Introduction to Economics:

The Monetary System

M. Mujiya Ulkhaq, Ph.D.

Department of Industrial Engineering
Diponegoro University, Semarang, Indonesia For undergraduate (bachelor) level,
E-mail: ulkhaq@live.undip.ac.id Department of Industrial Engineering,
Homepage: https://sites.google.com/view/mujiyaulkhaq/ Diponegoro University, Indonesia
 The Meaning of Money
• The social custom of using money for transactions is extraordinarily useful in a large, complex society.
• Imagine, for a moment, that an economy had no item widely accepted in exchange for goods and services. People would have
to rely on barter—the exchange of one good or service for another—to obtain the things they need.
• An economy that relies on barter will have trouble allocating its scarce resources efficiently. In such an economy, trade is
said to require the double coincidence of wants—the unlikely occurrence that two people each have a good or service that the
other wants. The existence of money makes trade easier.
• Money is the set of assets in the economy that people regularly use to buy goods and services from each other.
• Money has three functions:
o as a medium of exchange: an item that buyers give to sellers when they
want to purchase goods and services.
o as a unit of account: the yardstick people use to post prices and record
debts.
o as a store of value: an item that people can use to transfer purchasing
power from the present to the future.
• Economists use the term liquidity to describe the ease with which an asset
can be converted into the economy’s medium of exchange. When people
decide how to allocate their wealth, they have to balance the liquidity of
each possible asset against the asset’s usefulness as a store of value.

M. Mujiya Ulkhaq, Ph.D. The monetary system 2

 The Kinds of Money
• Commodity money is money that takes the form of a commodity with
intrinsic value.
• Fiat money is money without intrinsic value. A fiat is an order or decree,
and fiat money is established as money by government decree.
• The term intrinsic value means that the item would have value even if it
were not used as money. One example of commodity money is gold.

• Di Indonesia, uang beredar didefinisikan berdasarkan tingkat likuiditasnya:

o Uang beredar dalam arti sempit (M1): uang kartal yang dipegang masyarakat
dan uang giral, termasuk uang elektronik dan tabungan rupiah yang dapat
ditarik sewaktu-waktu.
o Uang beredar dalam arti luas (M2): M1 ditambah uang kuasi dan surat
berharga selain saham yang diterbitkan bank.
§ Uang kuasi terdiri simpanan berjangka dan tabungan lainnya (rupiah
dan valas), serta simpanan giro valuta asing.

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 Bank and the Money Supply
The Simple Case of 100-percent-reserve Banking
• Let’s first imagine a world without any banks at all. In this simple world, currency is the only form of money. Let’s suppose
that the total quantity of currency is $100. The supply of money is, therefore, $100.
• Now suppose that someone opens a bank, appropriately called First National Bank (FNB). FNB is only a depository
institution—that is, it accepts deposits but does not make loans. The purpose of the bank is to give depositors a safe place to
keep their money. Deposits that banks have received but have not loaned out are called reserves. In this imaginary economy,
all deposits are held as reserves.
• The financial position (or the balance sheet) of FNB can be described as

the reserves it holds in its vaults ← → the amount it owes to its depositors

• Before FNB opens, the money supply is the $100 of currency that people are holding. After the bank opens and people
deposit their currency, the money supply is the $100 of demand deposits. (There is no longer any currency outstanding, since
it is all in the bank vault.) Each deposit in the bank reduces currency and raises demand deposits by exactly the same amount,
leaving the money supply unchanged.
• Thus, if banks hold all deposits in reserve, banks do not influence the supply of money.

M. Mujiya Ulkhaq, Ph.D. The monetary system 4

 Bank and the Money Supply (2)
Money Creation with Fractional-reserve Banking
• Fractional-reserve banking is a banking system in which banks hold only a fraction of deposits as reserves. The fraction of
total deposits that a bank holds as reserves is called the reserve ratio. This ratio is influenced by both government regulation
and bank policy.
• The central bank sets a minimum amount of reserves that banks must hold, called a reserve requirement. Banks may hold
reserves above the legal minimum, called excess reserves, so they can be more confident that they will not run short of cash.
• Let’s suppose that FNB has a reserve ratio of 10%. Now, look again at the bank’s balance sheet

• Before FNB makes any loans, the money supply is the $100 of deposits. Yet when FNB lends out some of these deposits, the
money supply increases.
• The depositors still have demand deposits totaling $100, but now the borrowers hold $90 in currency. The money supply
(which equals currency plus demand deposits) equals $190.
• Thus, when banks hold only a fraction of deposits in reserve, the banking system creates money.
• It appears that the bank has created money out of thin air; but the economy is no wealthier than before.

M. Mujiya Ulkhaq, Ph.D. The monetary system 5

 Bank and the Money Supply (3)
The Money Multiplier
• How much money is created in this economy?
• Suppose the borrower from FNB uses the $90 to buy
something from someone who then deposits it in the
Second National Bank (SNB). If SNB also has a reserve
ratio of 10%, the balance sheet is then

• In this way, SNB creates an additional $81 of money.

If this $81 is eventually deposited in Third National
Bank (TNB), which also has a reserve ratio of 10%, the • The amount of money the banking system generates
balance sheet is with each dollar of reserves is called the money
multiplier. It is the reciprocal of the reserve ratio. If R
is the reserve ratio for all banks in the economy, then
each dollar of reserves generates 1/R dollars of money.
In our example, R = 10%, so the money multiplier is 10.
• The process goes on and on. • Thus, the higher the reserve ratio, the less of each
• Each time that money is deposited and a bank loan is deposit banks loan out, and the smaller the money
made, more money is created. multiplier.
M. Mujiya Ulkhaq, Ph.D. The monetary system 6
 Bank Capital and Leverage
• A bank gets financial resources not only from accepting deposits but also, like other companies, from issuing
equity and debt. The resources that a bank obtains from issuing equity to its owners are called bank capital.
• It not only makes loans and holds reserves but also buys financial securities, such as stocks and bonds.

• Many businesses rely on leverage, the use of borrowed money to supplement existing funds for investment
purposes. Indeed, whenever a business uses debt to finance an investment project, it is applying leverage.
• The leverage ratio is the ratio of the bank’s total assets to bank capital. In this example, the leverage ratio is
$1,000/$50 = 20.
• Bank regulators require banks to hold a certain amount of capital, called capital requirement. The goal of such a
capital requirement is to ensure that banks will be able to pay off their depositors (without having to resort to
government-provided deposit insurance funds).

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 Central Bank
Central bank is an institution designed to oversee the banking system and regulate
the quantity of money in the economy. Bank Indonesia (BI) is the central bank of
Indonesia. Other major central banks around the world include the Federal Reserve
(US), the Bank of England, the Bank of Japan, and the European Central Bank.
• Generally, the central bank has two related jobs.
o The first is to regulate banks and ensure the health of the banking system. In
particular, the Fed monitors each bank’s financial condition and facilitates
bank transactions by clearing checks. It also acts as a bank’s bank. When
financially troubled banks find themselves short of cash, the Fed acts as a
lender of last resort—a lender to those who cannot borrow anywhere else—
to maintain stability in the overall banking system.
o The second job is to control the quantity of money that is made available in
the economy, called the money supply. Decisions by policymakers
concerning the money supply constitute monetary policy.

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 Central Bank’s Tools of Monetary Control
Tools that influence the quantity of reserves
• Open-market operations
It is the purchase and sale of government bonds by the central bank.
o To increase the money supply, the central bank instructs its bond traders to buy bonds from the public in the
nation’s bond markets. By paying for the bonds with newly created dollars, the central bank increases the
number of dollars in the economy.
o To reduce the money supply, the central bank does just the opposite: it sells government bonds to the public
in the nation’s bond markets. The public pays for these bonds with its holdings of currency and bank deposits,
directly reducing the amount of money in circulation.
• Central bank lending to banks
The central bank can also increase the quantity of reserves by lending reserves to banks.
o Banks borrow from the central bank when they feel they do not have enough reserves on hand. Traditionally,
banks borrow from the central bank’s discount window and pay an interest rate on that loan called the
discount rate; these additional reserves allow the banking system to create more money.
o The central bank can alter the money supply by changing the discount rate. A higher discount rate
discourages banks from borrowing from the central bank. Conversely, a lower discount rate encourages banks
to borrow from the central bank, increasing the quantity of reserves and the money supply.

M. Mujiya Ulkhaq, Ph.D. The monetary system 9

 Central Bank’s Tools of Monetary Control (2)
Tools that influence the reserve ratio and in turn the money multiplier
• Reserve Requirements
It is regulations on the minimum amount of reserves that banks must hold against deposits. The changes in
reserve requirements is only happened rarely because such changes disrupt the business of banking.
o An increase in reserve requirements means that banks must hold more reserves and, therefore, can loan out
less of each dollar that is deposited. As a result, this increase raises the reserve ratio, lowers the money
multiplier, and decreases the money supply.
o Conversely, a decrease in reserve requirements lowers the reserve ratio, raises the money multiplier, and
increases the money supply.
• Paying Interest on Reserves
Traditionally, banks did not earn any interest on the reserves they held on deposit at the central bank. However, in
October 2008, the Federal Reserve (the central bank of US) began paying interest on reserves. That is, when a
bank holds reserves at the Fed, the Fed now pays the bank interest on those deposits. The higher the interest rate
on reserves, the more reserves banks will choose to hold. Thus, an increase in the interest rate on reserves will
tend to increase the reserve ratio, lower the money multiplier, and lower the money supply.

M. Mujiya Ulkhaq, Ph.D. The monetary system 10

 Problems in Controlling the Money Supply
The central bank’s control of the money supply is not precise. It must wrestle with two problems, each of which
arises because much of the money supply is created by the system of fractional-reserve banking. In this system, the
amount of money in the economy depends in part on the behavior of depositors and bankers.
• The first problem is that the central bank does not control the amount of money that households choose to hold
as deposits in banks.
The more money households deposit, the more reserves banks have, and the more money the banking system can
create. The less money households deposit, the less reserves banks have, and the less money the banking system
can create. Suppose that one day people lose confidence in the banking system and withdraw some of their
deposits to hold more currency. When this happens, the banking system loses reserves and creates less money.
The money supply falls, even without any central bank action.
• The second problem of monetary control is that the central does not control the amount that bankers choose to
lend.
When money is deposited in a bank, it creates more money only when the bank loans it out. Because banks can
choose to hold excess reserves instead, the central bank cannot be sure how much money the banking system will
create. For instance, suppose that one day bankers become more cautious about economic conditions and decide
to make fewer loans and hold greater reserves. In this case, the banking system creates less money than it
otherwise would. Because of the bankers’ decision, the money supply falls.

M. Mujiya Ulkhaq, Ph.D. The monetary system 11

 Bank Indonesia

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 Tugas dan Wewenang
Berdasarkan UU No. 23 tahun 1999 tentang Bank Indonesia.
• Tujuan Bank Indonesia (BI) adalah mencapai dan memelihara kestabilan nilai rupiah.
• Untuk mencapai tujuan tersebut, BI mempunyai tugas:
o Menetapkan dan melaksanakan kebijakan moneter;
Dalam rangka menetapkan dan melaksanakan kebijakan moneter, BI berwenang:
§ menetapkan sasaran-sasaran moneter dengan memperhati-kan laju inflasi yang ditetapkan; dan
§ melakukan pengendalian moneter dengan menggunakan cara-cara antara lain:
a. operasi pasar terbuka di pasar uang baik rupiah maupun valuta asing;
b. penetapan tingkat diskonto; dan
c. penetapan cadangan wajib minimum.
o Mengatur dan menjaga kelancaran sistem pembayaran;
Dalam rangka mengatur dan menjaga kelancaran sistem pembayaran, BI berwenang:
§ melaksanakan dan memberikan persetujuan dan izin atas penyelenggaraan jasa sistem pembayaran.
§ mewajibkan penyelenggara jasa sistem pembayaran untuk menyampaikan laporan tentang kegiatannya.
§ menetapkan penggunaan alat pembayaran.
o Mengatur dan mengawasi bank.
Dalam rangka melaksanakan tugas mengatur dan mengawasi bank, BI menetapkan peraturan, memberikan dan
mencabut izin atas kelembagaan dan kegiatan usaha tertentu dari bank, melaksanakan pengawasan bank dan
mengenakan sanksi terhadap bank sesuai dengan peraturan perundang-undangan.

M. Mujiya Ulkhaq, Ph.D. The monetary system 13

 Operasi Moneter
• BI menjalankan operasi moneter (OM) untuk mendukung pencapaian stabilitas moneter yang dilaksanakan di
pasar uang dan pasar valuta asing secara terintegrasi.
• OM terdiri dari operasi pasar terbuka (OPT)—open-market operation dan standing facilities (SF).
o OPT: kegiatan transaksi di pasar uang dan/atau pasar valuta asing yang dilakukan oleh BI dengan bank
dan/atau pihak lain. Pelaksanaan OPT rupiah dibagi menjadi dua yaitu OPT absorbsi dan OPT injeksi:
§ OPT absorbsi dilakukan untuk menyerap kelebihan likuiditas
§ OPT injeksi dilakukan untuk menambah ketersediaan likuiditas.
o SF: kegiatan penyediaan dana rupiah dari BI kepada bank dan penempatan dana rupiah oleh bank di BI.
SF tersedia di setiap akhir hari yang terdiri dari:
§ Deposit Facility (DF) yang merupakan penempatan dana rupiah oleh peserta SF di BI untuk OM yang
dilakukan secara konvensional atau berdasarkan prinsip syariah. DF yang dilakukan berdasarkan prinsip
syariah dilaksanakan dalam bentuk Fasilitas Simpanan Bank Indonesia Syariah (FASBIS).
§ Lending Facility (LF) atau Financing Facility (FF). LF adalah penyediaan dana rupiah dari BI kepada
peserta SF konvensional untuk OM yang dilakukan secara konvensional, dan FF adalah penyediaan
dana rupiah dari BI kepada peserta SF syariah untuk OM yang dilakukan berdasarkan prinsip syariah.

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 Giro Wajib Minimum
Di Indonesia, reserve requirement disebut
giro wajib minimum (GWM), yang
merupakan dana atau simpanan minimum
yang harus dipelihara oleh bank dalam
bentuk saldo rekening giro yang
ditempatkan di BI.
• GWM primer yakni simpanan minimum
(rupiah) yang wajib dipelihara oleh bank
dalam rekening giro di BI yang besarannya
ditetapkan dalam rasio terhadap dana pihak
ketiga yang dihimpun perbankan.
• GWM sekunder yakni cadangan minimum
(rupiah) yang wajib dipelihara oleh bank
berupa surat berharga, seperti Sertifikat Bank
Indonesia, Sertifikat Deposito Bank
Indonesia, dan Surat Berharga Negara.

M. Mujiya Ulkhaq, Ph.D. The monetary system 15

 Jumlah Uang Beredar M1
Jumlah Uang Beredar (M1)
3000000

2608796,67
2539067,31
2467951,35
2500000
2327208,49 2302911,17 2339449,79
2296045,42 2279163,48 2320882,57
2254591
2195617,78
2149551,5

2000000
Milyar Rupiah

1500000

1000000

500000

0
Januari Februari Ma re t April Me i Juni Juli Agustus September Oktober November Desember
2022

Uang Kartal Uang Giral M1 Sumber: BPS (2023)

M. Mujiya Ulkhaq, Ph.D. The monetary system 16

 Jumlah Uang Beredar M2
Jumlah Uang Beredar (M2)
9000000
8528022,31
8223055,02 8297349,52
7810949,31
7911484,49 7854186,71 7890747,01 7845551,9 7897628,2 7962693,36
8000000 7646789,2 7690134,49

7000000

6000000
Milyar Rupiah

5000000

4000000

3000000

2000000

1000000

0
Januari Februari Ma re t April Me i Juni Juli Agustus September Oktober November Desember
2022

Uang Kuasi Surat Berharga Selain Saham M1 M2

Sumber: BPS (2023)

M. Mujiya Ulkhaq, Ph.D. The monetary system 17

 References
• Mankiw, N. Gregory (2021), Principles of Economics, 9th Edition, Cengage.
• Peraturan Anggota Gubernur Dewan Bank Indonesia No. 24/8/PADG/2022.
• Undang-Undang No. 23 tahun 1999.

M. Mujiya Ulkhaq, Ph.D. The monetary system 18