Chapter

29

Monetary System
 10
MONEY AND PRICES IN THE LONG RUN
 What is “money”?
• In the past, people bartered to receive the
goods and services that they needs…
In this chapter, look for the answers to these
questions:
• What is “money”? What are the functions of money?
The types of money?
• What is the Federal Reserve?
• What role do banks play in the monetary system?
How do banks “create money”? What is “Money
multiplier”?
• How does the Federal Reserve control the money
supply?
What is “money”?
 What is “money”?
• Money is the set of assets • Money is distingust with
in the economy that people others assets that are
regularly use to buy goods valuable but are not used
and services from other to buy goods and services
people.
Functions of Money
A Medium
of
Exchange

A Unit of
account

A store of
value
 Functions of Money
1. Money = a medium of exchange
• When you buy bread, you
give the seller money and
they give you the breads
•  Money allows the
transfer from sellers to
buyers take place because
it is the commonly
accepted medium of
exchange
 Functions of Money
2. Money = a unit of account
• Price of a coat is $100
while price of a shirt is
$20 means that price
of a coat is 5 times of a
shirt
• When people post
price on price tags and
record economic value
(debt), money is used
as a unit of account
 Functions of Money
3. Money = a store of value
• People can store
money, which help to
transfer purchasing
power from the
present to the future
• At that meanings,
money is a store of
value
 Liquidity
• Liquidity: the ease with which an
asset can be converted into the
economy’s medium of exchange
• Money is the most liquid asset
available
• Most stocks and bonds can be sold
easily  they are relatively liquid
assets
• House is not kind of liquid asset
 The 2 Kinds of Money
Commodity money:
takes the form of a commodity
with intrinsic value
Examples: gold coins, cigarettes
in prisoner-of-wars- camps

Fiat money:
money without intrinsic value,
used as money because of
Government decree
Example: the U.S. dollar
 The Money Supply
• The money supply (or money stock):
the quantity of money available in the economy
• What assets should be considered part of the money supply?
Here are two candidates:
– Currency: the paper bills and coins in the hands of the
(non-bank) public
– Demand deposits: balances in bank accounts that
depositors can access on demand by writing a check
• These two are those most liquid assets

M1 = Currency + demand deposits

M2 = M1 + deposits in banks and other financial

institutions
 Figure 1 Money in the U.S. Economy

Billions
of Dollars
M2
$5,455
• Savings deposits
• Small time deposits
• Money market
mutual funds
• A few minor categories
($4,276 billion)

M1
$1,179
• Demand deposits
• Everything in M1
• Traveler’s checks
($1,179 billion)
• Other checkable deposits
($599 billion)
• Currency
($580 billion)
0

Copyright©2003 Southwestern/Thomson Learning

 Where is all the currency?
• In 2004, there was Where’s
$699 billion of currency the
outstanding money?
• Number of adults in US
= 223 millions
• In average, 1 adult held
about:
$699 b/233 m = $3134
• Most American people
carry far less than that
The Federal Reserve System (the Fed)
The State Bank of Vietnam
 Bank Reserves
Reserve

People Deposites BANK

Companies
Fractional reserve banking system
 Bank Reserves
• In a fractional reserve banking system,
banks keep a fraction of deposits as reserves, and use
the rest to make loans.
• The Fed establishes reserve requirements,
regulations on the minimum amount of reserves that
banks must hold against deposits.
• Banks may hold more than this minimum amount
if they choose.
• The reserve ratio, R
= fraction of deposits that banks hold as reserves
= total reserves as a percentage of total deposits
 Bank T-account
• T-account: a simplified accounting statement
that shows a bank’s assets & liabilities.
• Example:
FIRST NATIONAL BANK
Assets Liabilities
Reserves $100 Deposits $100
 Bank T-account
• T-account: a simplified accounting statement
that shows a bank’s assets & liabilities.
• Example:
FIRST NATIONAL BANK
Assets Liabilities
Reserves $ 10 Deposits $100
Loans $ 90

 Banks’ liabilities include deposits,

assets include loans & reserves.
 In this example, notice that R = $10/$100 = 10%.
 Banks and the Money Supply: An Example
Suppose $100 of currency is in circulation.
To determine banks’ impact on money supply,
we calculate the money supply in 3 different cases:
1. No banking system
2. 100% reserve banking system:
banks hold 100% of deposits as reserves,
make no loans
3. Fractional reserve banking system
 Banks and the Money Supply: An Example
CASE 1: no banking system
Public holds the $100 as currency.
Money supply = $100.
 Banks and the Money Supply: An Example
CASE 2: 100% reserve banking system
Public deposits the $100 at First National Bank (FNB).
FNB holds
100% of FIRST NATIONAL BANK
deposit Assets Liabilities
as reserves:
Reserves $100 Deposits $100
Loans $ 0
Money supply
= currency + deposits = $0 + $100 = $100
In a 100% reserve banking system,
banks do not affect size of money supply.
 Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system
Suppose R = 10%. FNB loans all but 10%
of the deposit:
FIRST NATIONAL BANK
Assets Liabilities
10 Deposits
Reserves $100 $100
Loans $ 90
0

Money supply = $190 (!!!)

depositors have $100 in deposits,
borrowers have $90 in currency.
 Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system
How did the money supply suddenly grow?
When banks make loans, they create money.
The borrower gets
– $90 in currency (an asset counted in the
money supply)
– $90 in new debt (a liability)

A fractional reserve banking system creates

money, but not wealth.
 Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system
Suppose borrower deposits the $90 at Second National
Bank (SNB).

Initially, SNB’s SECOND NATIONAL BANK

T-account looks Assets Liabilities
like this: Reserves $ 909 Deposits $ 90
Loans $ 81
0

If R = 10% for SNB, it will loan all but 10% of the deposit.
 Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system
The borrower deposits the $81 at Third National Bank
(TNB).

Initially, TNB’s THIRD NATIONAL BANK

T-account looks Assets Liabilities
like this: Reserves $$8.10
81 Deposits $ 81
Loans $72.90
$ 0

If R = 10% for TNB, it will loan all but 10% of the deposit.
 Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system
The process continues, and money is created with each
new loan.

Original deposit = $ 100.00 In this

1st NB lending = $ 90.00 example,
2nd NB lending = $ 81.00 $100 of
reserves
3rd NB lending = $ 72.90
.. .. generate
. . $1000 of
Total money supply = $1000.00 money.
 Diagram of how banks create money

Reserve

Depo Reserve
People
sites BANK

Depo
Comp
sites
BANK
anies

Comp
anies
 The Money Multiplier
• Money multiplier: the amount of money the
banking system generates with each dollar of
reserves
The money multiplier = 1/R.
• In our example,
R = 10%
money multiplier = 1/R = 10
$100 of reserves creates $1000 of money
ACTIVE LEARNING 1:
Exercise
While cleaning your apartment, you look under the sofa
cushion find a $50 bill (and a half-eaten taco). You
deposit the bill in your checking account.
The Fed’s reserve requirement is 20% of deposits.

A. What is the maximum amount that the

money supply could increase?
B. What is the minimum amount that the
money supply could increase?

32
ACTIVE LEARNING 1:
Answers
You deposit $50 in your checking account.
A. What is the maximum amount that the
money supply could increase?
If banks hold no excess reserves, then
money multiplier = 1/R = 1/0.2 = 5
The maximum possible increase in deposits is
5 x $50 = $250
But money supply also includes currency,
which falls by $50.
Hence, max increase in money supply = $200.
33
ACTIVE LEARNING 1:
Answers
You deposit $50 in your checking account.
A. What is the maximum amount that the
money supply could increase?
Answer: $200
B. What is the minimum amount that the money
supply could increase?
Answer: $0
If your bank makes no loans from your deposit, currency
falls by $50, deposits increase by $50, money supply
remains unchanged.
34
 The Fed’s Tools of Moneytary Control
• A monetary policy can be in either two types:
- An expansionary policy: increases money supply
- A contractionary policy: reduces money supply
• Fed (and any other Central Banks) often uses three
tools to control the money supply
1. Open market operations (OMOs)
2. Reserve requirements (Required reserve ratio)
3. Discount rate
 1. Open Market Operations (OMOs)
• Open Market Operations is the buying and selling of
US Government bonds by the Fed
 If Fed wants to increase the money supply, it creates
dollars and uses them to buy Gov bonds from the
public in the bond market
• In that case, Gov will ends up with bonds and the
public will receive money  The amount of money in
the pubic increases
Money
Public
BANK
Gov bonds
 1. Open Market Operations (OMOs)
• If Fed wants to lower the money supply, it
sells Gov bonds from its portfolio to the public
in the bond market and receive money back.
• In that case, money are taken out of
circulation and the public will receive bonds
 The supply of money in the pubic falls
Gov bonds
Public
BANK
Money
 2. Reserve requirements
• Reserve requirements are regulations on the minimum
amount of reserves that banks must hold against
deposits
• Changes in required reserve will affect the size of
money supply through changes in the money
multiplier.
 To increase money supply, Fed reduces R.
Banks make more loans from each dollar of reserves,
which increases money multiplier and money supply.
 To reduce money supply, Fed raises R, and the process
works in reverse.
 3. Discount Rate
• Discount rate is the interest rate on the loans
that the Fed makes to banks
- When a bank cannot meet its requirements, it
may borrow from other banks
- Then, if other banks cannot affort to give
loans, the bank may borrow reserves from the
Fed
- The discount rate is the rate that Fed charge
when a bank borrows from its reserve
 3. Discount Rate
• To decrease money supply, the Fed increase
the discount rate  discourages banks from
borrowing from the Fed and encourage them
to hold onto larger reserves.
• To increase money supply, Fed lowers the
discount rate  this encourges banks to lend
their reserves  increase money supply
What tool does the Fed prefer?
 What tool does the Fed prefer?
• Discount rate:
 Suppose that discount rate < Federal funds rate (Rate at which
a bank can borrow from others)
 What do you think a bank should choose?
 Answer: Still Federal funds rate.
 Reasons:
- Borrowing from Fed may depend on the purpose of the loan
- Fed bureaucracy: Fed is a bank’s supervisor  if it finds that
you borrows too frequently  which means you have bad
management  you can be up to an audit
- The privilege of borrowing: Fed is the lender of the last
resource, if you use it now, it can turn down in the future
 What tool does the Fed prefer?
• Reserve requirement:
- Fed may not like to use this tool because
changes too often in reserve requirement may
make an uncertainty in reserve requirement
law
- Changes in RR will affects every member bank
in the country
 What tool does the Fed prefer?
• Open Market Operations:
Fed prefer to use OMOs because:
- Flexible: Fed can sales/purchase any dollar they
want
- Reversible: Fed can conduct a purchase to day
and then sale tomorrow
- Quick implementation: The policy take in action
rapidly
- => Preference tools of FED:
OMO>Discount rate>Reserve requirement
 Problems in controlling the Money Supply

Reserve

???
People Deposites BANK
???

Companies
Problems in controlling the Money Supply

1. Fed cannot control the amount of money

that household choose to deposits in banks
 The more money household deposits, the
more money the banking system can create.
 If people loose confidence in banking system,
they will choose to deposit less and hold
more currency  Money supply falls without
expectation from Fed
Problems in controlling the Money Supply

2. Fed cannot control the amount that bankers

choose to lend
 The more bank choose to give loans (the less
reserve it keeps), the more money banking
system can create.
 If bank feel cautious about the economy and
choose to hold excess reserve, money supply
will fall
 Central bank cannot control money supply
perfectly
 Bank Runs and the Money Supply
• A run on banks:
When people suspect their banks are in trouble, they
may “run” to the bank to withdraw their funds, holding
more currency and less deposits.
• Under fractional-reserve banking, banks don’t have
enough reserves to pay off ALL depositors, hence banks
may have to close.
• Also, banks may make fewer loans & hold more
reserves to satisfy depositors.
• These events increase R, reverse the process of money
creation, cause money supply to fall.
CHAPTER SUMMARY
• Money includes currency and various types of bank
deposits.
• The Federal Reserve is the central bank of the U.S.,
is responsible for regulating the monetary system.
• The Fed controls the money supply mainly through open-
market operations. Purchasing govt bonds increases the
money supply, selling govt bonds decreases it.
• In a fractional reserve banking system, banks create
money when they make loans. Bank reserves have a
multiplier effect on the money supply.

CHAPTER 29 THE MONETARY

SYSTEM