Macroeconomics

ECN 2214

Chapter 29

The Monetary System

Sayeda Chandra Tabassum

Lecturer, Dept. of Economics, UIU
Money

The set of assets in an economy that people regularly use to buy goods and
services from other people. In other words, anything that is generally
accepted by people as payment for goods and services or in the repayment
of debts is called Money.

The Functions of Money

Money serves the three primary functions in the economy:

Medium of Exchange: By definition medium of exchange is anything that

is used to determine value during the exchange of goods and services.
Money as a medium of exchange avoids the problem of double coincidence
of wants that arise in a barter economy and encouraging specialization and
thus the division of labor.
Double Co incidence of Wants:

If there were no money all goods and services would have to be

exchanged by Barter. Exchanging commodities by barter is inconvenient
and costly. Every time we wanted to obtain a good in exchange for the
one we had we would have to find someone who ha id the good we
wanted and also wanted the good we had. Thus a double co incidence of
wants would be required to affect any exchange. Seeking such a double
co incidence of wants could be expensive in time and resources.

Unit of Account:

Money as a unit of account reduces the number of prices needed in the

economy, which also reduces transaction costs.

The value or price of each commodity is naturally expressed in terms of

the medium of exchange. Thus money becomes the unit of account or
standard of payment. The price of any good is then the amount of the
commodity used as money required to exchange for one unit of the
A unit of account is an abstract function of money as it does not require
the physical existence of money.

Store of Value:

A store of value is an item that people can use to transfer purchasing

power from the present to the future. When a seller accepts money today
in exchange for a good or service, that seller can hold the money and
become a buyer of another good or service at another time. Money is not
the only store of value in the economy: A person can also transfer
purchasing power from the present to the future by holding nonmonetary
assets such as stocks and bonds. The term wealth is used to refer to the
total of all stores of value, including both money and nonmonetary
assets.
The Characteristics of Money:
Liquidity:

Economists use the term liquidity to describe the case with which an asset
can be converted into the economy’s medium of exchange. Because money
is the economy’s medium of exchange, it is the most liquid asset available.
Other assets vary widely in their liquidity. Most stocks and bonds can be
sold easily with small cost, so they are relatively liquid assets. By contrast,
selling a house, requires more time and effort, so these assets are less
liquid.

When people decide in what form to hold their wealth, they have to balance
the liquidity of each possible asset against the asset’s usefulness as a store
of value.

• Money is the most liquid asset, but it is far from perfect as a store of
value. When prices rise, the value of money falls.
The Kinds of Money

Commodity money:
When money takes the form of a commodity with intrinsic value, it is called
commodity money. The term intrinsic value means that the item would have
value even if it were not used as money.
Example:

Gold: One example of commodity money is gold. Although today we no

longer use gold as money, historically gold has been a
common form of money because it is relatively easy to carry, measure, and
verify for impurities. When an economy uses gold as money (or uses paper
money that is convertible into gold on demand), it is said to be operating
under a gold standard.

Cigarettes:
Another example of commodity money is cigarettes. In prisoner-of-war
camps during World War II, prisoners traded goods and services with one
another using cigarettes as the store of value, unit of account, and medium of
exchange.
Fiat Money:

Money without intrinsic value is called fiat money. A fiat is an order or

decree, and fiat money is established as money by government decree.

Example: Paper currency that we use for everyday transaction.

Although the government is central to establishing and regulating a

system of fiat money (by prosecuting counterfeiters, for example), other
factors are also required for the success of such a monetary system. To a
large extent, the acceptance of fiat money depends as much on
expectations and social convention as on government decree.
Money Creation in the Economy:

100-Percent-Reserve Banking System

• Deposits = Reserves + Loans

In 100-percent-reserve banking, banks make no loans; they simply keep the

deposits safe until the depositors turn up to withdraw their deposits
Therefore, Loans = 0 and Deposits = Reserves

• In this system, banks have no effect on M1

When someone makes (withdraws) a $100 deposit, currency decreases

(increases) by $100 and demand deposits increase (decrease) by $100,
leaving M1 unchanged
Fractional-Reserve Banking
In a fractional-reserve banking system, banks hold a fraction of their
deposits as reserves and lend out the rest.

Money Creation with Fractional-Reserve Banking

• When a bank makes a loan from its reserves, the money supply increases
right away.

• When one bank loans money, that money generally ends up as a deposit in
a second bank.

• This creates more deposits and more reserves to be lent out by the second
bank.

• When the second bank makes a loan from its reserves, the money supply
increases again.

•And the process continues……

The Money Multiplier

 How much money is eventually created in this economy?

The money multiplier is the amount of money the banking system

generates with each dollar of reserves.

Reserve Ratio
The reserve ratio is the fraction of total deposits that banks hold as
reserves.

The fraction of its total deposits that a bank is required by the Central
Bank to keep as reserves is called the required reserve ratio.

When banks hold reserves in excess of the required reserves, those

reserves are called excess reserves.

Reserves = Required Reserves + Excess Reserves

The money multiplier is the reciprocal of
the reserve ratio:
M = 1/R

With a reserve ratio of R = 20% or 1/5,

The multiplier is 5.

Example: In this case, if the CB prints a

fresh dollar bill and buys a government
bond with it, the money supply may
increase by as much as $5.00
 3 Tools of Monetary Control

Open-Market Operations (OMOs): the purchase and sale

of U.S. government bonds by the Fed.

 To increase money supply, CB buys govt bonds, paying

with new dollars.
…which are deposited in banks, increasing reserves
…which banks use to make loans, causing the money
supply to expand.
 To reduce money supply, CB sells govt bonds, taking
dollars out of circulation, and the process works in reverse
Reserve Requirements (RR):
affect how much money banks can create by
making loans.

 To increase money supply, CB reduces RR.

Banks make more loans from each dollar of reserves, which
increases money multiplier and money supply.
 To reduce money supply, CB raises RR,
and the process works in reverse.
 CB rarely uses reserve requirements to control money supply:
Frequent changes would disrupt banking.
The Discount Rate:
the interest rate on loans the Fed makes to banks

 When banks are running low on reserves, they

may borrow reserves from the CB.
 To increase money supply,
CB can lower discount rate, which encourages
 banks to borrow more reserves from CB.
 Banks can then make more loans, which
increases the money supply.
 To reduce money supply, CB can raise discount
rate.
 The Federal Funds Rate

On any given day, banks with insufficient reserves can

borrow from banks with excess reserves.
The interest rate on these loans is the federal funds
rate.
The Federal Open Market Committee uses OMOs to
target the fed funds rate.
Many interest rates are highly correlated,
so changes in the fed funds rate cause changes in other
rates and have a big impact in the economy.