CH11 Money

Chapter 11
The Monetary
System
© 2015 Pearson Education, Ltd.

11.1 Money
Money is an asset that people use to make and

receive payments when buying and selling goods
and services.

Types of Money
Barter trade
Commodity money
A commodity-backed money
Fiat money
11.1 Money
The U.S. dollar and other national currencies are
examples of fiat money.
Fiat money
An asset that is used as legal tender by government
decree and is not backed by a physical commodity
like gold.

11.1 Money
Money serves three functions in a modern

economy:
1. It is a medium of exchange.
2. It is a store of value.
3. It is a unit of account (measure of worth).

11.1 Money
A medium of exchange
is an asset that can be
traded for goods and
services.

11.1 Money
A store of value is an asset that enables

people to transfer purchasing power into the
future.

11.1 Money
A unit of account is a
universal yardstick
that is used to express
relative prices of
goods and services.

11.1 Money
Question: What function(s) does each item fulfill?
Function
Medium of Store of Unit of
Item Exchange Value Account
Sea shell
Gold coin
Cow
U.S. dollar
Bitcoin

11.1 Money
Answer:
Function
Medium of Store of Unit of
Item Exchange Value Account
Sea shell YES NO YES
Gold coin YES YES YES
Cow YES YES NO
U.S. dollar YES YES YES
Bitcoin YES YES? YES?

Money
• Properties of money
o Easily recognizable
o Divisible
o Limited supply
o Easy to carry
11.1 Money
The money supply can be defined in various

ways:
M0 currency
M1 currency + checking accounts
M2 currency + checking accounts + savings
accounts, and most other types of bank accounts.

11.1 Money
Money market accounts Traveler's checks

Time deposits 5% 0.03%
5%
Currency in
circulation
11%
Checking accounts
14%
Savings accounts
65%

As of March 23, 2021 in
Turkey:
• M1 = 1.26 trillions of TL (0.99- a year earlier)
(Currency 180, Bank deposits 331, Foreign currency
deposits 751, -bank vaults 16)
• M2 = 3.55 trillions of TL (M1 + 1.21 Time deposits +
1.08 Foreign currency time deposits)
• M3 = 3.66 trillions of TL (M2 + 1.1 REPO and Liquid
Funds)
How Banks Create Money
(a bit old fashioned)
Money multiplier
• 100 TL banknote deposited, r of it put in reserve (100*r
percent), the rest is loaned
• 100*(1-r) deposited, , r of it put in reserve, the rest is loaned
• 100*(1-r)2 deposited, , r of it put in reserve, the rest is loaned
• …
• Total money = 100 + 100*(1-r) + 100*(1-r)2 + …
• Total money = 100 * (1/r)
• Money Multiplier = 1/reserve ratio

The Money Multiplier in
Reality
The monetary base is the sum of currency in circulation and
bank reserves.
The money multiplier is the ratio of the money supply to the
monetary base.
How is money created
(modern version)
• No need to start from deposits
• Banks may borrow reserves from the Central Bank
• They give loans commensurate with the reserves

they hold at CB
• Central Bank adjusts the interest rate on reserves to

affect the money creation by banks – sometimes
this may not work!

11.1 Money
We can divide each monetary measure by GDP:
Currency in circulation $1.22 trillion

= = $0.07
GDP $17.31 trillion
Money supply $11.49 trillion

= = $0.66
GDP $17.31 trillion

11.1 Money
Exhibit 11.1 Currency in Circulation Divided by Nominal GDP

and Money Supply (M2) Divided by Nominal GDP

11.2 Money, Prices, and GDP
Let’s remember a few definitions from Chapter 5:
• Nominal GDP is the total value of production

(final goods and services), using the prices from
the same year the output was produced.
• Real GDP is the total value of production (final

goods and services), using fixed prices taken
from a particular base year (which may or may
not be the year the output was produced).
Consider the Island of Dr. Jay, which produces

only basketballs.
Calculate nominal and real GDP for the base year

of 2013:
Basketballs
Nominal
Year Number Price GDP Real GDP
2013 10 $80
2014

Suppose that nominal GDP increases to $1,000 in

2014, but the source of the increase is unknown:
Basketballs
Nominal
Year Number Price GDP Real GDP
2013 10 $80 $800 $800
2014 ?? ?? $1,000 ??
We will consider two possible scenarios.

Scenario A:
Basketballs Nominal Real
Year Number Price GDP GDP
2013 20 $40 $800 $800
2014 25 $40 $1,000 $1,000
The growth rate of real GDP is $1000  $800

= 0.25
$800
The growth rate of prices is $0
= 0.00
$40
Scenario B:
2013 20 $40 $800 $800
2014 20 $50 $1,000
Calculate the level of real GDP in 2014.

Calculate the growth rate of real GDP.
Calculate the growth rate of prices.
Scenario B:
2013 20 $40 $800 $800
2014 20 $50 $1,000 $800
$800  $800
The growth rate of real GDP is = 0.00
$800
The growth rate of prices is $50  $40

= 0.25
$40
Here is a summary of our results:

Growth Rate
of Nominal Growth Rate Growth Rate of
Scenario GDP of Real GDP Prices
A 25% 25% 0%
B 25% 0% 25%

Under each scenario, we found that:
Growth rate of nominal GDP = Growth rate of

real GDP + Growth rate of prices
Growth rate of nominal GDP = Growth rate of

real GDP + Inflation rate

The quantity theory of money assumes that the

ratio of money to GDP is constant:
Money Supply
= constant
Nominal GDP
A constant ratio is a good approximation of how

an economy behaves in the long run.

Exhibit 11.1 Currency in Circulation Divided by Nominal GDP

and Money Supply (M2) Divided by Nominal GDP

A constant ratio implies that money and nominal
GDP must grow at the same rate:
Growth rate of money supply = Growth rate of

nominal GDP
Using our previous relationship, we get:
Growth rate of money supply = Inflation rate +

Growth rate of real GDP
Rearranging terms, the quantity theory predicts

the rate of inflation:
Inflation rate = Growth rate of money supply –

Growth rate of real GDP

11.3 Inflation
Some distinctions:
Inflation
A situation of rising prices.
Deflation
A situation of falling prices (negative inflation).
Hyperinflation
A situation of extreme inflation where prices double
within three years.
11.3 Inflation
Question: What causes inflation?
Data: Average money growth and inflation rates

for 2000‒2010 for 179 countries (World
Development Indicators).
Prediction: Inflation rate = Growth rate of

money supply – 3%

11.3 Inflation
Money Growth and Inflation (179 countries)
3,500
Zimbabwe
3,000
2,500
Average inflation rate (%)
2,000
1,500
1,000
500
0
0 500 1,000 1,500 2,000 2,500 3,000 3,500
Average money growth (%)

11.3 Inflation
Money Growth and Inflation (178 countries)
Democratic Republic of Congo
110
100
90
80
Average inflation rate (%)
70
Angola
60
50
40 Belarus
30 Venezuela
Serbia Guinea
20
Tajikistan
10
0
Japa 0 10 20 30 40 50 60 70 80 90 100 110
n Average money growth (%)

Money Supply
Growth and Inflation
in Brazil
Money and Prices
in Brazil, 1985–1995
11.3 Inflation
Under inflation, all prices

and all wages do not
always move together.
Under inflation, some

relative prices, including
the real wage and real interest rate, can change.
This creates winners who benefit from unexpected

gains and losers who suffer from unexpected losses.
11.3 Inflation
Who wins and who loses from unexpected

inflation?
Winners:
1. A homeowner paying a mortgage at a fixed

rate of interest
2. The owners of a firm (shareholders) paying
a pension that is not indexed for inflation

11.3 Inflation
Losers:
1. A bank receiving payments on a mortgage at a

fixed rate of interest
2. A retiree receiving a pension that is not
indexed for inflation

Borrowers and lenders
• Real interest rate = Nominal int.rate
-Inflation
• If expected inflation > actual inflation  lenders
gain
• If expected inflation < actual inflation  borrowers
gain
• But note that if the gap occurs frequently,
individuals would refrain from lending and
borrowing short-term contracts only
• So, if inflation is expected, no damage other than
the three costs listed below
Costs:
• Shoe-leather costs
• Menu costs
• Unit of account costs
11.3 Inflation
Inflation imposes social costs due to:
1. Raising logistical costs

2. Distorting relative prices
Inflation can lead to counterproductive policies

such as price controls.

11.3 Inflation
Inflation generates social benefits such as:
1. Generating government revenue from printing

currency
2. Sometimes stimulating economic activity

11 The Monetary System
Evidence-Based Economics Example:
Question: What caused the

German hyperinflation of
1922‒1923?
Data: Historical money

supply data.

Historical Timeline:
• 1919: Germany signs the Treaty of Versailles,
thus ending World War I.
• 1923: German workers in the Ruhr go on
strike to protest the French occupation.
• November 1923: Hitler attempts to overthrow
the government in the Beer Hall Putsch.
• 1933: Hitler is elected chancellor of Germany.

Exhibit 11.3 Currency in Circulation During the Weimar

Republic

Evidence-Based Economics Example:
Question: What caused the German

hyperinflation of 1922–1923?
Answer: The German government could not

make reparation payments to the Allies after
World War I. As the German economy struggled,
the government started to print more and more
currency to pay its bills.
11.4 The Federal Reserve
The central bank is the government institution

that:
• Monitors financial institutions

• Controls certain key interest rates
• Indirectly controls the money supply
These activities are known as monetary policy.

The Federal Reserve Bank, or the Fed, is the

central bank of the United States.

The Fed is composed of three parts:
• Twelve Federal Reserve district banks

throughout the country
• A 7-member Board of Governors in
Washington D.C.
• A 12-member Federal Open Market
Committee, composed of 5 regional bank
presidents and the 7 board members
Exhibit 11.4 Geographic Boundaries of the Federal

Reserve Districts

The Fed uses monetary policy to pursue two key

goals or objectives:
1. Low and predictable levels of inflation
2. Maximum (sustainable) levels of employment

What does the central bank do?
• Influences short-term interest rates, especially

the federal funds rate
• Influences the money supply and the inflation

rate
• Influences long-term real interest rates

To understand these three objectives, we will
discuss the following, in order:
1. The role of bank reserves in the economy
2. The equilibrium in the market for bank
reserves
3. The Fed’s influence on the money supply and
inflation
4. The impact of short-term interest rates on
long-term interest rates
Bank reserves are the combination of deposits that

private banks hold at the central bank and cash in
their vaults.
Bank reserves provide liquidity to

private banks.
Liquidity refers to funds (and

assets) that can be used immediately
to conduct transactions.
Federal funds market

The market where banks borrow and lend
reserves to one another.
Federal funds rate

The overnight (24-hour) interest rate charged
in this market.
We will use the supply and demand model to see

how the federal funds rate is determined.
The demand curve for reserves plots the total

quantity of reserves demanded by private banks
for each level of the federal funds rate.
The demand curve slopes downward because

optimizing banks choose to hold more reserves as
the cost of those reserves—the federal funds
rate—falls.

Exhibit 11.5 The Demand Curve in the Federal Funds

Market (demand curve for reserves only)
The demand curve for bank reserves shifts when

one of the following changes occurs:
1. Economic expansion or contraction

2. Changing liquidity needs
3. Changing deposit base
4. Changing reserve requirement
5. Changing interest paid by the Fed for deposits
at the Fed
Example: The Christmas holiday increases

withdrawals and thus the liquidity needs of banks.
Question: What would happen to the demand

curve in the federal funds market?

Exhibit 11.5 The Demand Curve in the Federal Funds Market

(demand curve for reserves and right shift in the demand curve)
Situation: An economic contraction decreases

bank lending.
Question: What would happen to the demand

curve in the federal funds market?

Exhibit 11.5 The Demand Curve in the Federal Funds Market

(demand curve for reserves and left shift in the demand curve)
The supply curve for reserves plots the quantity

of reserves supplied by the Federal Reserve
through open market operations.

In an open market purchase, the Fed buys

government bonds from private banks and in
return gives the private banks more reserves.
In an open market sale, the Fed sells

government bonds to private banks, and in return
the private banks give some of their reserves.

The supply curve for reserves plots the quantity

of reserves supplied by the Federal Reserve
The supply curve is vertical because the Federal

Reserve supplies reserves not to earn economic
profits but rather to pursue monetary policy.

The Federal Reserve chooses between two

alternative strategies when it implements
monetary policy:
1. The Federal Reserve can keep reserves fixed,

even when the demand curve shifts, and thus
allow the federal funds rate to fluctuate.

Exhibit 11.6 Equilibrium in the Federal Funds Market

2. The Federal Reserve can supply more or less

reserves to keep the federal funds rate
constant.

Exhibit 11.8 Picking Reserves to Keep the Federal Funds Rate Fixed

The Federal Reserve can control either the

quantity of reserves or the federal funds rate (the
price) but not both.
The Fed has followed the second strategy for the

past 30 years.

However, the Fed will periodically raise and

lower its federal funds target in order to meet its
dual objectives of low inflation and maximum
employment.

Exhibit 11.9 Shifts in the Federal Funds Rate Induced by a Shift in the
Supply of Reserves

Exhibit 11.10 The Federal Funds Rate Between July 1954 and
January 2014
TCMB Overnight Interest Rates and Interest on Monthly
Deposits (2000-2008)
100.00
90.00
80.00
70.00
60.00
50.00 CBRT O/N INTEREST RATE

TRL DEPOSIT RATE
40.00
30.00
20.00
10.00
0.00
2000 2001 2002 2003 2004 2005 2006 2007 2008
TCMB Overnight Interest Rates and Interest on Monthly
Deposits (2003-2008)
50.00
45.00
40.00
35.00
30.00
25.00
CBRT O/N INTEREST RATE
20.00 TRL DEPOSIT RATE
15.00
10.00
5.00
0.00
2003-10
2004-10
2005-10
2006-10
2007-10
2008-10
2003-1
2003-4
2003-7
2004-1
2004-4
2004-7
2005-1
2005-4
2005-7
2006-1
2006-4
2006-7
2007-1
2007-4
2007-7
2008-1
2008-4
2008-7
The Great Disinflation of the 1980s
Summary of the Fed’s Control of the Federal

Funds Rate:
The Fed can influence the federal funds rate by

either shifting the quantity of reserves supplied or
by shifting the demand for reserves.

Exhibit 11.9 Shifts in the Federal Funds Rate Induced by a Shift in the
Supply of Reserves

Summary of the Fed’s Control of the Federal

Funds Rate:
The Fed can shift the demand of reserves by

changing the reserve requirement and by
changing interest paid on reserves.
The Fed can shift the supply curve of reserves

We said earlier that the second part of the Fed’s

management of bank reserves is to influence the
money supply and the inflation rate.
Question: Why can’t the Fed directly control

either the money supply or the inflation rate?

Answer: The money supply is the sum of

currency in circulation plus deposits at banks by
households and firms. It does not include bank
reserves.
In the long run, inflation is equal to the growth

rate of money.

However, the Fed can use its three tools—open

market operations, reserve requirements, and
interest on reserves—to influence the money
supply and the inflation rate.
Question: What policies would reduce the

growth rate of money and the inflation rate?

Answer: Open market sales, increased reserve

requirements, and paying interest on reserves
would reduce the growth rate of money and the
inflation rate.

The third consequence of the Fed’s management

of bank reserves is its influence over long-term
interest rates by altering inflationary
expectations:
Real interest rate = Nominal interest rate –

Inflation rate

Investment decisions depend on long-term

expected real interest rates.
Long-term indicates 10 years or more.
The expected real interest rate is the nominal

interest rate minus expected inflation.

There are two types of real interest rates:
Realized real interest rate = Nominal interest rate

– Realized inflation rate
Expected real interest rate = Nominal interest rate

– Expected inflation rate

Monetary policy in the form of open market

operations can impact long-term interest rates.
Think of a 10-year loan rate as 10 1-year loans

lined up one after the other:

Questions:
What is the nominal 10-year interest rate for a

federal funds rate target of 4%?
What is the nominal 0-year interest rate for a

federal funds rate of 3% for the first two years
and 4% afterward?

Answer: The 10-year nominal interest rates are:
4%  4%  4%  4%  4%  4%  4%  4%  4%  4%
= 4.0%
10
3%  3%  4%  4%  4%  4%  4%  4%  4%  4%
= 3.8%
10

Question: What would be the real 10-year

interest rate if inflationary expectations remained
at 2%?

Answer:
10-year real interest rate = 10-year nominal

interest rate – Inflationary expectations
10-year real interest rate = 4.0% – 2.0% = 2.0%
10-year real interest rate = 3.8% – 2.0% = 1.8%

The Fed can reduce the short-term federal funds

rate to lower long-term expected real interest
rates.
A 1% reduction in the federal funds rate target

translates into a less than 1% reduction in long-
term expected real interest rates.
In most cases, inflationary expectations stay about

the same.

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Chapter 11

© 2015 Pearson Education, Ltd.

Money is an asset that people use to make and

© 2015 Pearson Education, Ltd.

© 2015 Pearson Education, Ltd.

Money serves three functions in a modern

© 2015 Pearson Education, Ltd.

© 2015 Pearson Education, Ltd.

A store of value is an asset that enables

© 2015 Pearson Education, Ltd.

© 2015 Pearson Education, Ltd.

Question: What function(s) does each item fulfill?

© 2015 Pearson Education, Ltd.

© 2015 Pearson Education, Ltd.

The money supply can be defined in various

© 2015 Pearson Education, Ltd.

Money market accounts Traveler's checks

© 2015 Pearson Education, Ltd.

• Money Multiplier = 1/reserve ratio

© 2015 Pearson Education, Ltd.

• Banks may borrow reserves from the Central Bank

• They give loans commensurate with the reserves

• Central Bank adjusts the interest rate on reserves to

© 2015 Pearson Education, Ltd.

We can divide each monetary measure by GDP:

Currency in circulation $1.22 trillion

Money supply $11.49 trillion

© 2015 Pearson Education, Ltd.

Exhibit 11.1 Currency in Circulation Divided by Nominal GDP

© 2015 Pearson Education, Ltd.

• Nominal GDP is the total value of production

• Real GDP is the total value of production (final

Consider the Island of Dr. Jay, which produces

Calculate nominal and real GDP for the base year

© 2015 Pearson Education, Ltd.

Suppose that nominal GDP increases to $1,000 in

We will consider two possible scenarios.

© 2015 Pearson Education, Ltd.

The growth rate of real GDP is $1000  $800

Calculate the level of real GDP in 2014.

The growth rate of prices is $50  $40

Here is a summary of our results:

© 2015 Pearson Education, Ltd.

Under each scenario, we found that:

Growth rate of nominal GDP = Growth rate of

Growth rate of nominal GDP = Growth rate of

© 2015 Pearson Education, Ltd.

The quantity theory of money assumes that the

A constant ratio is a good approximation of how

© 2015 Pearson Education, Ltd.

Exhibit 11.1 Currency in Circulation Divided by Nominal GDP

© 2015 Pearson Education, Ltd.

Growth rate of money supply = Growth rate of

Using our previous relationship, we get:

Growth rate of money supply = Inflation rate +

Rearranging terms, the quantity theory predicts

Inflation rate = Growth rate of money supply –

© 2015 Pearson Education, Ltd.

Question: What causes inflation?