Macroeconomics: Lecture 4-5

Functions of money
⎯ Money is a set of assets in an economy that people regularly use to buy goods and
services from other people.
⎯ money ≠ wealth…

What would happen if someone destroyed all the money in the world? Would the society be
poorer?
⎯ money ≠ saving…

Is a man with 5 million USD on his account richer than a man with 0 USD on his account?

P: money is a representation of purchasing power, but it’s not the same as wealth. The world
after the money has been destroyed will not be the same.
If you have 5 million in your account, but it’s a debt (money that you need to pay back), anyway
it gives you 0 USD in the end.

Money has three functions in the economy:

⎯ Medium of exchange
⎯ Unit of account
⎯ Store of value

P: Medium of exchange – general equivalent, means that money is used as a good, which is
being used as a general accepted asset in exchange.
Unit of account – measure the GDP in one number for example.
Store of value – something which makes it possible to you to transfer the purchasing power from
today to tomorrow, so if you have some saving and you want to transfer the saving into the
future.

Medium of Exchange
• A medium of exchange is an item that buyers give to sellers when they want to
purchase goods and services.
• A medium of exchange is anything that is easily acceptable in payment.
• Money is a generally accepted medium of exchange.

Unit of Account
• A unit of account is the yardstick people use to post prices and record debts.
• When we want to measure and record economic value, we use money as the unit
of account.

Store of Value
• A store of value is an item that people can use to transfer purchasing power from
the present to the future.
• Money is not the only store of value in the economy: we can transfer purchasing
power to the future by holding nonmonetary assets (stocks, bonds, real estates,
gold, artworks…).
Macroeconomics: Lecture 4-5
Liquidity
• Liquidity of a nonmonetary asset is given by its capability
• a) to become a medium of exchange or
• b) to get converted into money (liquidation)
• Liquidity of money is highest, i. e. money is the most liquid asset available.

P: it is a feature of money, consistence in its ability to be accepted by the general public in

exchange. You can use the asset as a medium of exchange. The money by definition has a higher
liquidity of all assets.

Money can be defined in terms of monetary aggregates:

M1 = currency + demand deposits + other checkable deposits

M2 = M1 + saving deposits

P: Currency – banknotes and coins. Saving deposits have lower liquidity, higher rate of return
and that’s a general rule.

Currency is the banknotes and coins in the hands of the public. It is a part of the money stock.
• In an alternative meaning: currency as CZK, EUR, USD

Demand deposits are balances on current accounts that depositors have an access to on demand
by
• writing a check
• withdrawal of money in a bank
• withdrawal of money from ATM
• payment with a debit card at a store

Summary
• The term money refers to assets that people regularly use to buy goods and services.
• Money has three functions in the economy: a medium of exchange, a unit of account, and
a store of value.
• Commodity money is money that has an intrinsic value.
• Fiat money is money without an intrinsic value.
Macroeconomics: Lecture 4-5
Money Supply
Bank deposits
Checkable deposits (on current accounts)
• demand deposits
• other checkable deposits
Saving/time deposits (on saving accounts)
• small time deposits – less than $100,000
• large time deposits – more than $100,000
Call deposits (call deposit accounts)
Nonbank deposits

The banking system consists of:

⎯ Commercial banks
⎯ Central bank

P: Central bank on the top and commercial banks in the middle, and the clients of commercial
banks in the bottom (2 level system).

A Balance Sheet of a Commercial Bank

P: Account record. Assets refer to what you have and liabilities answer to a question where it
does come from. There are 2 options, either if it comes from someone else in that case is a debt
or it’s my own capital.
Reserves – it’s analogy to current account of mister A. Any commercial bank has a current
account in the central bank and this current account called reserve account.
Fixed assets – buildings, land properties.
Macroeconomics: Lecture 4-5
A Balance Sheet of the Central Bank

P: Capital (equity), which each entity has, it’s difference between the value of your assets and
liabilities that have other entities.
Equity= total assets – liabilities towards other entities.
Discounts Loans to commercial banks – means that loans provided to commercial banks.
Government Bonds – which the central bank is buying and selling to influence the money
supply.

Central Bank
Central bank = an institution responsible for
• monetary policy
o stability of prices
o employment (FED, not ECB)
• other things
o providing financial services to the government
o supervising the banking system of the country
o maintaining stability of the banking sector by acting as a lender of the last
resort
P: Monetary policy – primary reason why central bank is existing, prices stability – it means that
central bank has the goal and task to keep the purchasing power of money, which we use more or
less stable over time.
Stability of prices means zero inflation.
CPI index on which inflation is based is overstating the real inflation, because there are some
unmeasured quantity changes.
Government the most important client of the central bank.

The Federal Reserve (Fed) serves as the nation’s central bank in the USA.
• The Fed was created in 1913 after a series of bank failures convinced Congress that the
United States needed a central bank to ensure the health of the nation’s banking system.
• https://www.federalreserve.gov/aboutthefed/mission.htm
Macroeconomics: Lecture 4-5
Monetary policy is the control of the money supply by policymakers in the central bank

• The money supply refers to the quantity of money available in the economy.
• by money we usually mean the monetary aggregate M1

P: on the top of the banking system is the central bank.

The CB has three tools in its monetary toolbox:

1. Open-market operations
2. Changing the reserve requirement
3. Changing the discount rate

P: private commercial banks can increase the money supply.

I. Open-Market Operations
• The CB conducts open-market operations when it buys government bonds from
or sells government bonds to the public:
• When the CB buys government bonds, the money supply increases.
• When the CB sells government bonds, the money supply decreases.

P: the central bank buys a bond from a non-banking entity or sells a bond to a non-banking
entity, and it influences and controls the money supply, which is in circulation.

⎯ Reserves are deposits that banks have received but have not lent out.
⎯ Reserves are a liability of the CB and an asset of a commercial bank
⎯ In a fractional-reserve banking system, banks hold a fraction of the money deposited as
reserves and lend out the rest.

The money multiplier is a number which tells us how many times the initial change in reserves
increases the final value of money supply.

P: reserve ratio is a fraction in the numerator that’s total reserves and in dominator it’s total
deposits.
Macroeconomics: Lecture 4-5
The money multiplier is the reciprocal of the reserve ratio:
MM = 1/RR
With a reserve requirement, RR = 20% or 1/5, the money multiplier is 5.

deposits = money multiplier × reserves

Δ deposits = money multiplier × Δ reserves

Money Creation with Fractional-Reserve Banking

• When a bank provides a loan from its reserves, the money supply increases.
• The money supply is given by the amount deposited in banks
• Deposits into a bank are recorded as both assets and liabilities.
• The fraction of total deposits that a bank has to keep as reserves is called
the reserve ratio.
• Loans become an asset to the bank.

Acception of a Deposit
• Commercial bank accepts deposits,
• keeps a portion as reserves, and lends out the rest.
• It assumes a reserve ratio of 10%.

P: the bank needs to keep the reserve requirements, which is legal requirements regulated by the
central bank and we assume that the resume requirements is 10% so there must always be so
much reserves, so much purchasing power on the reserve account to keep the reserve ratio at
10%.

• When a bank accepts a deposit, it keeps a part of it in reserves and lends out the rest.
• This creates more deposits and more reserves to be lent out.
• When a bank provides a loan from its reserves, the money supply increases.
Macroeconomics: Lecture 4-5

Open Market Operation

• Central bank buys government bonds for 100 mil. USD from a non-banking entity (Mr.
A) who is a client of Commercial Bank 1
• RR = 10%
• Simplifying assumptions:
• Excess reserves = 0
• Cash = 0