Introduction to

Macroeconomics
Lecture 6

ECO 216
NBS
Spring 2024
Dr. Shujahat Haider Hashmi
 The monetary system:
How does it work?

IN THIS LECTURE:
What is money?
How a nation’s banking system determines the amount of
money in the economy?
How does the central bank of a country controls/influences
the banking system and the money supply?

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Two main macroeconomic policies

Macroeconomic policies

Fiscal policy Monetary Policy

Made by independent
Made by elected govt.
central bank
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 Definition of money

Money is the type

of assets that can be
readily used to
make transactions.

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 Connection between money and prices

• Inflation rate = the percentage increase

in the average level of prices.
• Price = amount of money required to
buy a good.
• Because prices are defined in terms of money, we
need to consider the nature of money,
the supply of money, and how it is controlled.

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 Functions of money

• store of value
transfers purchasing power from the present to the
future
• unit of account
the common unit by which everyone measures
prices and values
• medium of exchange
we use it to buy stuff.
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 Types of money
1. Fiat money
• has no intrinsic value
• example: the paper currency we use
• the use of fiat money in exchange is a social convention:
everyone values fiat money because they expect
everyone else to value it.
2. Commodity money
• has intrinsic value
• examples:
gold coins, silver coins, copper coins, rice, spices,
cigarettes in P.O.W. camps, etc.
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 Question
Which of these are money?
a. Currency
b. Cheque / Check
c. Deposits in checking accounts
(“demand deposits”)
d. Credit cards
e. Certificates of deposit
(“time deposits”)

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Measuring the Quantity of Money

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 Managing the Quantity of Money
• The money supply is the quantity of money available in the
economy.
• Government have monopoly over the printing of money
• Monetary policy is the control over the money supply.
• In Pakistan the SBP controls the monetary policy and in US the
Federal Reserve
• Open-market operations is the way through which the supply
of money is controlled by the central bank. It involves the
purchase and sale of government bonds between
banks/public and the central bank.
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 Role of banks in monetary system
• Money supply includes both currency in the hands of the
public and deposits at banks that households can use on
demand for transactions

• Since the money supply includes deposits at banks, the

banking system plays an important role

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 Role of banks in monetary system
• Reserves (R): the portion of deposits stored in its cellar
that banks do not lent out
• A bank’s liabilities include deposits; assets include
reserves and outstanding loans
• 100-Percent-Reserve Banking: A system in which banks
hold all deposits as reserves
• Fractional-Reserve Banking: A system in which banks hold
a fraction of their deposits as reserves

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If no banks

With no banks,
D = 0 and M = C = $1000.
 100-Percent-Reserve Banking
• Initially C = $1000, D = $0, M = $1,000
• Now suppose households deposit the $1,000 at
“Firstbank”
After the deposit:
C = $0
D = $1,000
M = $1,000
• Conclusion:
100%-Reserve Banking
has no impact on the size
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 Fractional-Reserve Banking (1 of 3)
• Suppose banks hold 20% deposits in reserve (rr = 0.2),
making loans with the rest to the private sector
• Firstbank will make $800 in loans
The money supply now
equals $1,800:
• Depositor has $1,000 in
demand deposits
• Borrower holds $800 in
currency
Lesson: In a fractional-reserve banking
system, banks create money, by giving credit 15
 Fractional-Reserve Banking (2 of 3)
• Suppose the borrower deposits the $800 in Secondbank
• Secondbank will loan 80% of this deposit
• The Secondbank’s balance sheet is:

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 Fractional-Reserve Banking (3 of 3)
• If this $640 is eventually deposited in Thirdbank,
• Then Thirdbank will keep 20% of it in reserve and loan
out the rest:

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Total amount of money

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 Summing up

• Fractional reserve banking system creates money (but not

wealth)
• When a bank loans out some of its deposits, it gives
borrowers the ability to make transactions and therefore
increases the supply of money.
• The borrower still has debt obligation!
• So banks just increase the economy’s liquidity

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Bank Capital, Leverage, Capital Requirements
• Bank Capital: the resources a bank’s owners have put into
the bank; difference between the value of a bank’s assets
and liabilities
• A more realistic balance sheet of a bank

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Bank Capital, Leverage, Capital Requirements
• Leverage: the use of borrowed money for the purpose of
investment
• Leverage ratio = assets/capital
= $(200 + 500 + 300)/$50 = 20

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Bank Capital, Leverage, Capital Requirements
• Being highly leveraged makes banks vulnerable
• Example: Suppose a recession causes our bank’s assets to
fall by 5% to $950
• Then, Capital = Assets – Liabilities = 950 – 950 = 0

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Bank Capital, Leverage, Capital Requirements
Capital requirement
• Minimum amount of capital mandated by central bank
• Intended to ensure that banks will be able to pay off
depositors
• Higher for banks that hold more risky assets

• The example of 2008-2009 financial crisis

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 The role of Central Bank
A model of money supply
• Monetray base: B = C + R
controlled by the central bank
• Reserve-deposit ratio: rr = R/D
depends on regulations and bank policies
• Currency-deposit ratio: cr = C/D
depends on households’ preferences

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 Solving for money supply
M=C+D
B=C+R
Divide the first equation by the second

Divide both top and bottom of the right side by D

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 Solving for money supply (contd.)

Where is called the money multiplier, which is always > 1

Implication:
• Each dollar of the monetary base produces m dollars of
money in the economy.

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Three exogenous variables of Money Supply
B , rr, cr
• An increase in the monetary base increases the money
supply
• A decrease in the reserve–deposit ratio raises the money
multiplier and the money supply
• A decrease in the currency–deposit ratio raises the
money multiplier and the money supply

Govt. can change the first two directly, and

the last one indirectly
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 Changing the monetary base (amount of
currency)
• Through open-market operations, the central bank can
buy the government bonds from the public or sell them
to the public

• Central bank can also lend money to private banks on an

interest rate which is also called “discount rate”.
Reduction in discount rate will increase monetary base.

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 Changing the reserve-deposit ratio (rr)

• Central bank imposes a minimum reserve-deposit ratio

on banks
• Less frequently used tool by central banks

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Paragraph from SBP website

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