Lecture 4 the monetary system

LECTURE 6:
The Monetary System


Lecture Objectives



The Meaning of Money
•

Money

– Set of assets in an
economy
– To
That
regularly
buypeople
goods and
servicesuse from other people

• The functions of money
– Medium of exchange
– Unit of account
– Store of value

2

The Meaning of Money
•

Medium of exchange
– Item that buyers give to sellers

•

• When they want to purchase goods
and

Unit
of account
– Yardstick
people use to post prices and
•

services

record

debts

Store of value
– Item that people can use to
transfer purchasing power

3

The Meaning 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

4


The Meaning of Money
•
The kinds of money

•
Fiat money
– Money without intrinsic

value

– Used as money because of
government decree

•
Money in the economy
•
Money stock
– Quantity of money
circulating

in the economy
5


The Meaning of Money
•
Money in the economy
•
Currency
– Paper bills and coins in the

•

public

Demand deposits
– Balances in bank accounts

•

hands of the

• Depositors can access on
demand check

by writing a

Measures of money stock
6


Figure 1
Two measures of the money stock for

economy

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,
evaders, tax and other criminals
Currency – not a particularly

good way to hold

wealth

– Can be lost or stolen
– Doesn’t earn interest
8


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.


Central Banks
in Different Countries
•

In USA: The Federal Reserve System (Fed)

•

In Australia: The Reserve Bank of Australia (RBA)
In Vietnam: The State Bank of Vietnam

•

SELF-STUDY


The Central Bank
•

The primary tool - open-market
– Purchase & sale
of the government
bonds
operation
• increase the money supply
– Open-market purchase

• decrease the money

supply

– Open-market sale

14


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

FIRST NATIONAL BANK
Assets

Reserves

Liabilities

$100.00 Deposits

$100.00
15


Case study
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• Open discussion


Banks and the Money Supply
•

Money creation: fractional

reserve banking

– Banking system
– Banks hold only a fraction of deposits as
reserves
– Reserve ratio
• Fraction of deposits that banks hold as reserves

• Bank must hold – reserve requirement
•

– Minimum set by the Fed
Bank may hold

additional excess reserves
16


Banks and the Money Supply
•

Money creation: fractional reserve
– Reserve ratio = 1/10
(10 percent,
R)
banking
FIRST NATIONAL BANK
Assets

Reserves
Loans

•

Liabilities

$10.00 Deposits

$100.00

$90.00

Banks hold only

a fraction of deposits in

reserve

– Banks create money

– Increase in money
17


Banks and the Money
•

Supply

The money multiplier
SECOND NATIONAL

Assets
Reserves
Loans

BANK

Liabilities
$9.00 Deposits
$90.00

$81.00
THIRD NATIONAL BANK

Assets
Reserves
Loans

Liabilities
$8.10 Deposits
$81.00

$72.90

18


Banks and the Money
•

Supply

The• money multiplier

Original deposit = $100.00

•
[= .9 × $100.00]
First National lending = $
• 90.00
Second National lending = $ 81.00 [= .9 ì $90.00]
ã
[= .9 ì $81.00]
ã
ã
Third National lending = $
Total money supply = $1,000.00
72.90

…
19


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

20


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
21




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

22