations, the Required Reserve Ratio, and the Discount Rate.

      • The Federal Reserve: Monetary Policy Page

        Read this article, which adds depth to the three tools of monetary policy and covers the difference between the federal funds rate, which is set by banks, and the targeted federal fund rate. Some of the reading describes how the Fed provides signals to the market for the purpose of stimulating economic activity and goal achievement.