THE

M O N E TA RY
SYSTEM
Chapter 29
 W H AT I S M O N E Y ?
• Money is the set of assets in the economy that people regularly use to buy goods and
services from each other.
• The social custom of using money in a large, complex society is extraordinarily
useful.
• If there was no money people would rely on ‘barter’- the exchange of one good or
service for another.
• For example, in order to get a meal from the restaurant, we have to offer to wash
some dishes, clean the restaurateur car or give an expensive watch that you are
wearing.
• An economy that relies on barter will have trouble allocating its scarce resources
efficiently. In such an economy, trade is said to require the double coincidence of
wants- the unlikely occurrence that two people each have a good or service that the
other wants.
WHY IS MONEY EASIER AS A MEANS OF
TRADE?

The existence of money

makes trade easier. The He is happy to accept your This is like a cycle. The
restaurateur does not care money, knowing the other restaurateur accepts the
whether you can produce a people will do the same for money and uses it to pay
valuable good or service him. his chef.
for him.

The chef uses her paycheck

to send her child to
As money flows from
daycare. The day care
person to person in the
center uses this tuition to
economy, it facilitates
pay a teacher. The teacher
production and trade.
hires a gardener to mow
her lawn.
THE FUNCTIONS OF MONEY

Money has • Medium of

three exchange
functions •
in the A unit of account
economy : • Store of value.
THE FUNCTIONS OF MONEY

• A medium of exchange is an item buyers give to sellers when

they want to purchase goods and services. Example when you
buy a shirt at a clothing store, the store gives you the shirt and
you give the store your money.
• The transfer of money from buyer to seller allows the
transaction to take place. When you walk into a store you are
confident that the store will accept your money for the items it
is selling.
• Money is the most common medium of exchange.
THE FUNCTIONS OF MONEY

• A unit of account is the yardstick people use to post prices

and record debts.
• An example is when you go shopping, you might observe that
a shirt cost $30 and a cheeseburger costs $3.
• Even though it would be accurate to say that the price of a
shirt is 10 cheeseburgers, and the price of a cheeseburger is
1/10 of a shirt, prices are never quoted in this way.
• When we want to measure and record economic value, we use
money as the unit of account.
W H A T I S T H E S T O R E O F VA L U E ?

• A store of value is an item that people can use to transfer purchasing

power from the present to the future.
• When a seller accepts money today in exchange for a good or
service, the seller can hold the money and become buyer of another
good or service at another time.
• Money is not the only store of value in the economy.
• Nonmonetary assets such as stock and bonds are also store of values.
• Wealth= total of all stores of value including both monetary(money)
and nonmonetary assets.
 LIQUIDITY AND MONEY

• Liquidity- The ease with which an asset can be

converted into the economy’s medium of exchange.
• As money is the economy’s medium of exchange, it is
the most liquid asset available.
• Other assets vary widely in their liquidity.
• A house, an expensive painting requires more time to be
sold so these are less liquid.
• When people decides in what form to hold their wealth,
they have to balance the liquidity of each possible asset
against the asset’s usefulness as a store of value.
• Money is not a perfect store of value however it may be
the most liquid asset.
THE KINDS OF MONEY

Money that takes the

form of a commodity
Commodity Money with intrinsic value
is known as
commodity money.
COMMODITY MONEY

One example of a commodity money is gold.

Gold has ‘intrinsic value’ because it is used in industry and in the

making of jewelry.

Although we no longer use gold as money historically gold has been

a common form of money in the past. It was easier to carry, measure
and verify for impurities.
COMMODITY MONEY

Another example of commodity money is cigarettes. In prisoner of war

camps during the World War II, prisoners traded goods and services with
one another using cigarettes as the store of value, unit of account and
medium of exchange.
Non-smokers were happy as they could use cigarettes to buy other goods
and services.
F I AT M O N E Y

• Money without intrinsic value is called fiat money. A fiat is an order or

decree and fiat money is established as money by government decree.
• If we compare the paper dollars in our wallet to the paper dollars from a
game of Monopoly, we can use the first to pay our bill at a restaurant but not
the second.
• This is because government has decreed its dollars to be valid money.
• Acceptance of fiat money depends much on expectations and social
convention as on government decree.
• (Soviet govt)The people of Moscow preferred to accept cigarettes in
exchange for goods and services because they were more confident that
these alternative monies would be accepted by others in the future.
MONEY IN THE U.S ECONOMY

• Currency is the paper bills and coins in the hands of the public.
• It is the most widely accepted medium of exchange in our economy. It is
part of the money stock.
• Demand deposits - Balances in bank accounts that depositors can access
on demand simply by writing a check or swiping a debit card at a store.
• Bank depositors usually cannot write checks against the balances in their
savings accounts, but they can transfer funds from savings into checking
accounts.
• In addition, depositors in money market mutual funds can often write
checks against their balances.
MONEY IN THE U.S ECONOMY

There should be a clear

distinguished line between The coins in our pocket are part
assets that can be called of the money stock but the
“money” and assets that Empire State Building is not.
cannot.

The money stock in the US

economy includes not only
currency but also deposits in
banks and other financial
institutions that can be readily
accessed and used to buy goods
and services
TWO MEASURES
OF THE MONEY
STOCK
M1 AND M2
T H E F E D E R A L R E S E RV E S Y S T E M

In USA the agency that regulates money is known as the Federal

Reserve or simply known as the Fed. In Bangladesh this is more
commonly known as the Central Bank or Bangladesh Bank.

Central Bank is an institution designed to oversee the banking

system and regulate the quantity of money in the economy.

Other central banks includes Bank of England, Bank of Japan and

the European Central Bank.
THE FED OPEN MARKET COMMITTEE

If the open market committee

decides to increase the After purchase these dollars
The Fed’s primary tool is the
money supply, Fed creates are in the hands of the public.
open market operation- the
dollars and uses them to buy Thus, an open market
purchase and sale of U.S
government bonds from the purchase of bonds by the Fed
government bonds.
public in the nation’s bond increases the money supply.
markets.

After the sale, the dollar it

Conversely if the Open
receives for the bonds are out
market committee decides to
of the hands of the public.
decrease the money supply,
Thus, an open market sale of
the Fed sells government
bonds by the Fed decreases
bonds to the public.
the money supply.
B A N K S A N D T H E M O N E Y S U P P LY

• Banks can influence the quantity of demand

deposits in the economy and the money supply.
• Reserves are deposits that banks have received
but have not loaned out.
• In this imaginary economy, all deposits are
held as reserves, so this system is called the
100 percent reserve banking.
• We can express the financial position of First
National Bank with a T- account, which is
simplified accounting statement showing
changes in a bank assets and liabilities. Here is
the T account for First National Bank if
economy’s entire $100 of money is deposited
in the bank.
B A N K S A N D T H E M O N E Y S U P P LY

• On the left side of the T account are the bank assets of

$100( the reserves that it holds in its vaults ). On the right side
are the bank’s liabilities of $100 (the amount it owes to its
depositors). Because the assets and liabilities of First National
Bank exactly balance, this accounting statement is sometimes
called a balance sheet.
• If banks holds all deposits in reserve, banks do not influence
the supply of money.
M O N E Y C R E AT I O N W I T H F R A C T I O N A L -
R E S E RV E B A N K I N G
• A banking system in which banks hold only a fraction of
deposits as reserves is known as fractional-reserve banking.
• The fraction of total deposits that a bank holds as reserves is
called the reserve ratio. It is determined by a combination of
government regulation and bank policy.
• A reserve requirement is the minimum amount of reserves
that banks must hold.
• If banks holds reserves above the legal minimum it is called
the excess reserves.
 M O N E Y C R E AT I O N W I T H
F R A C T I O N A L - R E S E RV E
BANKING

• Let’s suppose the First National has a reserve ratio

of 1/10 or 10 percent. This means that it keeps 10%
of its deposits in reserves and loans out the rest.
Now let’s look again at the banks T- account:
 • First National still has $100 in liabilities
because making the loans did not alter
the bank’s obligation to its depositors.
MONEY
• Now the bank has two kind of assets.
C R E AT I O N $10 reserves in its vault and loans of $90
WITH (These loans are liabilities of the people
taking out the loans, but they are assets
FRACTIONAL- of the bank making the loans because the
R E S E RV E borrowers will later repay the bank).

BANKING • Hence the First National’s assets is still

equal to its liabilities.
• Now, we consider the supply of
money in the economy. Before
the bank make any loans the
money supply is $100 of
deposits in the bank. Yet when
First National makes these
loans, the money supply
increases. The depositors still
have demand deposits totaling
$100, but now the borrowers
hold $90 in currency. The
money supply(which equals
currency plus demand deposits)
equals $190. Thus, when banks
holds a fraction of deposits in
reserves, banks create money.
M O N E Y C R E AT I O N W I T H F R A C T I O N A L -
R E S E RV E B A N K I N G
• Here we note that when First National Bank loans out some of its reserves
and creates money, it does not create any wealth.
• Loans from First Nationals give the borrowers some currency and thus the
ability to buy goods and services.
• The borrowers are still taking debts which does not make them any richer.
• Bank creates an assets of money and it also creates a corresponding
liability for those who borrowed the created money.
• In the end, in this process of money creation, the economy is more liquid
which means that there is more medium of exchange.
• However, it is not wealthier than before.
T H E M O N E Y M U LT I P L I E R

• Previously, the creation of money was shown for First National Bank with a T
account. However, the money creation does not stop there.
• Suppose now the borrower from the First National Bank uses the $90 to buy
something from someone who then deposits the currency in Second National Bank.
Here is the T- account for the Second National Bank.
T H E M O N E Y M U LT I P L I E R

• After the deposit, the bank has liabilities of $90. If Second National Bank has a
reserve ratio of 10 percent, it keeps assets of $9 in reserves and makes $81 in loans. In
this way, Second National Bank creates an additional $81 of money.
• Now suppose this $81 is deposited in Third National Bank, which also has a reserve
ratio of 10 percent, this bank keeps $8.10 in reserve and makes $72.90 in loans. Here
is the T-account for Third National Bank:
T H E M O N E Y M U LT I P L I E R

• The process goes on and on. Each time that money is deposited, and a
bank loan is made, more money is created.
• How much money is eventually created in the economy? Let’s add it up:
Original Deposits= $100
First National Lending= $90
Second National Lending= $81
Third National Lending= $72.90
Total money supply= $1000
T H E M O N E Y M U LT I P L I E R
• It turns out that the $100 of reserves generates $1000 of money.
• The amount of money in the banking system generates, with each dollar of reserve is
called the “money multiplier”. In this economy where the $100 of reserves generates
$1000 of money, the money multiplier is 10.
• The money multiplier is the reciprocal of the reserve ratio.
• In our example R= 1/10%, so the money multiplier is 10.
• This reciprocal formula makes sense. If banks hold $1000 in deposits then a reserve ratio
of 10 percent or 1/10% means that the bank must hold 100 in reserves. The money
multiplier just turns this idea around. If banking system as a whole holds a total of $100
in reserves it can have only $1000 in deposits.
• In other words, if R is the ratio of reserves to deposits at each bank then the ratio of
deposits to reserves in the banking system i.e (1/R) is the money multiplier.
• Money Supply= Excess reserves X money multiplier
HOW THE FED INFLUENCES THE
Q U A N T I T Y O F R E S E RV E S

• Open Market Operations

The Fed instructs open market operations, when it buys or sells bonds. To
increase the money supply, the Fed instructs its bonds traders at the New York
Fed to buy bonds from the public in the nation’s bond markets. The dollars the
Fed pays for the bonds increase the number of dollars in the economy. Some of
these dollars are held as currency and some are deposited in banks. Each new
dollar held as currency increases the money supply by exactly $1. Each new
dollar deposited in a bank increases the money supply by more than a dollar
because it increases reserves and thereby the amount of money that the
banking system can create.
O P E N M A R K E T O P E R AT I O N S

• To reduce the money supply, the Fed does just the opposite. It
sells government bonds to the public in the nation’s bond
markets. The public pays for these bonds with its holdings of
currency and bank deposits, directly reducing the amount of
money in circulation. In addition, as people make withdrawals
from banks to buy these bonds from the Fed, banks finds
themselves with a smaller quantity of reserves. In response,
banks reduce the amount of lending, and the process of money
creation reverses itself.
 FED LENDING TO BANKS

The Fed can increase the

When Banks do not have Traditionally the banks pay an
quantity of reserves in the
enough reserves on hand, they interest rate on the loan called
economy by lending reserves to
borrow from the Fed. the discount rate.
banks.

Suppose Fed now changes the

When Fed makes such a loan to discount rate. A higher discount A lower discount rate
the bank, the banking system rate discourages banks from encourages banks to borrow
has more reserves, and these borrowing reserves from Fed. from Fed, increasing the
additional reserves creates more An increase in discount rate quantity of reserves as well as
money. reduces the quantity of reserves the money supply.
and reduces the money supply.
FED LENDING TO BANKS

In recent years, Fed set up new mechanisms for banks to borrow from
the Fed. The Fed sets a quantity of funds that it wants to lend to the
banks and eligible banks bid to borrow those funds. These loans go to
banks that have accepted collateral and are offering to pay the highest
interest rate.

The Fed uses lending not only to control the money supply but also to
help financial institutions when they are in trouble.
HOW THE FED- INFLUENCES THE
R E S E R V E R AT I O

Reserve Requirement- Fed can influence the reserve ratio by altering reserve
requirements which is the minimum amount of reserves that banks must hold. An
increase in reserve requirements means that bank must hold more reserves and can loan
out less of each dollar that is deposited. As a result money supply is decreased.

Paying interest on reserves- Before banks did not earn any interest on the reserves they
held. However, from 2008 October, the Fed began paying interest on reserves. When
banks hold reserves on deposits at the Fed, the Fed pays bank interest on those deposits.
So, banks choose to hold more reserves. Thus, an increase in interest rate on reserves will
tend to increase the reserve ratio, lowering the money multiplier and lowering the money
supply.
PROBLEMS IN CONTROLLING THE MONEY
S U P P LY
• The first problem is that Fed does not control the amount of money that household
choose to hold as deposits in banks.
• More deposit> More reserves> More money
• Suppose now one day people begin to lose confidence and decide to withdraw
deposits and hold more currency. When this happens banking system looses reserves
and creates less money. The money supply falls without any Fed action.
• The second problem is that Fed does not control the amount that bankers choose to
lend.
• Suppose one day bankers become more cautious about economic conditions and
decide to make fewer loans and hold greater reserves. In this process banks create less
money than it otherwise would. Because of the banker’s decision, the money supply
falls.