INTRODUCTION TO

MACROECONOMICS

TOPIC 6: THE MONETARY SYSTEM

What are the common between them?

2
Motivating questions
• What is money?
• Where is money from?
• The government prints more paper money?
• From which mechanism?

3
Study Plan
• What is money?
• Banks and the Creation of Money
• Central Banks

4
What is Money?
The definition of money
• Money is any items or veritable records in an economy that people
regularly use to buy goods and services from other people.
• Money has (at least) three functions:
• Medium of exchange.
• Unit of account.
• Store of value.

6
The functions of money (1)
Medium of exchange: a medium of exchange is anything that is
readily acceptable as payment that can return you a good or
service.

7
Ancient-time medium of exchanges
• Market was not as predominant
as today.
• People was most self-subsistent
(produced and consumed by
themselves).
• Trading was a rare event before
the emergence of the modern
market economy.

8
Medieval-time medium of exchange
• The emergence of the state: coins as the medium of exchange.

9
Modern-time medium of exchange

10
Medium of exchange
Criterion to use money as a medium of exchange:
• Acceptable by most traders.
• Standardized quality.
• Durable.
• Valuable relative to its weight.
• Divisible.
 Medium of exchange in various cases
• Currencies in (physical or online) games.
• Bitcoin in certain online activities.
• Cigarettes and gasoline were used as a form
of commodity money in prisons of Europe
during World War 2.

12
The functions of money (2)
Unit of account: a unit of account is the yardstick people use to post
prices and record debts. Examples:
• Local currency (VND): 1 kg of rice at 25,000 VND, 1 kg of minced pork at
120,000 VND.
• International currency (USD): nominal GDP per cap. Vietnam at ~$4,000, the
United States at ~$70,000 per year.
• Gold: houses in Hanoi ancient quarter. 10 taels (lượng) of gold per squared
meter.

13
 The functions of money (3)
• Store of value: a store of value
is an item that people can use
to transfer purchasing power
from the present to the future.

• Money can be used to store

wealth due to its liquidity and
convenience.

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Things can be considered as store of
value but not very liquid?

15
 (Hyper) Inflation and store of value
• Zimbabwe’s official inflation rate on July
2008 was 231,000,000%.
Source: https://www.reuters.com/article/idUSL3459092

• Vietnam’s inflation rate during 1986 was

398% (World Bank).

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Other (less noticeable) function of
money
Means of final payment (as the legal tender)
• You can only pay taxes by the legal tender
• By laws, Viet Nam Dong (VND) is the only legal tender in
Vietnam

17
 Kinds of money
• Commodity money takes the form of a
commodity with intrinsic value.
• Examples: gold coins, silver taels, cigarettes…

• Fiat money is used as money because of

government decree. It does not have intrinsic
value.
• Examples: paper notes, cheque deposits…

18
 Kinds of money (2)
• Credit money: “I Owe You” (IOU)
• Imagine a friend owes you $1,000, while you owe $500 to your landlord
for rent.
• You cannot normally go to your landlord and tell them that while you
can’t give them cash, they can have your friend’s IOU, and collect the
money from your friend.

• But you can go to a bank to ask them to pay for you (from your
checking account).

19
Credit money: “I Owe You” (IOU)

20
Are checking accounts/demand deposits
money?
• Does checking account/demand
deposits/current accounts satisfy ALL
of these functions:

• Medium of exchange

• Unit of account.

• Store of value.
 Is gold money?
• Does gold satisfy ALL of these
functions:
• Medium of exchange
• Unit of account.
• Store of value.

22
Are crypto currencies (Bitcoin) money?
• Does Bitcoin satisfy ALL of these functions:
• Medium of exchange
• Unit of account.
• Store of value.

23
 Are credit cards money?
• You can open an international credit card
(Visa or Master) at a bank.
• Credit limit it is the maximum amount
granted by the credit card-issuing bank that
you can borrow on your credit card at any
given time.
• Ex: VCB Platinum Credit Card has the credit
limit of 100 million VND.
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Liquidity
• In general, liquidity describes how easily an item can be traded
for another item.
• For money, liquidity refers to how easy the conversion process
into the common currency is.
• The conversion process always incurs transaction costs.
• Example: time and cost associated with withdrawing money from time
deposit accounts, or with selling foreign exchange for the local currency.
• Liquidity is the “moneyness” of an asset.
Liquidity rank
Most liquid
• Cash, Checks (cheques).
• Checking Deposits.
• Time Deposit, Deposit Certificates.
• Gold, Foreign Exchange (USD, Euro…).
• Bonds, Stocks and Other Financial Products.
• Real estates, Cars, Jewelry … Less liquid

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Money supply
• The money supply refers to the total amount of money held by
the public (firms, households, the government, foreign
entities…) at a particular point in time.

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Money supply of an economy
Narrow money (M1, M2):
• M1: currency, checks, demand
deposits.
• M2: M1 + time deposits + saving
deposits + money market mutual
fund
Broad money (M3, M4): M2 + less
liquid assets
• Large-time deposits.
• Repurchase agreements.
• Commercial papers.
• Treasury bills.
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Check
The money stock includes all of the following except:
A. metal coins.
B. paper currency.
C. lines of credit accessible with credit cards.
D. bank balances accessible with debit cards.
Banks and the Creation of
Money
Banks create money by lending.

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 Banks and the money supply
• (Commercial) banks receive deposit and
make loans.
• Banks’ profit comes from the difference
between the interests paying to savers
(depositors) and the interests charging on
borrowers.

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 Balance sheet of a bank
• Banks, as any economic unit, has a balance Assets Liabilities
sheet (the T-account).
Reserves/Cash Deposits
• An asset is anything you own that has a
Loans Bank Capital
market price, and that you expect to receive
income or other benefits from in the future. E.g. Other Assets Other Liabilities
(What borrowers owe to (What bank owes to
loans and reserves. bank + bank’s money) depositors + bank’s capital)

• A liability is an obligation to make a payment

at some time in the future. E.g.. deposits of the
customers and bank’s own capital.
• Total assets must always equal total liabilities.

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 Money creation with fractional-reserve banking (1)

• This simplified T-account shows a bank that

has only deposits as its liabilities from its Assets Liabilities
customers (depositors). Reserves Deposits
• When receiving deposits, the bank keeps a Loans
portion as reserves and lends out the rest. (What borrowers owe to (What bank owes to
bank + bank’s money) depositors + bank’s capital)
These are reserves and loans on the Assets
column.
• Reserves helps to provide cash (or high
liquid money) to pay back to depositors
when depositors wants to withdraw money.
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 Money creation with fractional-reserve banking (2)
• Consider the case that a
bank has initial reserves at Assets Liabilities Assets Liabilities
$100 obtaining from
deposits. Reserves Deposits Reserves Deposits
• The bank, Vietcombank, $100 $100 $10 $100
decides to lend its money. Loans
• It lends $90 and keeps $10 $90
as reserves. Total assets Total liabilities Total assets Total liabilities
$100 $100 $100 $100
• The reserve ratio (reserves
(What borrowers owe to (What bank owes to (What borrowers owe to (What bank owes to
over deposits) is $10/$100= bank + bank’s money) depositors) bank + bank’s money) depositors)

10% .
 Money creation with fractional-reserve banking (2)
• When the lending bank
(Vietcombank) lends money to Assets Liabilities Assets Liabilities
a customer, that money is
generally deposited into another
Reserves Deposits Reserves Deposits
bank (Techcombank in this $10 $100 $90 $90
case).
• This creates more deposits on Loans
$90
Techcombank as reserves (not
lending yet). Total assets Total liabilities Total assets Total liabilities
$100 $100 $90 $90
• The total value of reserves and
(What borrowers owe to (What bank owes to (What borrowers owe to (What bank owes to
loans of the whole economy bank + bank’s money) depositors) bank + bank’s money) depositors)

increases from $100 to $190.

$90 more is created in the money supply
 Money creation with fractional-reserve banking (3)
• When the deposit-receiving
bank (Techcombank) decides Assets Liabilities Assets Liabilities
to make a loan from its
reserves, it can lend 90% of the Reserves Deposits Reserves Deposits
receiving deposits and keep $10 $100 $9 $90
10% as reserves.
Loans Loans
• When this loans from $90 $81
Techcombank, worth at $81, is
Total assets Total liabilities Total assets Total liabilities
deposited at another bank, the $100 $100 $90 $90
total money supply increases (What borrowers owe to (What bank owes to (What borrowers owe to (What bank owes to
bank + bank’s money) depositors) bank + bank’s money) depositors)
by another $81.
$81 more is created in the money supply
 Money creation with fractional-reserve banking (4)
• How much money is eventually created in the economy?
• Assume the process continues infinitely:
Original deposit = $ 100.00
1st lending = $ 90.00 [=0.9 x $100.00]
2nd lending = $ 81.00 [=0.9 x $90.00]
3rd lending = $ 72.90 [=0.9 x $81.00]
… =…
Total money supply = $ 1000.00
2 3 2
Math note: Total supply increase = $100 + 1 − 𝑟 ∗ $100 + 1 − 𝑟 ∗ $100 + 1 − 𝑟 ∗ $100 = $100 1 + 1 − 𝑟 + 1−𝑟 +⋯
1−(1−𝑟)(𝑛→∞) $100
= $100 ∗ ≈ (by applying 1 − 𝑎𝑛 = (1 − 𝑎)(1 + 𝑎2 + 𝑎3 + ⋯ 𝑎𝑛−1 )
1−(1−𝑟) 𝑟
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The money multiplier
• Theoretically, the money multiplier is the reciprocal of the
reserve ratio:
1
𝑀=
𝑅
• Example:
1
• With a reserve ratio at 𝑅 = 10%, the multiplier is = 10.
10%
• $100 dollar increase in deposit at a bank, if the multiplier fully applies,
can lead to $100 × 10 = $1000 increase in the money supply.

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Required reserves
• The government can set reserve requirements: regulations on
the minimum amount of reserves that banks must hold against
deposits, usually as a ratio of the total deposits.
• The minimum ratio is called the required reserve ratio (RRR).
• Banks may hold more than this minimum:
Reserves = Required Reserves + Excess Reserves
• Excess reserves is always available for lending.
How can money supply increase?
• Banks need to keep adequate reserves as buffers from risks (e.g.
unexpected withdraws from depositors…).
• Banks are willing to lend more money when:
• Banks have more available reserves over its required level.
• Loans are profitable for banks to keep less excess reserves.

• Bank reserves (required and excess) are “deposited” at the central

bank (thinking as putting them in a cash vault).
• Now, the central bank comes into our picture.
Frequently Asked Questions (FAQs)
• Q: How banks’ reserves are kept at the central bank?
A: You can think banks’ reserves at the central bank as “electronic
deposits” – money existing as electric records - at the central bank. It
is similarly to your checking account at commercial banks. When
commercial banks ask, the central bank can quickly send paper
money to replace electronic records. Reserves at the central bank can
be seen as “cash reserves” – the most liquid asset of the bank (as
liquid as paper money).
 Bank Leverage
• Bank capital (equity): the bank’ own funds Assets Liabilities
(rather than deposits or borrowings).
Reserves/Cash Deposits
• Leverage: the use of borrowed funds to
Loans Bank Capital
supplement existing funds for
lending/investment purposes. Other Assets Other Liabilities
Total Assets
Leverage =
Bank Capital
• Banks are required to keep a certain
leverage ratio (similar role to reserves but
from banks’ “own” money).
Note on reserves and bank capital
• For banks, reserves are help to cover the risk of unexpected
withdraws from depositors (liquidity risk).
• Capital is help to cover the losses incurring from borrowers
failing to pay back its loans (insolvency risk).
• These type of funds make banks operational under various risks
Check
A bank has a 10 percent reserve requirement, $36,000 in loans,
and has loaned out all it can, given the reserve requirement.
A. It has $3,600 in deposits.
B. It has $32,400 in deposits.
C. It has $39,600 in deposits.
D. It has $40,000 in deposits.
 Assets Liabilities
Check
Reserves $30 Deposits $200

Loans $170

Given a bank with the balance sheet as in the above table, if the bank faces a
reserve requirement of 6 percent, then the bank:
A. is in a position to make new loans equal to a maximum of $12.
B. is in a position to make new loans equal to a maximum of $18.
C. has excess reserves of $120.
D. has excess reserves of $30.
Central Banks and Monetary
Policy
Central banks (1)
• Central banks both conduct monetary policy and serve as the ultimate bank
of governments and commercial banks.
• Note: central banks only interact with commercial banks, not with firms and
households.

• Central banks’ macroeconomic principal responsibilities:

• Control inflation.
• Support economic growth.
• Reduce cyclical unemployment.

• Central banks have the duty to ensure stability of the banking system.
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Central banks (2)
• Central banks’ other responsibilities:
• Monopoly on increasing the monetary base (e.g. currency issue).
• Handle commercial banks’ payments.
• Lender of last resort for the banking system.
• Manage the exchange rate and the country’s foreign exchange reserves.
• Control credit growth.
World’s notable central banks:
• Federal Reserve (Fed).
• European Central Bank (ECB).
• Bank of England (BoE).
• Bank of Japan (BoJ).
• People's Bank of China (PBoC).
Central Banks’ Tools (1)
• Open Market Operation (OMO) are activities of selling and
buying securities of the central bank (the CB) in order to
change available reserves to banks for lending:
• The CB sell securities (as government bonds) to withdraw money
from banks, less reserves are available for lending. The money supply
can decrease accordingly.
• The CB buys securities to inject money to banks, more reserves are
available for lending. The money supply can increase accordingly.
 OMO’s balance sheet

Assets Liabilities Assets Liabilities

Deposits Reserves as cash Deposits

Reserves as
$200 $200 $200
cash Sell government bonds
$100 to the central bank
Govt’ bonds
$100
Total assets Total liabilities
Total assets Total liabilities

More reserves → more

available fund for loans
Frequently Asked Questions (FAQs)
• Q: Why banks want to keep government bonds as their reserves?
A: Government bond is a highly liquid asset that can be quickly
transformed into “cash money” and has a higher interest rate than
cash reserves (more profits for banks to hold them).

• Q: Why banks want to sells government bonds to the central bank

to obtain “cash reserves”?
A: Banks can use the obtained reserves to make commercial loans at
a higher interest rate (than government bond’s interest rate).
Central Banks’ Tools (2)
• Discount window: the CB can lend money directly to banks at the
discount interest rate.
• Required Reserve Ratio: the CB can impose the required reserve
requirement on banks.
• Paying interest rate on reserves at the CB: a high interest on reserves can
encourage commercial banks to keep more reserves.
• Repurchase Agreements (Repos): an agreement to buy government’s
bonds from banks and sell back to banks for a fixed (very) short-term
period of time. It is similar to OMO but not an outright transaction.
Monetary Policy
• Monetary policy include actions taken by the central bank to
achieve broader macroeconomic objectives like high
employment, economic growth, and price stability.
• Monetary policy’ tools include: open market operation, discount
windows, foreign exchange intervention, quantitative easing…
• More on monetary policy will be discussed toward the final weeks
of the course.
Can CBs can fully control the money
supply?
• It is strongly argued that CBs CANNOT fully control the money supply.
• When commercial banks as well as firms/households do not hold a positive
prospect about the economy:
• Banks want to lend less to prevent loss and hold reserves as buffers against late
payments from customers.
• Firms and households do not want to make investments or save more.
• It leads banks to keep higher levels of reserves, resulting in a higher reserve
ratio. Hence, the money supply may decrease.
• The CB can intervene but commercial banks need to react as the CB hope for.
Check
Assume that the reserve ratio is 5 percent, banks do not hold excess reserves,
people do not hold currency, and the money multiplier fully applies. The
central bank purchases $20 mil worth of government bonds, bank reserves:
A. increase by $20 mil; the money supply eventually increases by $400 mil.
B. decrease by $20 mil; the money supply eventually decreases by $400 mil.
C. increase by $20 mil; the money supply eventually increases by $100 mil.
D. decrease by $20 mil; the money supply eventually decreases by $100 mil.
Federal Reserve (Fed)
US’s Central Bank - Fed
• The Federal Reserve (Fed) is the most powerful CB of the
world.
• Fed can affect banks’ excess reserves by changing the Federal
funds rate.
• The Federal funds rate (or the Fed funds rate) is the interest
rate that large commercial banks/depository institutions lend
to and borrow from each other for loans of reserves for very
short-term periods, e.g. overnight loan.
 The Money Market (1)
The two banks’ balance sheets right before the end of the day: • Citibank sees a great economic
Wells Fargo Citibank opportunity and “over-lend”
itself during the day.
Assets Liabilities Assets Liabilities
• Suppose that the CB requires all
Reserves Customer Reserves Customer banks to keep the (minimum)
$20 Deposits $10 Deposits
$100 required reserves ratio at 10%.
$190
Customer Loans Loans
$80 $180 • Citibank does not meet this
ratio.
Total assets Total liabilities Total assets Total liabilities
$100 $100 • How can Citibank meet the
$190 $190
required reserved ratio from
The reserve ratio is: The reserve ratio is: Fed?
20/100 = 20% 10/190 = 5.3%
 The Money Market (2)
The two banks’ balance sheets at the end of the day: • Citibank can ask for overnight
loans from the Wells Fargo
Wells Fargo Citibank who has reserves surplus.
Assets Liabilities Assets Liabilities • The market for very short-
term loans between banks
Reserves Customer Reserves Customer
$10 Deposits
with reserves surplus and
$20 Deposits
Customer Loans $100 $190 banks with reserves deficits is
$80 Loans Interbank called as the money market in
Interbank Loans $180 Borrowings the US (or the interbank
$10 $10 lending market).
Total assets Total liabilities Total assets Total liabilities • The interest rate charging on
$100 $100 $200 $200 this type of loans is called the
The reserve ratio is: The reserve ratio is: Fed funds rate.
10/100 = 10% 20/200 = 10%
How Fed adjust the federal funds rate?

• Banks are legally required to maintain interest-bearing accounts at Fed

and liquid assets (such as: government bonds) of its total assets to cover
possible sustained cash outflows.
• Fed can conduct its OMO – selling/buying or repo government bonds – to
supply more reserves to or withdraw more reserves from banks.
• Abundant supply of reserves → lower the fed Funds interest rate.
• Scarce supply of reserves → higher the fed Funds interest rate.

• Recently, Fed also uses interest rate on reserves and overnight reverse
repurchase agreement rate to influence banks’ lending rates.
 Fed’s target and actual rates

Source: Federal Reserve Bank of St. Louis (FRED)

How the fed funds rate affects the
financial system and the economy?
• The financial system are highly interconnected, changes in the short-term
fed funds rate (between banks) affect other interest rates in the market
(deposit rates, various lending rates…) in the same direction.
• Banks, facing a higher cost of borrowing reserve money, incline to lend
less money and lend at higher lending interest rates; and vice versa.
• Firms and households, facing higher cost of lending interest rates from
banks, borrow less money; and vice versa.
• Read more at https://www.stlouisfed.org/open-vault/2020/august/how-
does-fed-influence-interest-rates-using-new-tools
The relationship between various bank rates in the US

Note:
• Market Yield 5-year: US government bond market “interest rate” at the 5-year term.
• Bank Prime Loan Rate: base rates used by banks for short-term business loans.
• Commercial Bank Interest Rate on Credit Card: interest rate for credit-card loans.
Video explaining Fed Fund Rate

https://www.youtube.com/watch?v=AkMsMDk_brU
 Monetary policy’s transmission
mechanism

Central bank
Open market operations Market
& other tools interest rates
Firms’ and households’
Federal Funds Rate
borrowings
Loan availability

Investment (I) and

Consumption (C) of GDP
Fed’s rate change is a hugely important event
Check
Which of the following actions by the Fed would tend to increase
the more reserves from banks (and the money supply)?
A. an open-market sale of government bonds.
B. a decrease in reserve requirements.
C. an increase in the interest rate paid on reserves.
D. an increase in the discount rate on Fed lending.
State Bank of Vietnam (SBV)
and Vietnam Banking System
Vietnam’s banking system
• The central bank: the State Bank of Vietnam (SBV)
• Commerial banks:
• Big four state-owned banks (ngân hàng thương mại nhà nước).
• Joint-stock (domestic) commercial banks (ngân hàng thương mại cổ
phần) (e.g. Techcombank) or foreign-owned banks (e.g. Shinhan Bank).
• Finance companies (công ty tài chính). E.g F88, Fcredit…
The State Bank of Vietnam (SBV)
• The bank of all banks in Vietnam.
• It is a ministry-equivalent body of the Vietnam central
government.
• It is headed by the bank governor who holds a 5-year term and
approved by the National Assembly.
Commerical banks
• Big 4 state-owned banks (SOBs): Vietcombank, BIDV, Argibank,
VietinBank.

• Joint-stock commerical banks:

• Techcombank, VIB, Sacombank, ACB, VP Bank...
Source: www.wichart.vn
SBV’s tools
• The State Bank of Vietnam (SBV) can set:
• The required reserves ratio.
• Policy rates (SBV’s lending rate at the discount window).
• The annual total credit growth.
• Maximum deposit rates of commercial banks.
• The fluctuating band for USD/VND exchange rate.
• SBV can intervene into the open market to supply or withdraw banks’
reserves.
• It can also buy or sell US dollars in the foreign exchange (FX) market to
achieve its exchange rate’s target.

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SBV set credit growth limit
• Credit is the term that captures the total
value of all commercial banks’ domestic
loans.
• As an economy with a significant
economic growth, banks’ loan (credit) in
Vietnam constantly expands.
• Very high rates of credit growth can
“over-fuel” economic activities and
render the economy too “hot” –
equivalent to very fast increase of the
money supply.
• Results? Too much inflation?
 Vietnam's M2 and Credit (unit: billion VND)
16,000,000
14,000,000
12,000,000
10,000,000
8,000,000
6,000,000
4,000,000
2,000,000
0

Credit M2

Note: Credit outstanding is the total value of all commercial banks’ domestic loan.
Source: IMF
SVB’s intervention into the FX market
“Vietnam's central bank said on Tuesday it was making
efforts to shore up foreign exchange reserves by buying
up more U.S. dollars, after it was forced to sell a large
amount of greenback earlier in the year to support its
dong currency.”

“The State Bank of Vietnam (SBV) earlier this year was

forced to sell a large amount of U.S. dollars to the market
to support the dong, which has hit record lows in recent
months from capital outflows as the U.S. Federal Reserve
repeatedly raises interest rates to tame inflation.
Market analysts said the SBV had sold about $20 billion
worth.“
https://www.reuters.com/markets/asia/vietnam-central-bank-aims-keep-
inflation-45-next-year-2022-12-27/
USD/VND exchange rates

Source: www.wichart.vn 80
 The lender of last resort
• A risk of bank run at Saigon Commercial
Bank (SCB) – connected to the troubled real
estate company Van Thinh Phat happened on
Oct 2022.
• SBV performed the role as the lender of last
resort to support the bank system.
Bank run occurs when many clients
• During the first ten days of October, SBV withdraw their money from a bank. It
causes the bank become unable to
“pumped” totally at 61,274 billion VND, via
pay back deposit money, run out of
the open market, into the economy. money and get bankrupt.
Sources: https://vneconomy.vn/ngan-hang-nha-nuoc-day-manh-bom-
tien-lai-suat-lien-ngan-hang-ha-nhiet-nhung-ty-gia-tang-nong.htm
81
Summary (1)
• Three functions of money: medium of exchange, unit of account,
store of value.
• T-account balance sheet of banks.
• The money supply (M1, M2, M3, M4): notes, cheques, checking
account, time deposits, money market mutual fund…
• Money is created by banks’ lending: banks can make loans out of
excess reserves; the money multiplier theory.
Summary (2)
• Open market operation: the central bank buys and sells government
bonds from/to bank to withdraw and supply excess reserves.
• Other tools: discount windows, interest rate on reserves…

• Fed changes the federal funds rate – interest rate charging on short-
term loans between financial institutions - to achieve its
macroeconomic objective.
• An increase of the fed funds rate leads higher market interest rates and less
credit availability (less money supply); and vice versa.

• Vietnam’s banking system.

 Suggested readings on money and its history
• “Money creation in the modern economy” from the Bank of England
https://www.bankofengland.co.uk/-/media/boe/files/quarterly-
bulletin/2014/money-creation-in-the-modern-economy.pdf

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