lec (13) ch29 the monetary system

8/6/2019 Lec (13) Ch29 the Monetary System

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THE MONETARY SYSTEM 2

What Money Is and Why Its ImportantWithout money, trade would require barter ,the exchange of one good or service for another.Every transaction would require a doublecoincidence of wants the unlikely occurrencethat two people each have a good the other wants.

Most people would have to spend time searching for others to trade with a huge waste of resources.

This searching is unnecessary with money ,

the set of assets that people regularly use to buyg&s from other people.


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The 3 Functions of MoneyMedium of exchange : an item buyers give to

sellers when they want to purchase g&sUnit of account : the yardstick people use topost prices and record debts

Store of value : an item people can use totransfer purchasing power from the present tothe future


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The 2 Kinds of MoneyCommodity money :

takes the form of a commoditywith intrinsic value

Examples: gold coins,cigarettes in POW camps

Fiat money :money without intrinsic value,used as money because of

govt decreeExample: the U.S. dollar


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The Money SupplyThe money supply (or money stock ):

the quantity of money available in the economyWhat assets should be considered part of themoney supply? Two candidates:

Currency : the paper bills and coins in thehands of the (non-bank) publicDemand deposits : balances in bank accountsthat depositors can access on demand bywriting a check


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Measures of the U.S. Money SupplyM1: currency, demand deposits,

travelers checks, and other checkable deposits.M1 = $1.4 trillion (June 2008)

M2: everything in M1 plus savings deposits,small time deposits, money market mutual funds,

and a few minor categories.M2 = $7.7 trillion (June 2008)


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Central Banks & Monetary PolicyCentral bank : an institution that oversees the

banking system and regulates the money supplyMonetary policy : the setting of the moneysupply by policymakers in the central bank

Federal Reserve (Fed) : the central bank of theU.S.


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Bank ReservesIn a fractional reserve banking system ,

banks keep a fraction of deposits as reservesand use the rest to make loans.

The Fed establishes reserve requirements ,regulations on the minimum amount of reserves

that banks must hold against deposits.Banks may hold more than this minimum amountif they choose.

The reserve ratio , R

= fraction of deposits that banks hold as reserves= total reserves as a percentage of total deposits


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The Money MultiplierMoney multiplier : the amount of money the

banking system generates with each dollar of reserves

The money multiplier equals 1/ R .

In our example,R = 10%money multiplier = 1/ R = 10$100 of reserves creates $1000 of money


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The Feds 3 Tools of Monetary Control1. Open-Market Operations (OMOs):

the purchase and sale of government bonds by thecentral bank.

To increase money supply, CB buys govt bonds,paying with new dollars.

To reduce money supply, Fed sells govt bonds,taking dollars out of circulation, and the processworks in reverse.


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The Feds 3 Tools of Monetary Control2 . Reserve Requirements (RR):

affect how much money banks can create bymaking 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.


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The Feds 3 Tools of Monetary Control3 . The Discount Rate :

the interest rate on loans the CB makes to banksWhen banks are running low on reserves,they may borrow reserves from the CB.

To increase money supply,

CB can lower discount rate, which encouragesbanks to borrow more reserves from Fed.

Banks can then make more loans, which increasesthe money supply.

To reduce money supply, CB can raise discount rate.


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The Feds 3 Tools of Monetary Control3 . The Discount Rate :

the interest rate on loans the Fed makes to banksCBs use discount lending to provide extra liquiditywhen financial institutions are in trouble.

If no crisis, CBs rarely use discount lending

CB is a lender of last resort.


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Problems Controlling the Money SupplyIf households hold more of their money as

currency, banks have fewer reserves,make fewer loans, and money supply falls.

If banks hold more reserves than required,they make fewer loans, and money supply falls.


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Lecture finishedThank you

lec (13) ch29 the monetary system

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