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Lecture Objectives

• Money: concept, functions and kinds

LECTURE 6: • Measurement of MS
• The Central Bank and its functions.
The Monetary System • Analyze what tools the Central Bank use to
control money supply.
• Examine how commercial banks create
money.

The Meaning of Money

• Money
– Set of assets in an economy
– That people regularly use
– To buy goods and services from other people
• The functions of money
– Medium of exchange
– Unit of account
– Store of value

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The Meaning 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 3

The Meaning of Money The Meaning of Money

• Liquidity • The kinds of money
– Ease with which an asset can be converted • Fiat money
into the economy’s medium of exchange – Money without intrinsic value
• The kinds of money – Used as money because of
• Commodity money government decree
– Money that takes the form of a commodity • Money in the economy
with intrinsic value • Money stock
Intrinsic value – Quantity of money circulating in the economy
•
– Item would have value even if it were not
used as money 4 5

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Figure 1
The Meaning of Money
Two measures of the money stock for economy
• Money in the economy
• Currency
– Paper bills and coins in the hands of the
public
• Demand deposits
– Balances in bank accounts
• Depositors can access on demand by writing a
check
• Measures of money stock
– M1, M2 6
The two most widely followed measures of the money stock are M1 and M2. This
figure shows the size of each measure in 2007 7

Where is all the currency?

• 2007: $759 billion of currency outstanding
– Average adult: holds about $3,272 of currency
– Much of the currency is held abroad
– Much of the currency is held by drug dealers, tax
evaders, and other criminals
• Currency – not a particularly good way to hold
wealth
– Can be lost or stolen
– Doesn’t earn interest
Central Bank and its Functions
• Issue currency
• Act as banker to the government
• Regulate banks to promote safe and sound
banking practices.
• Act as a banker’s bank, making loans to
banks and as a lender of last resort.
• Conduct monetary policy by controlling the
money supply.

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The Central Bank

Central Banks
in Different Countries • The primary tool - open-market operation
– Purchase & sale of the government bonds
• In USA: The Federal Reserve System (Fed)
• increase the money supply
• In Australia: The Reserve Bank of Australia (RBA)
• In Vietnam: The State Bank of Vietnam
– Open-market purchase

SELF-STUDY • decrease the money supply

– Open-market sale

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Banks and the Money Supply

Case study
• Reserves
– Deposits that banks have received but have
not loaned out • https://www.bloomberg.com/news/articles
/2020-01-01/china-cuts-banks-reserve-
• The simple case of 100% reserve banking
ratio-to-boost-economic-growth-in-2020
• All deposits are held as reserves
– Banks do not influence the supply of money
• https://www.youtube.com/watch?v=G8qq
FIRST NATIONAL BANK N1kHK7c
Assets Liabilities • Open discussion
Reserves $100.00 Deposits $100.00

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Banks and the Money Supply Banks and the Money Supply
• Money creation: fractional reserve banking • Money creation: fractional reserve banking
– Banking system – Reserve ratio = 1/10 (10 percent, R)
– Banks hold only a fraction of deposits as FIRST NATIONAL BANK
reserves Assets Liabilities
Reserves $10.00 Deposits $100.00
– Reserve ratio Loans $90.00
• Fraction of deposits that banks hold as reserves
• Banks hold only a fraction of deposits in
• Bank must hold – reserve requirement reserve
– Minimum set by the Fed – Banks create money
• Bank may hold additional excess reserves – Increase in money supply
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Banks and the Money Supply Banks and the Money Supply
• The money multiplier • The money multiplier
SECOND NATIONAL BANK • Original deposit = $100.00
Assets Liabilities • First National lending = $ 90.00 [= .9 × $100.00]
Reserves $9.00 Deposits $90.00 • Second National lending = $ 81.00 [= .9 × $90.00]
Loans $81.00
• [= .9 × $81.00]
•
THIRD NATIONAL BANK
Third National
• Total money supply = lending =$
$1,000.00
Assets Liabilities 72.90
Reserves $8.10 Deposits $81.00
…
Loans $72.90

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Banks and the Money Supply
• The money multiplier
– Amount of money the banking system
generates with each dollar of reserves
– Reciprocal of the reserve ratio = 1/R
• The higher the reserve ratio
– The smaller the money multiplier
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Banks and the Money Supply
• The tools of monetary control
1. 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
– The preferred tool
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Banks and the Money Supply

• The tools of monetary control
2. 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
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Banks and the Money Supply Banks and the Money Supply
• The tools of monetary control • Problems in controlling the money supply
3. The discount rate • The Central Bank
– Higher discount rate – Does not control the amount of money
• Reduce the money supply • That households choose to hold as deposits in
banks
– Smaller discount rate
• Increase the money supply • The Central Bank
– Does not control the amount
• That bankers choose to lend

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Presentation ideas:

• https://www.nasdaq.com/articles/nigerias-
central-bank-reschedules-monetary-policy-
committee-meeting-2020-01-13
• https://www.nasdaq.com/articles/nigerias-
central-bank-reschedules-monetary-policy-
committee-meeting-2020-01-13