LECTURE 6:

The Monetary System

Lecture Objectives
 The Meaning of Money

• Money
– Set of assets in an
economy
– That
– To buypeople regularly
goods and servicesuse from other people
• The functions of money
– Medium of exchange
– Unit of account
– Store of value

2
 The Meaning of Money

• Medium of exchange
– Item that buyers give to sellers
• When they want to purchase goods services
and
•
Unit of account
– Yardstick people use to post prices and record
debts
• Store of value
– Item that people can use to
transfer purchasing power
• From the present to the future 3
 The Meaning of Money

• Liquidity
– Ease with which an asset can be converted
into the economy’s medium of exchange
• The kinds of money
• Commodity money
– Money that takes the form of a commodity
with intrinsic value
Intrinsic value
•
– Item would have value even if it were
not used as money 4
 The Meaning of Money

• The kinds of money

• Fiat money
– Money without intrinsic value
– Used as money because of
government decree
• Money in the economy
• Money stock
– Quantity of money in the economy
circulating
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 The Meaning of Money

• Money in the economy

• Currency
– Paper bills and coins in the hands of the
public
• Demand deposits
– Balances in bank accounts
• Depositors can access on demand by writing a
check
• Measures of money stock
– M1, M2 6
Figure 1
Two measures of the money stock for economy

The two most widely followed measures of the money stock are M1 and M2. This
figure shows the size of each measure in 2007 7
 Where is all the currency?

• 2007: $759 billion of currency outstanding

– Average adult: holds about $3,272 of currency
– Much of the currency is held abroad
– Much of the currency is held by drug dealers, tax
evaders, and other criminals
• Currency – not a particularly good way to hold
wealth
– Can be lost or stolen
– Doesn’t earn interest

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 Central Bank and its Functions
• Issue currency
• Act as banker to the government
• Regulate banks to promote safe and sound
banking practices.
• Act as a banker’s bank, making loans to
banks and as a lender of last resort.
• Conduct monetary policy by controlling the
money supply.
 Central Banks
in Different Countries
• In USA: The Federal Reserve System (Fed)
• In Australia: The Reserve Bank of Australia (RBA)
• In Vietnam: The State Bank of Vietnam

SELF-STUDY
 The Central Bank

• The primary tool - open-market

operation
– Purchase & sale of the government bonds
• increase the money supply
– Open-market purchase

• decrease the money supply

– Open-market sale

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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

FIRST NATIONAL BANK

Assets Liabilities
Reserves $100.00 Deposits $100.00

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 Case study

• https://www.bloomberg.com/news/articles
/2020-01-01/china-cuts-banks-reserve-ratio
-to-boost-economic-growth-in-2020

• https://www.youtube.com/watch?v=G8qq
N1kHK7c
• Open discussion
 Banks and the Money Supply

• Money creation: fractional reserve banking

– Banking system
– Banks hold only a fraction of deposits as
reserves
– Reserve ratio
• Fraction of deposits that banks hold as reserves

• Bank must hold – reserve requirement

– Minimum set by the Fed
• Bank may hold additional excess reserves
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 Banks and the Money Supply

• Money creation: fractional reserve

banking
– Reserve ratio = 1/10 (10 percent, R)
FIRST NATIONAL BANK
Assets Liabilities
Reserves $10.00 Deposits $100.00
Loans $90.00

• Banks hold only a fraction of deposits in

reserve
– Banks create money
– Increase in money
supply 17
 Banks and the Money Supply

• The money multiplier

SECOND NATIONAL BANK
Assets Liabilities
Reserves $9.00 Deposits $90.00
Loans $81.00

THIRD NATIONAL BANK

Assets Liabilities
Reserves $8.10 Deposits $81.00
Loans $72.90

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 Banks and the Money Supply

• The money multiplier

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

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 Banks and the Money Supply

• 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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 Banks and the Money Supply

• The tools of monetary control

1. Open-market operations
– Purchase and sale of government bonds
– To increase the money supply
• buys government bonds
– To reduce the money supply
• sells government bonds
– The preferred tool

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 Banks and the Money Supply

• The tools of monetary control

2. Reserve requirements
– Regulations on minimum amount of reserves
• That banks must hold against deposits
– An increase in reserve requirement
• Decrease the money supply
– A decrease in reserve requirement
• Increase the money supply
– Used rarely – disrupt business of
banking
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 Banks and the Money Supply

• The tools of monetary control

3. The discount rate
– Higher discount rate
• Reduce the money supply
– Smaller discount rate
• Increase the money supply

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 Banks and the Money Supply

• Problems in controlling the money

• supply
The Central Bank
– Does
• That not control
households the to
choose amount
hold ofas money
deposits in
banks

• The Central Bank

– Does not control the amount
• That bankers choose to lend

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 Presentation ideas:

• https://www.nasdaq.com/articles/nigerias-
central-bank-reschedules-monetary-policy-
committee-meeting-2020-01-13
• https://www.nasdaq.com/articles/nigerias-
central-bank-reschedules-monetary-policy-
committee-meeting-2020-01-13