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THE MONETARY SYSTEM

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The Meaning Of Money
Bartering is the exchange of one good for another.
◦ Bartering requires a double coincidence of wants.
Money is the set of assets in an economy that people
regularly use to buy goods and services from other
people.
Money has three functions in the economy:
①Medium of exchange
②Unit of account
③Store of value

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The Functions of Money
① 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.

②Unit of Account
◦ A unit of account is the yardstick people use to post prices and record
debts.

③Store of Value
• A store of value is an item that people can use to transfer purchasing
power from the present to the future.

Liquidity
◦ Liquidity is the ease with which an asset can be
converted into the economy’s medium of exchange.

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The Kinds of Money
Commodity money takes the form of a commodity
with intrinsic value.
◦ Examples: Gold, silver, cigarettes.
Gold standard is a system in which the currency is
based on the value of gold and where the currency
can be converted to gold on demand.
Fiat money is used as money because of
government decree.
◦ It does not have intrinsic value.
◦ Examples: Coins, currency, current account deposits.

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Money in the Economy
Money stock refers to the quantity of money
circulating in the economy.
Currency is the paper bills and coins in the
hands of the public.
Demand deposits are balances in bank
accounts that depositors can access on
demand by writing a cheque or using a debit
card.

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Money in the Economy
Measures of money stock
◦ M1
◦ Demand deposits, Traveler’s checks
◦ Other checkable deposits, Currency
◦ M2
◦ Everything in M1
◦ Savings deposits, Small time deposits
◦ Money market mutual funds
◦ A few minor categories

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Figure 1a Three Measures of the Money Stock for the Euro Area in €
billions

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The Role Of Central Banks
A central bank is an institution designed to oversee the
banking system and regulate the quantity of money in
the economy.
Whenever an economy relies on fiat money, there
must be some agency that regulates the system.
◦ The agency is known as the central bank.

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The Functions of Central Banks
Two functions of a central bank are...

◦ Macroeconomic stability in maintaining stable

growth and prices and through the avoidance
of excessive and damaging swings in
economic activity.

◦ The maintenance of stability in the financial

system.

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 The Functions of Central Banks
The Central Bank’s jobs
◦ Regulate banks and ensure the health of the banking
system
◦ Monitors each bank’s financial condition
◦ Facilitates bank transactions - clearing checks
◦ Acts as a bank’s bank
◦ Central Bank – lender of last resort

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 The Functions of Central Banks
The Central Bank’s jobs
◦ Control the money supply
◦ Quantity of money available in the economy
◦ Monetary policy
Money supply
◦ Quantity of money available in economy
Monetary policy
◦ Setting of the money supply

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The Functions of Central Banks
 Open market operations refers to the purchase
and sale of non- monetary assets from and to
the banking sector by the central bank.
 To increase the money supply, the central bank
buys bonds from the public.
• The amount of currency in the hands of the public is
increased.
 To reduce the money supply, the central bank
sells bonds to the public.
• The amount of currency in the hands of the public is
reduced.

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The Functions of Central Banks
Liquidity is the cash needed to ensure transactions
in the financial system are honored.
To maintain financial stability central banks supply
liquidity to the rest of the banking system.
◦ The central bank can step in as a lender of the last resort.
◦ Central banks assess banks’ ability to meet different levels
of financial stress and have the power to impose
regulations.

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A Banks Balance Sheet

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A Banks Balance Sheet
Capital requirement
◦ Government regulation specifying a minimum
amount of bank capital

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Banks And The Money Supply
Most banks make profits by accepting deposits and
making loans.
 The difference between the average interest a bank
earns on its assets and the average interest rate paid
on its liabilities is termed the spread.
 Banks hold a fraction of the money deposited as
reserves and lend out the rest to make their profit.
◦ Note that banks operating under Islamic Sharia
principles make profits from the sharing of risk
and reward between lenders and borrowers.

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 Banks and the Money Supply
Money
◦ Currency + Demand deposits
Behavior of banks
◦ Can influence the quantity of demand deposits
in the economy (and the money supply)

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Banks and the Money Supply

Reserves
◦ Deposits that banks have received but have not loaned
out
The simple case of 100% reserve banking
◦ All deposits are held as reserves
◦ Banks do not influence the supply of money

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The Money Multiplier
The money multiplier
◦ Amount of money the banking system generates
with each dollar of reserves
◦ Reciprocal of the reserve ratio = 1/R
The higher the reserve ratio
◦ The smaller the money multiplier

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Fractional-Reserve Banking

Fractional-reserve banking
◦ Banks hold only a fraction of deposits as reserves
Reserve ratio
◦ Fraction of deposits that banks hold as reserves
Reserve requirement
◦ Minimum amount of reserves that banks must
hold; set by the Central Bank

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Fractional-Reserve Banking
Excess reserve
◦ Banks may hold reserves above the legal minimum
Example: First National Bank
◦ Reserve ratio 10%

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Fractional-Reserve Banking
Banks hold only a fraction of deposits in reserve
◦ Banks create money
◦ Assets
◦ Liabilities
◦ Increase in money supply
◦ Does not create wealth

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The Money Multiplier

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The Money Multiplier
The money multiplier
◦ Original deposit = $100.00
◦ First National lending = $ 90.00 [= .9 × $100.00]
◦ Second National lending = $ 81.00 [= .9 × $90.00]
◦ Third National lending = $ 72.90 [= .9 × $81.00]
◦…
◦ Total money supply = $1,000.00

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A Banks Balance Sheet

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A Banks Balance Sheet

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A Banks Balance Sheet

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH EDITION

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A Banks Balance Sheet

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The Central Bank’s Tools Of Monetary
Control
A central bank has three main tools in its
monetary toolbox:
① Open-market operations.
② Changing the refinancing rate.
③ Quantitative easing.

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Open-Market Operations
A central bank conducts open-market operations when
it buys government bonds from, or sells government
bonds to the public:
◦ When the central bank buys government bonds, the
money supply increases.
◦ The money supply decreases when the central bank
sells government bonds.

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The Refinancing Rate
The refinancing rate is the interest rate the CB lends
on a short-term basis to the banking sector.
◦ Increasing the refinancing rate decreases the money
supply.
◦ Decreasing the refinancing rate increases the money
supply.
◦ In the USA, the refinancing rate is called the
discount rate and in the UK it’s called the repo rate.

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Quantitative Easing
 Having exhausted the use of lowering interest rates the
central banks decided on quantitative easing.
 The purpose of QE is to put banks in a better position to
be able to lend and in so doing help to boost demand.
 The process of QE involves the central bank buying
assets.
 In selling assets to the central bank, institutions will hold more
money in relation to other assets.
 They maintain their portfolios by using the money to buy bonds
and shares of companies, which is in effect lending to firms.
 The issue is whether QE is working or how long it would
take to see any measurable effects.

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Summary
① The term money refers to assets that people
regularly use to buy goods and services.
② Money serves three functions in an economy: as a
medium of exchange, a unit of account, and a store
of value.
③ Commodity money is money that has intrinsic
value.
④ Fiat money is money without intrinsic value.
⑤ It is the function of a central bank to control the
money supply through open-market operations, or
by changing the refinancing rate, or through
quantitative easing.

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Summary
⑥ When banks loan out their deposits, they increase
the quantity of money in the economy.
⑦ Macroprundential policies are designed to reduce
the risk of a bank run and defaulting.
⑧ Quantitative easing is when the central bank injects
money into banks in order to encourage lending.
⑨ Because the central bank cannot control the
amount bankers choose to lend or the amount
households choose to deposit in banks, the central
bank’s control of the money supply is imperfect.

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