Money and the Banking System — The Federal Reserve and Monetary Policy

Lesson Purpose:

Banks and other financial intermediaries operate in capital markets that perform the important functions of coordinating the actions of savers and borrowers and facilitating the investment that is critical to a growing market economy.  Additionally, the lending function of commercial banks is the means by which the money supply in our economy changes in response to the ups and downs of the business cycle.

This lesson focuses on the operation of the commercial banking system, and the mechanics of money creation through the lending process.  It also looks at the operation of capital markets where interest (the price of money), creates incentives that affect the levels of saving, lending, and borrowing activities in the economy. An understanding of how banks create money is also a necessary pre-requisite for topic 12, which focuses on monetary policy and the Federal Reserve System.

Key Terms:

money fiat money investment commercial bank
money supply interest capital market currency exchange
loanable funds required reserves excess reserves

Content Standards:

Standard 10: Students will understand that: Institutions evolve in market economies to help individuals and groups accomplish their goals. Banks, labor unions, corporations, legal systems, and not-for-profit organizations are examples of important institutions . . . .

grade 8:

  • Banks and other financial institutions channel funds from savers to borrowers and investors.

Standard 11: Students will understand that: Money makes it easier to trade, borrow, save, invest, and compare the value of goods and services.

grade 12:

  • The basic money supply of the United States consists of currency, coins, and checking account deposits.
  • In many economies, when banks make loans, the money supply increases; when loans are paid off, the money supply decreases.

Standard 12: Students will understand that: Interest rates, adjusted for inflation, rise and fall to balance the amount saved with the amount borrowed, thus affecting the allocation of scarce resources between present and future uses.

grade 12:

  • An interest rate is the price of money that is borrowed or saved.
  • Like other prices, interest rates are determined by the forces of supply and demand.
  • The real interest rate is the nominal or current market interest rate minus the expected rate of inflation.
  • Higher real interest rates provide incentives for people to save more and to borrow less.  Lower real interest rates provide incentives for people to save less and to borrow more.
  • Real interest rates are positive because people must be compensated for deferring the use of resources from the present into the future.
  • Riskier loans command higher interest rates than safer loans because of the greater chance of default on the repayment of risky loans.

Standard 15: Students will understand that: Investment in factories, machinery, new technology, and the health, education, and training of people can raise future standards of living.

grade 12:

  • Investment in physical and human capital can increase productivity, but such investments entail opportunity costs and economic risks.
  • Investing in new physical or human capital involves a trade-off of lower current consumption in anticipation of greater future production and consumption.
  • Higher interest rates discourage investment.

Standard 20: Students will understand that: Federal government budgetary policy and the Federal Reserve System’s monetary policy influence the overall levels of employment, output, and prices.

grade 12:

  • Monetary policies are decisions by the Federal Reserve System that lead to changes in the supply of money and the availability of credit.  Changes in the money supply can influence overall levels of spending, employment, and prices in the economy by inducing changes in interest rates charged for credit and by affecting the levels of personal and business investment spending.
  • The major monetary policy tool that the Federal Reserve System uses is open market purchases or sales of [U.S.] government securities.  Other policy tools used by the Federal Reserve System include increasing or decreasing the discount rate charged on loans it makes to commercial banks and raising or lowering reserve requirements for commercial banks.

Session Objectives:

  • Identify the differences between commodity-backed money and fiat money.
  • Discuss different methods of valuing currency – government set value; pegging to other currencies; floating exchange rate – and how economic changes, trade policies, and central banks can affect the value of currencies.
  • Explain currency exchange rates and currency speculation.
  • Briefly review the history and development of fractional reserve banking.
  • Define the money supply and relate changes in the money supply to commercial banking. Explain how the composition of the money supply responds to market forces.
  • Define and demonstrate the money multiplier.
  • Define interest.  Review the operation of supply, demand, and price in product markets, and develop the example of interest as the price in capital markets.
  • Discuss the relationship between interest rates and investment, and relate to the business cycle model.
  • Add interest and investment to the previously developed circular flow model.
  • Discuss how deficit spending and other fiscal policies may impact interest rates, investment, and national economic goals (growth, stability, security, equity).
  • Present and explain the Quantity Theory of Money.

Key Content:

  • Money supply measures include currency in circulation and transaction and time (demand) deposits.
  • Markets determine the values of nations’ currencies, reflecting nations’ productive capacities and confidence in the stability of their governments.
  • Banks and other financial intermediaries perform an important role in the economy by coordinating the actions of savers and lenders on the one hand, and borrowers and investors on the other.
  • The real interest rate is the price of money.  (The nominal interest rate is the real interest rate plus the expected rate of inflation.)
  • Changes in real interest rates change the levels of saving and borrowing in the economy.
  • The level of investment in the economy, and therefore the rate of economic growth, is directly related to interest rates.


  • Money has no value unless it is backed by a precious metal.
  • Money has always been backed by precious metals.
  • Checks aren’t real money.
  • The quantity of money in circulation is constant.
  • The Federal Reserve and the U.S. Treasury determine the composition of the money supply.
  • Money deposited in a bank (financial intermediary) stays there until the depositor takes it out.
  • All banks are always “loaned up.
  • Deposits are assets and loans are liabilities for banks.

Frequently Asked Questions:

  • Wouldn’t money be worthless without gold/silver backing?
  • Why are banks important to the economy?
  • How are banks different from other types of financial intermediaries?
  • How do banks create money?
  • What is the money multiplier?
  • How do banks “set” interest rates?
  • Why are interest rates different for different things – mortgages, savings accounts, auto loans, etc.?
  • Isn’t it always good for the economy if interest rates are low?
  • Isn’t it better for business if people spend their money rather than saving it?
  • Is it better (for you / for the economy) to put your money in a savings account or to buy government bonds?

Classroom Activity Options

  • Demonstrate an example of money creation through the process of commercial lending.
  • Demonstrate an example of the money multiplier, noting how money is created and destroyed by the deposit/lending/repayment cycle.
  • Review the circular flow model.  Further develop the model by adding in savings, borrowing, and investment.
  • Use historical tables and historical business model charts to develop the relationship between real and nominal interest rates and the level of inflation.
  • Use interest rate table (or assign students to investigate various interest rates) to develop the relationship between interest rates and risk.
  • Use historical tables to demonstrate the relationship between interest rates, investment, and economic growth.

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