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Government, Business and

The Monetary System

The Monetary System
• Medium of exchange
• Barter System: double coincidence of wants—
the unlikely occurrence that two people each
have a good or service that the other wants.
• As money flows from person to person in the
economy, it facilitates production and trade,
thereby allowing each person to specialize in
what he or she does best and raising
everyone’s standard of living.

The Meaning of Money


– Set of assets in an economy that people regularly use to buy goods and
services from other people
– Those few types of wealth that are regularly accepted by sellers in exchange of
goods and services

The functions of money
– Medium of exchange

• Item that buyers give to sellers when they want to purchase goods and services

– Unit of account

• Yardstick people use to post prices and record debts

– Store of value

• Item that people can use to transfer purchasing power from the present to the future


Wealth: total of all stores of value, including money and nonmonetary
assets (Time Value of Money)
Liquidity: Ease with which an asset can be converted into the economy’s
medium of exchange

The Kinds of Money • Commodity money – Money that takes the form of a commodity with intrinsic value . • Intrinsic value – Item would have value even if it were not used as money • Gold standard .Gold as money – Or paper money that is convertible into gold on demand 4 .

The Kinds of Money • Fiat money – Money without intrinsic value – Used as money because of government decree – To a large extent. the acceptance of fiat money depends as much on expectations and social convention as on government decree. 5 .

This implies that the current money supply curve is vertical. M2 =M1 +savings deposits+ small (i. M1 = cash + coins + checking deposits + traveler's checks. the supply of money is a constant.Money in the Economy (Money Stock) • Money stock – Quantity of money circulating in the economy has a powerful influence on many economic variables. At any given point in time. we focus on M1. M3 = M2 +large (over $100. . M2 and keep the value of money as stable as possible. under $100. when we discuss the money supply.e. • • • • • 6 At the core of monetary policy is regulation of the supply of money. .. This value is guaranteed by stabilizing the money supply.000 certificates of deposit) time deposits + money market deposits + money market mutual funds. which is measured by the central bank as M1. Because other measures of money supply are based upon the most liquid M1. each of which is more broadly defined and less liquid than the previous one. Insight gained from studying the expansion and contraction of M1 can be applied to M2 and M3.000) time deposits.

Reserve Bank of India controls monetary policy tools like repo. M4: M3 + All deposits with post office savings banks (excluding National Savings Certificates).monetary liabilities o f the banking sector (Other than Time Deposits). reverse repo. SLR to manage money supply in the economy. CRR. M2 : M1 + Savings deposits with Post office savings banks. M1 : Currency with the public + Deposit money of the public (Demand deposits with the banking system + ‘Other’ deposits with the RBI). .Money Stock in India • • • • • • • 7 The Reserve Bank of India defines the monetary aggregates as: M0 (Reserve Money) : Currency in circulation + Bankers’ deposits with the RBI + ‘Other’ deposits with the RBI = Net RBI credit to the Government + RBI credit to the commercial sector + RBI’s claims on banks + RBI’s net foreign assets + Government’s currency liabilities to the public – RBI’s net non-monetary liabilities. M3 : M1+ Time deposits with the banking system = Net bank credit to the Government + Bank credit to the commercial sector + Net foreign exchange assets of the banking sector + Government’s currency liabilities to the public – Net non.

This figure shows the size of each measure in 2009.Two Measures of the Money Stock for the U. Economy The two most widely followed measures of the money stock are M1 and M2.S. 8 .

tax evaders. and other criminals • Currency – not a particularly good way to hold wealth – Can be lost or stolen – Doesn’t earn interest 9 .653 of currency – Much of the currency is held abroad – Much of the currency is held by drug dealers.Where is all the currency? • 2009: $862 billion currency outstanding – Average adult: holds about $3.

22 Billion • M1 24237.55 80.67 • M3 112200.52 INR Billion INR Billion INR Billion .India • Population= 1.15 1127.49 123.40 • M2 24701.

The Central Banking System • Central bank . Collection and Publication of Data • Federal Reserve (Fed).The central bank of the United States • Reserve Bank of India – The Central bank of India 11 .Institution designed to – – – – – – – – – Issue of currency Banker to Government Bankers Bank and Supervisor Controller of Credit and Money Supply.Monetary Policy Exchange Control Lander of Last Resort Custodian of Foreign Exchange Clearing House Function: facilitates banks transactions.

Banks and the Money Supply • Reserves – Deposits that banks have received but have not loaned out • The simple case of 100% reserve banking – All deposits are held as reserves • Banks do not influence the supply of money 12 .

Fractional-Reserve Banking • Fractional-reserve banking – Banks hold only a fraction of deposits as reserves • Reserve ratio – Fraction of deposits that banks hold as reserves • Reserve requirement – Minimum amount of reserves that banks must hold. set by the Central Bank 13 .

Fractional-Reserve Banking • Excess reserve – Banks may hold reserves above the legal minimum • Example: First National Bank – Reserve ratio 10% 14 .

Fractional-Reserve Banking • Banks hold only a fraction of deposits in reserve – Banks create money • Assets • Liabilities – Increase in money supply – Does not create wealth 15 .

The Money Multiplier 16 .

The Money Multiplier • The money multiplier – Original deposit = $100.9 × $81.00 17 .00] – Third National lending = $ 72.00] –… – Total money supply = $1.000.00] – Second National lending = $ 81.00 [= .9 × $100.00 [= .9 × $90.00 – First National lending = $ 90.90 [= .

The Money Multiplier • The money multiplier – Amount of money the banking system generates with each uni of reserves – Reciprocal of the reserve ratio = 1/R • The higher the reserve ratio – The smaller the money multiplier 18 .

Financial Crisis of 2008–2009 • Bank capital – Resources a bank’s owners have put into the institution – Used to generate profit 19 .

Financial Crisis of 2008–2009 • Leverage – Use of borrowed money to supplement existing funds for purposes of investment • Leverage ratio – Ratio of assets to bank capital • Capital requirement – Government regulation specifying a minimum amount of bank capital 20 .

050 Bank capital rises from $50 to $100 So.000 of assets would now be worth $1.000 of assets would be worth $950 – Value of the owners’ equity falls to zero – So.Financial Crisis of 2008–2009 • If bank’s assets – rise in value by 5% – – – – Because some of the securities the bank was holding rose in price $1. for a leverage ratio of 20 • A 5% fall in the value of the bank assets • Leads to a 100% fall in bank capital 21 . for a leverage rate of 20 • A 5% increase in the value of assets • Increases the owners’ equity by 100% • If bank’s assets – reduced in value by 5% – Because some people who borrowed from the bank default on their loans – $1.

S.Financial Crisis of 2008–2009 • Banks in 2008 and 2009 – Shortage of capital • After they had incurred losses on some of their assets – Mortgage loans – Securities backed by mortgage loans – Reduce lending (credit crunch) • Contributed to a severe downturn in economic activity • U. taxpayer a part owner of many banks – Goal: to recapitalize the banking system • Bank lending could return to a more normal level – Occurred by late 2009 22 . Treasury and the Fed – Put many billions of dollars of public funds into the banking system • To increase the amount of bank capital – It temporarily made the U.S.

Central Bank’s Tools of Monetary Control • Influences the quantity of reserves – Open-market operations – Central Bank lending to banks • Influences the reserve ratio – Reserve requirements – Paying interest on reserves 23 .

Tools of Monetary Control • Open-market operations – Purchase and sale of government bonds – To increase the money supply • buys government bonds – To reduce the money supply • sells government bonds – Used more often 24 .

25 . eligible banks bid.Tools of Monetary Control • Central Bank lending to banks • To increase the money supply • Borrow from discount window and pay an interest rate called the discount rate – Higher discount rate • Reduce the money supply – Smaller discount rate • Increase the money supply – Term Auction Facility • Sets a quantity of funds it wants to lend. loan go to the highest bidder – Acceptable collateral – Pay the highest interest rate – Uses such lending not only to control the money supply but also help financial institutions when they are in trouble.

Tools of Monetary Control • Reserve requirements – Regulations on minimum amount of reserves that banks must hold against deposits – An increase in reserve requirement • Decrease the money supply – A decrease in reserve requirement • Increase the money supply – Used rarely – disrupt business of banking 26 .

Tools of Monetary Control • Paying interest on reserves – The higher the interest rate on reserves • The more reserves banks will choose to hold – An increase in the interest rate on reserves • Increase the reserve ratio • Lower the money multiplier • Lower the money supply 27 .

High bank rate forces the commercial banks to raise the rate of interest which makes credit dear. it increases cash reserves of the banks and their ability to give credit. central bank raises the CRR but when it wants to enhance the credit giving powers of the bank. credit availability of commercial banks is curtailed / controlled. When central bank buys securities. It is a powerful instrument to control credit and lending capacity of the banks. Cheap credit promotes investment whereas dear money discourages it. Similarly. A decrease in bank rate will have the opposite effect. To curtail the credit giving capacity of the banks. But SLR is reduced when the situation in the economy demands expansion of credit. in a way. Mind. Consequently. It is. Thus. cost of borrowing. it reduces the CRR. every bank is required to keep a fixed percentage (ratio) of its assets in cash called liquidity ratio. increase in bank rate by the central bank adversely affects credit creation by commercial banks. As a result.Instrument of Money Policy. SLR is raised to reduce the ability of the banks to give credit. Cash Reserve Ratio (CRR): – – Commercial banks are required under the law to keep a certain percentage of their total deposits with the central bank in the form of cash reserves. In a situation of excess demand and inflationary pressure. there is another measure called Statutory Liquidity Ratio or SLR. demand for loans and other purposes falls. central bank increases the bank rate.India • Bank Rate: – – • Open Market Operations: – • rate of interest at which the central bank lends to commercial banks. This is called CRR. This is done to influence money supply in the country. These refer to buying and selling of government securities by central bank. . sale of government securities to commercial banks means flow of money into the central bank which reduces cash reserves. Bank rate at which banks borrow from RBI is called repo rate and rate at which banks park their surplus funds with RBI is Reverse Repo Rate .

Problems • The Central Bank’s control of the money supply is Not precise • The Central Bank – Does not control the amount of money that households choose to hold as deposits in banks – Does not control the amount that bankers choose to lend 29 .

Bank runs and the money supply • Bank runs – Depositors suspect that a bank may go bankrupt • “Run” to the bank to withdraw their deposits – Problem for banks under fractional-reserve banking • Cannot satisfy withdrawal requests from all depositors • When a bank run occurs – The bank .is forced to close its doors until some bank loans are repaid – Or until some lender of last resort provides it with the currency it needs to satisfy depositors – Complicate the control of the money supply 30 .

Increased their reserve ratios Smaller money multiplier Decrease in money supply . early 1930s – Wave of bank runs and bank closings – Households and bankers .more cautious – Households withdrew their deposits from banks – Bankers .Bank runs and the money supply • Great Depression.responded to falling reserves • • • • 31 Reducing bank loans.

Bank runs and the money supply • Bank runs today – Not a major problem • The federal / Central government – Guarantees the safety of deposits at most banks • Deposit Insurance Corporation (DIC) • No bank runs – Depositors are confident – DIC will make good on the deposits • Government deposit insurance – Cost: • Bankers .little incentive to avoid bad risks – Benefit: • A more stable banking system 32 .

Call Rate • Call Rate – Interest rate at which banks make overnight loans to one another • Lender – has excess reserves • Borrower – needs reserves – A change in call rate • Changes other interest rates 33 .