MONETARY SYSTEM

Lecture 2
 DEFINITION

• The Monetarry System is the set of institution by which government provides

money in a country's economy modern monetary system usually consist of
mints, central banks and commercial bank.
• the meaning of money : Money is the set of assets in the economy that
people regullary use to buy goods and services from other people. the cash
in yor wallet is money because you can use it to buy a meal at the restaurant
or a shirt at a clothing store.
 THE FUNCTION OF MONEY

• medium exchange : in is an item that buyers give to sellers when they

purchase goods and services.
ex: when you buy a shirt at clothing store, the store give you a shirt and
you give the store your money.
• unit of account : money is the common standard for measuring relative
worth of goods and services. and the other means is the yardstick people use
to postprice and recor debts
ex: when you go shopping you might observe that a shirt cost $20 and a
hamburger cost $2 even though it would be accurate to say that the price of
a shirt is 10 hamburgers and the price of Hamburger 1/10 of a shirt price or
never quoted in this way.
 THE FUNCTION OF MONEY

• - Store a value : money is the most liquid asset. and item that people can use
to transfer purchasing power from the present to the future. Money value can
be retained overtime it is a convenion way to store wealth. The term of
wealth is used to rever to the total of all stores of value, including both
money and monetary assets.
• - Liquidity : the ease with which and asets can be converted into the
economist medium of exchange or liquidity measures how easily assets can
be spent to buy goods and services.
 THE KINDS OF MONEY

• Commodity Money
• Fiat Money
• Currency
• Demand Deposit
 THE KINDS OF MONEY

• Commodity Money :
• money whose value comes from a commodity of which it is made.
Commodity money consists of objects that have value in themselves as
well as value in their use as money.
• example: gold, silver, cigarette.
 THE KINDS OF MONEY

• Fiat Money :
• currency which derives its value from government regulation or law. It
differs from commodity money, which is based on a good, often a
precious metal such as gold or silver, which has uses other than as a
medium of exchange. The term derives from the Latin fiat ("let it be
done", "it shall be")
 THE KINDS OF MONEY
• Currency :
• A generally accepted form of money, including coins and paper notes,
which is issued by a government and circulated within an economy. Used
as a medium of exchange for goods and services, currency is the basis for
trade.
• Explain: Generally speaking, each country has its own currency. For example,
Switzerland's official currency is the Swiss franc, and Japan's official currency
is the yen. An exception would be the euro, which is used as the currency for
several European countries.
• Investors often trade currency on the foreign exchange market, which is one
of the most heavily traded markets in the world.
 THE KINDS OF MONEY
• Demand Deposit:
• Balances in bank accounts that depositors can accession demand by writing a
check. Funds held in an account from which deposited funds can be withdrawn at
any time without any advance notice to the depository institution. Demand
deposits can be "demanded" by an account holder at any time. Many checking
and savings accounts today are demand deposits and are accessible by the
account holder through a variety of banking options, including teller, ATM and
online banking. In contrast, a term deposit is a type of account which cannot be
accessed for a predetermined period (typically the loan's term).
• Explains : M1 is a category of the money supply that includes demand
deposits as well as physical money, such as coins and currency, and
Negotiable Order of Withdrawal (NOW) accounts. According to the Federal
Reserve's Consumer Compliance Handbook, demand deposit accounts have
these characteristics: no maturity period (or an original maturity of fewer
than seven days), payable on demand, may be interest bearing, no limit on
the number of withdrawals or transfers an account holder may make, and no
 BANK AND MONEY SUPPLY

• Bank Reserve :
• Bank reserves are the currency deposits which are not lent out to the
bank's clients. A small fraction of the total deposits is held internally by
the bank or deposited with the central bank. Minimum reserve
requirements are established by central banks in order to ensure that the
financial institutions will be able to provide clients with cash upon
request.
• Explains : The main purpose of holding reserves is to avoid bank runs
and generally appear solvent. Central banks place these restrictions
on banks, because the banks can earn a much larger return on their
capital by lending out money to clients rather than holding cash in
their vaults or depositing it with other institutions. Bank reserves
decrease during periods of economic expansion and increase during
 BANK AND MONEY SUPPLY

• Fractional Reserve Banking :

• A banking system in which only a fraction of bank deposits are backed by
actual cash-on-hand and are available for withdrawal. This is done to
expand the economy by freeing up capital that can be loaned out to other
parties. Most countries operate under this type of system.
• Also known as "fractional deposit lending".
• Many U.S. banks were forced to shut down during the Great Depression
because so many people attempted to withdraw assets at the same time.
Today there are many safeguards in place to prevent such an instance
from occurring again, but the fractional-reserve banking system remains
in place
 KEY POINTS

• The main way that banks earn profits is through issuing loans. Because their
depositors do not typically all ask for the entire amount of their deposits back
at the same time, banks lend out most of the deposits they have collected.
• The fraction of deposits that a bank keeps in cash or as a deposit with the
central bank, rather than loaning out to the public, is called the reserve ratio.
• A minimum reserve ratio (or reserve requirement) is mandated by the Fed in
order to ensure that banks are able to meet their obligations.
• Because banks are only required to keep a fraction of their deposits in
reserve and may loan out the rest, banks are able to create money.
• A lower reserve requirement allows banks to issue more loans and increase
the money supply, while a higher reserve requirement does the opposite.
 THE MONEY MULTIPLIER

• The money multiplier is the amount of money that banks generate with each
dollar of reserves. Mathematical relationship between the monetary base and
money supply of an economy. It explains the increase in the amount of cash in
circulation generated by the banks' ability to lend money out of their depositors'
funds. When a bank makes a loan, it 'creates' money because the loan becomes
a new deposit from which the borrower can withdraw cash to spend. This money-
creating power is based on the fractional reserve system under which banks are
required to keep at hand only a portion (between 10 to 15 percent, typically 12
percent) of the depositors' funds. The rest may be converted into loans, thereby
increasing the available cash by a factor that is a multiple of the initial deposit.
 FEDERAL RESERVE SYSTEM

• The Federal Reserve System (also known as the Federal

Reserve, and informally as the Fed) is the central banking
system of the United States.
 FEDERAL RESERVE SYSTEM

Current functions of the Federal Reserve System include:

• To address the problem of banking panics
• To serve as the central bank for the United States
• To strike a balance between private interests of banks and the centralized
responsibility of government
• To supervise and regulate banking institutions
• To protect the credit rights of consumers
• To manage the nation's money supply through monetary policy to achieve
the sometimes-conflicting goals of
 FEDERAL RESERVE SYSTEM
• maximum employment
• stable prices, including prevention of either inflation or deflation
• moderate long-term interest rates
• To maintain the stability of the financial system and contain systemic risk in
financial markets
• To provide financial services to depository institutions, the U.S. government,
and foreign official institutions, including playing a major role in operating the
nation's payments system
• To facilitate the exchange of payments among regions
• To respond to local liquidity needs
• To strengthen U.S. standing in the world economy
 THE FED'S TOOLS OF MONETARY
CONTROL
• The term monetary policy refers to the actions that the Federal Reserve
undertakes to influence the amount of money and credit in the U.S. economy.
Changes to the amount of money and credit affect interest rates (the cost of
credit) and the performance of the U.S. economy. To state this concept
simply, if the cost of credit is reduced, more people and firms will borrow
money and the economy will heat up.
 THE FED'S TOOLS OF MONETARY
CONTROL
• Reserve requirement
The reserve requirement (or cash reserve ratio) is a central
bank regulation employed by most, but not all, of the world's central banks,
that sets the minimum fraction of customer deposits and notes that
each commercial bank must hold as reserves (rather than lend out).
These required reserves are normally in the form of cash stored physically in
a bank vault (vault cash) or deposits made with a central bank.
 THE FED'S TOOLS OF MONETARY
CONTROL
• Open market operation
The buying and selling of government securities in the open market in order to
expand or contract the amount of money in the banking system. Purchases
inject money into the banking system and stimulate growth while sales of
securities do the opposite.
THE FED'S TOOLS OF MONETARY
CONTROL
 THE FED'S TOOLS OF MONETARY
CONTROL
• DISCOUNT RATE

The interest rate charged to commercial banks and other depository institutions
for loans received from the Federal Reserve Bank’s discount window. The
discount rate also refers to the interest rate used in discounted cash flow (DCF)
analysis to determine the present value of future cash flows. The discount rate in
DCF analysis takes into account not just the time value of money, but also the
risk or uncertainty of future cash flows; the greater the uncertainty of future cash
flows, the higher the discount rate. A third meaning of the term “discount rate” is
the rate used by pension plans and insurance companies for discounting their
liabilities.
PROBLEMS IN CONTROLLING THE MONEY
SUPPLY
1. The Fed does not control the amount of money that consumers choose to deposit
in banks.
a. The more money that households deposit, the more reserves the banks
have, and the more money the banking system can create.
b. The less money that households deposit, the smaller the amount of
reserves banks have, and the less money the banking system can
create.
2. The Fed does not control the amount that bankers choose to lend.
a. The amount of money created by the banking system depends on loans
being made.
b. If banks choose to hold onto a greater level of reserves than required by
 PROBLEMS IN CONTROLLING THE MONEY
SUPPLY
3. Therefore, in a system of fractional-reserve banking, the amount of money in the economy
depends in part on the behavior of depositors and bankers.
4. Because the Fed cannot control or perfectly predict this behavior, it cannot perfectly
control the money supply.
5. Case Study: Bank Runs and the Money Supply
a. Bank runs create a large problem under fractional-reserve banking.
b. Because the bank only holds a fraction of its deposits in reserve, it will not have
the funds to satisfy all of the withdrawal requests from its depositors.
c. Today, deposits are guaranteed through the Federal Depository Insurance
Corporation (FDIC).
 FYI: THE FEDERAL FUNDS RATE

1. The federal funds rate is the short-term interest rate that banks charge one
another for loans.
2. When the federal funds rate rises or falls, other interest rates often move in
the same direction
3. In recent years, the Fed has set a target for the federal funds rate
 SUMMARY

1. The term money reverse to accept that peopla regulary use to buy goods
and services.
2. Money serves three functions as a medium to exchange it provide the item
use to make transaction as a unit of account it provide the way in which
prices other economic values are recorded. As a store of value, it provides
a way of transfering, purhasing power from the present to the future.
3. Commodity money , such as gold is money that has intrinsict value: it
would be valued even if it were not used as money.
4. Fiat money such as paper dollars , is money without intrinsict value: it
would be workless if it were not used as money
 SUMMARY

5. In the US economy, money takes the form of currency and various type of bank
deposite such as checking acount
6. The federal reserve, the central bank of the US is responsible for regulating the US
monetary system.
7. The fed chairman is appointed by the president and confirmed by congress every 4
years. Thechairman is the lead member of the federal open market commit, which
meets about every 6 weeks to consider changes in monetery policy.
8. When banks loan out some of their deposite they increase the quantity of money in
the economy. Because of this role run of banks is determining the money supply,
the fed’s control of the money supply is imperfect.
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