Chapter 29

Review
The Monetary System
 I. The meaning of money
• Definition of money: the set of assets in an
economy that people regularly use to buy goods
and services from other people
• The function of money
– Medium of exchange: an item that buyers give to
sellers when they want to purchase goods and services
– Unit of account: the yardstick people use to post prices
and record debts
– Store of value: an item that people can use to transfer
purchasing power from the present to the future
 I. The meaning of money
• Two kinds of money:
– Commodity money: money that takes the form of
commodity with intrinsic value (e.g. gold coins)
– Fiat money: money without intrinsic value that is
used as money because of government decree
 I. The meaning of money
• Money circulating in the economy is called money stock
• It includes:
– Currency: the paper bills and coins in the hands of the public
– Demand deposits: balances in bank accounts that depositors
can access on demand by writing a check
• We have two measures of money supply we are going to
use:
– M1: currency, demand deposits,
traveler’s checks, and other checkable deposits.
– M2: everything in M1 plus savings deposits,
small time deposits, money market mutual funds, and a few
minor categories.
 II. Banks and the Money Supply
• We can consider three scenarios:
– No banking system;
– 100 percent reserve banking;
– Fractional-reserve banking

• Definition of reserves: deposits that banks

have received but have not loaned out
 II. Banks and the Money Supply
• Under first two scenarios when we have no
banking system or banks reserve 100 percent
of deposits, banks have no effect on Money
supply
• However banks keep/reserve only part of the
deposits and use the rest to make profits
(fractional-reserve banking system)
• In this system we have reserve ratio: the
fraction of deposits that banks hold as
reserves
 II. Banks and the Money Supply
• In fractional-reserve banking system, banking
system creates money by issuing loans (but no
additional wealth because debt is created as
well)
• When bank issues loan, borrower usually
purchase something and at some point same
money is deposited at a bank
• Each time money is deposited, bank issues
new loan, therefore creates more money
 II. Banks and the Money Supply
• Definition of money multiplier: the amount of
money the banking system generates with
each dollar of reserves
– Money multiplier = 1 / reserve ratio
• Example: if reserve ratio is 12.5% then money
multiplier = 1/0.125 = 8
 III. Federal Reserve System
• Central bank of the US
• Central bank: an institution designed to
oversee the banking system and regulate the
quantity of money in the economy
• Fed’s duties cover:
– Regulation of banks to ensure the health of the
banking system (monitoring financial conditions,
facilitating transaction)
– Control the quantity of money supply in the
economy
 III. Federal Reserve System
Ways to control the supply of money in the
economy:
• Open Market Operations.
– The purchase and sale of government bonds by
the Fed
– If Fed wants to increase the supply of money, it
creates dollar by purchasing government bonds
from the public. If Fed wants to lower the supply
of the money, it sells government bonds, to take
money out of the hands of the public
 III. Federal Reserve System
Ways to control the supply of money in the
economy:
• Reserve requirements.
– Regulations on the minimum amount of reserves
that banks must hold against deposits
– To increase the money supply, Fed reduces RR,
banks make more loans on same amount of
reserves, increases the money multiplier and
money supply
– To decrease the money supply, Fed increases RR
 III. Federal Reserve System
Ways to control the supply of money in the
economy:
• Discount rate.
– The interest rate on the loans that the Fed makes
to banks
– A higher discount rate discourages banks from
borrowing from the Fed and likely encourages
banks to hold onto larger amount of reserves. This
in turn lowers the money supply
– A lower discount rate encourages banks to borrow
 III. Federal Reserve System
• Problems in Controlling the Money Supply:
– Fed can not control the amount of money that
consumers choose to deposit in banks
– Fed can not control the amount that banks choose to
lend and reserve
• 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
• Thus, Fed cannot control money supply perfectly
 Key points of Chapter 29
• The term money refers to assets that people
regularly use to buy goods and services
• It serves three functions:
– Medium of exchange: provides the item used to
make transaction
– Unit of account: provides the way in which prices
and other economic values are recorded
– Store of value: provides a way of transferring
purchasing power from the present to the future
 Key points of Chapter 29
• Two types of money:
– Commodity money: such as gold, is money that
has intrinsic value. It would be valued even if it
were not used as money
– Fiat money: such as paper currencies, is money
without intrinsic value. It would be worthless if it
were not used as money
• Money takes form of currency and various
types of bank deposits
 Key points of Chapter 29
• The Federal Reserve (Central Bank) is
responsible for regulating the monetary
system. The chairman is the lead member of
the Federal Open Market Committee –
responsible for monetary policy of the country
 Key points of Chapter 29
• The Fed controls the money supply through
open-market operations. The purchase of
government bonds increase the money supply,
and the sale of government bonds decreases the
money supply. The Fed can also expand the
money supply by lowering reserve requirements
or decreasing the discount rate, and it can
contract the money supply by raising reserve
requirements or increasing the discount rate
 Key points of Chapter 29
• When banks loan out some of their deposits,
they increase the quantity of money in the
economy. Because of this role of banks in
determining the money supply, the Fed’s
control of the money supply is imperfect