Unit 6-Ch29-The Monetary System

Unit 6
The monetary system
1. The Meaning of Money

• Money
– The set of assets in an economy that
people use to buy goods and services
from other people.
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1. The Meaning of Money
• Functions of money
– Medium of exchange
– Unit of account
– Store of value
Functions of money
• Medium of exchange
- A medium of exchange is an item that
buyers give to sellers when they want to
purchase goods and services.
- A medium of exchange is anything that is
readily acceptable as payment.
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Functions of money
• Unit of account
- A unit of account is the yardstick people
use to post prices and record debts.
• Store of Value
- A store of value is an item that people
can use to transfer purchasing power from
the present to the future.
The Kinds of Money

• Commodity money
– Money that takes the form of a commodity
with intrinsic value
– Examples: gold, silver, cigarettes
• Fiat money
– Money without intrinsic value
– Used as money because of government
decree
– Examples: coins, currency, check deposits
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2. Money in the economy
• Money stock
– Quantity of money circulating in the
economy
• Liquidity
- Liquidity is the ease with which an asset
can be converted into the economy’s
medium of exchange.
2. Money in the economy

Currency
- The paper bills and coins in the
hands of the public.
Demand deposits (checking account)
– Balances in bank accounts - depositors
can access on demand by writing a check
or using a debit card.
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Figure 1
Measures of the Money Stock: M0, M1, M2
3. Banks and the money supply

3.1 Banking system
Central Bank
Commercial Banks
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3.1 Banking system
• Central bank
– Regulates banks to ensure they follow
federal laws intended to promote safe and
sound banking practices.
– Acts as a banker’s bank, making loans to
banks and as a lender of last resort.
– Conducts monetary policy by controlling
the money supply.
– Issues money.
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3.1 Banking system

• Commercial Banks
- Financial intermediaries
- Create a medium of exchange by allowing
people to write checks against their
deposits.
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3.2 Banks and the Money Supply
• Money supply (MS): equals currency plus
demand (checking account) deposits:
➔MS= Cu + D
• Monetary base (B): issued by the Central
Bank, equals to currency and reserves at
commercial banks (Reserves: deposits
that banks have received but have not
loaned out)
➔ B=Cu+R
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• Central bank issues $1000
Scenario 1: No banks
Cu= 1000, D=0
➔MS= Cu+D=1000
➔MS=B
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Scenerio 2: 100% reserve banking

- Now suppose households deposit the
$1000 at “Firstbank” and this deposit are
held as reserves.
➔Cu=0, D=1000, R=1000
➔MS= Cu+D=1000
First Bank’s balance sheet 100% Reserve Banking has no impact
Assets Liabilities on size of money supply.
R = 1000 D = 1000
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• Scenerio 2: Fractional-Reserve Banking
- Suppose banks hold 10% of deposits in
reserve
- Suppose households deposit the $1000 at
“Firstbank”, this bank will reserve 10%
and loans 80% of the deposit.
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First Bank Second Bank Third Bank
Assets Liabilities Assets Liabilities
R: 90 D: 900
R: 100 D: 1000
Loans: 810
Loans: 900
The borrower holds $810

The borrower holds $900 in currency and deposits in
in currency and deposits in Third bank
Second bank
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Finding the total amount of money

– Original deposit = 1000
– First bank lending = 0.9 × 1000= 900
– Second bank lending = 0.9 × 900= 810
– Third bank lending = 0.9× 810=729
–…
➔ If there are n commercial banks in the
economy, the total amount of money is
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Finding the total amount of money
MS= 1000 (1+0,9+0,92+0,93+....+0,9n)
= 10000 ???
➔ A fractional reserve banking system
creates money:
- When one bank loans money, that money is
generally deposited into another bank.
- This creates more deposits and more reserves
to be lent out.
- When a bank makes a loan from its reserves,
the money supply increases.
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A model of the money supply

• Monetary base: B = Cu + R (1)
• Money supply: MS = Cu + D (2)
What is the relation between MS and B?
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Devide (2) by (1)
MS Cu + D
=
B Cu + R
MS Cu / D + D / D
 =
B Cu / D + R / D
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• The currency-deposit ratio: cr = Cu/D
• The reserve-deposit ratio: rr = R/D
➔ MS cr + 1
= = mM
B cr + rr
➔ MS = mM x B
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• The money multiplier is the amount of
money the banking system generates
with each dollar of monetary base.
• Money multiplier depends on two
variables:
- cr: cr increases ➔ mM decreases. Why?
- Rr: rr increases ➔ mM decreases. Why?
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3.3 Tools of Monetary Policy

MS = mM x B
– Open-market operations
– Reserve requirements
– The discount rate
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Open-market operations
• Open-market operations: the purchase
or sale of government bonds by the
Central bank to the public.
• The Central bank buys government bonds➔
it pays with new dollars, increasing B and
therefore MS.
• The Central bank sells government bonds?
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Reserve requirements
• Reserve requirements: Central bank
regulations that require banks to hold a
minimum reserve-deposit ratio.
- Reserve requirements affect rr and m:
• If Central bank reduces reserve
requirements, then banks can make more
loans and “create”more money from each
deposit.
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The discount rate
• The discount rate: The interest rate that
the Fed charges on loans it makes to
banks.
• When banks borrow from the Central bank,
their reserves increase, allowing them to
make more loans and “create” more money.
• The Central bank can increase B by
lowering the discount rate to induce banks to
borrow more reserves from the Central
bank.
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Which instrument is used most often?

• Open market operations:
- Most frequently used.
• Changes in reserve requirements:
- Least frequently used.
• Changes in the discount rate:
- Largely symbolic;
- The Central bank is a “lender of last
resort,” does not usually make loans to
banks on demand.
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Problems in Controlling the Money Supply
• The Fed cannot control precisely the
money supply.
- Households can change cr, causing m
and MS to change.
- Banks often hold excess reserves
(reserves above the reserve requirement).
If banks change their excess reserves, then
rr, m and MS change.
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4. Market for money

• The Theory of Liquidity Preference
- Explains the factors that determine an
economy’s interest rate: according to
Keynes, the interest rate adjusts to balance
the supply of and demand for money.
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Money supply (MS)
• Money supply (MS)
- Is the stock of money, including currency
and deposits demand.
- Is a policy variable that is controlled by
the Central bank.
- Does not depends on interest rate
➔ MS curve is a vertical line
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Money supply
Nominal MS0
MS1 MS2
Interest rate
,i ?
M1 M0 M2
Quantity of money, M
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Money Demand
• People choose to hold money instead of
other assets that offer higher rates of return
because money can be used to buy goods
and services.
Motivations of money demand:
- Transaction motive
- Precautionary motive
- Speculation motive
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Money Demand
• Determinants of money demand
- Nominal interest rate (i): is the opportunity
cost of holding money.
➔An increase in the interest rate raises the
cost of holding money and, as a result,
reduces the quantity of money
demanded.
➔ money demand is downward sloping
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Money Demand
• Determinants of money demand
- Price level (P): higher prices, more money
is exchanged every time a good or
service is sold. As a result, people will
choose to hold a larger quantity of money.
- Income (Y): higher income results in
higher money demand
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Money Demand
Nominal
Interest rate , i
Price increases or
Income increases
E1
i1
E2
i2
MD1
MD0
M1 M2 M3Quantity of money, M
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Equilibrium
Nominal
Interest MS0
rate , i
E0
i0
MD
Quantity of money, M
M0
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Think-Pair-Share Activity
Suppose you are a personal friend of the chair of the Board of Governors of the Federal Reserve
System (Jerome Powell). He comes over to your house for lunch and notices your couch. He is so
struck by the beauty of your couch that he simply must have it for his office. He buys it from you for
$1,000 and, since it is for his office, he pays you with a check drawn on the Federal Reserve Bank
of New York.
A. Are there more dollars in the economy than before? Why or why not?
B. Why do you suppose that the Fed doesn’t buy and sell couches, real estate, and so on
instead of government bonds when they desire to change the money supply?
C. If the Fed doesn’t want the money supply to rise when it purchases new furniture, what
might it do to offset the purchase?
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Unit 6-Ch29-The Monetary System

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Unit 6

The monetary system

1. The Meaning of Money

The Kinds of Money

2. Money in the economy

3. Banks and the money supply

3.1 Banking system

3.2 Banks and the Money Supply

Scenerio 2: 100% reserve banking

3.2 Banks and the Money Supply

First Bank Second Bank Third Bank

Assets Liabilities Assets Liabilities

The borrower holds $810

Finding the total amount of money

A model of the money supply

A model of the money supply

3.3 Tools of Monetary Policy

Which instrument is used most often?

4. Market for money

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