1. 27
The Monetary System
For use with Mankiw and Taylor, Economics 4th edition © Cengage EMEA 2017

2. The Meaning Of Money
Bartering is the exchange of one good for another.
Bartering requires a double coincidence of wants.
Money is the set of assets in an economy that people regularly use to buy goods and services from other people.
Money has three functions in the economy:
Medium of exchange
Unit of account
Store of value
For use with Mankiw and Taylor, Economics 4th edition © Cengage EMEA 2017

3. The Functions of Money
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 readily acceptable as payment.
Unit of Account
A unit of account is the yardstick people use to post prices and record debts.
Store of Value
A store of value is an item that people can use to transfer purchasing power from the present to the future.
Liquidity
Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange.
For use with Mankiw and Taylor, Economics 4th edition © Cengage EMEA 2017

4. The Kinds of Money
Commodity money takes the form of a commodity with intrinsic value.
Examples: Gold, silver, cigarettes.
Gold standard is a system in which the currency is based on the value of gold and where the currency can be converted to gold on demand.
Fiat money is used as money because of government decree.
It does not have intrinsic value.
Examples: Coins, currency, current account deposits.
For use with Mankiw and Taylor, Economics 4th edition © Cengage EMEA 2017

5. Money in the Economy
Money stock refers to the quantity of money circulating in the economy.
Currency is the paper bills and coins in the hands of the public.
Demand deposits are balances in bank accounts that depositors can access on demand by writing a cheque or using a debit card.
For use with Mankiw and Taylor, Economics 4th edition © Cengage EMEA 2017

6. Money in the Economy Measures of money stock M1
Demand deposits, Traveler’s checks
Other checkable deposits, Currency M2
Everything in M1
Savings deposits, Small time deposits
Money market mutual funds
A few minor categories
For use with Mankiw and Taylor, Economics 4th edition © Cengage EMEA 2017

7. Figure 1a Three Measures of the Money Stock for the Euro Area in € billions
For use with Mankiw and Taylor, Economics 4th edition © Cengage EMEA 2017

8. The Role Of Central Banks
A central bank is an institution designed to oversee the banking system and regulate the quantity of money in the economy.
Whenever an economy relies on fiat money, there must be some agency that regulates the system.
The agency is known as the central bank.
For use with Mankiw and Taylor, Economics 4th edition © Cengage EMEA 2017

9. The Functions of Central Banks
Two functions of a central bank are...
Macroeconomic stability in maintaining stable growth and prices and through the avoidance of excessive and damaging swings in economic activity.
The maintenance of stability in the financial system.
For use with Mankiw and Taylor, Economics 4th edition © Cengage EMEA 2017

10. The Functions of Central Banks
The Central Bank’s jobs
Regulate banks and ensure the health of the banking system
Monitors each bank’s financial condition
Facilitates bank transactions - clearing checks
Acts as a bank’s bank
Central Bank – lender of last resort

11. The Functions of Central Banks
The Central Bank’s jobs
Control the money supply
Quantity of money available in the economy
Monetary policy
Money supply
Quantity of money available in economy
Setting of the money supply

12. The Functions of Central Banks
Open market operations refers to the purchase and sale of non- monetary assets from and to the banking sector by the central bank.
To increase the money supply, the central bank buys bonds from the public.
The amount of currency in the hands of the public is increased.
To reduce the money supply, the central bank sells bonds to the public.
The amount of currency in the hands of the public is reduced.
For use with Mankiw and Taylor, Economics 4th edition © Cengage EMEA 2017

13. The Functions of Central Banks
Liquidity is the cash needed to ensure transactions in the financial system are honoured.
To maintain financial stability central banks supply liquidity to the rest of the banking system.
The central bank can step in as a lender of the last resort.
Central banks assess banks’ ability to meet different levels of financial stress and have the power to impose regulations.
For use with Mankiw and Taylor, Economics 4th edition © Cengage EMEA 2017

14. A Banks Balance Sheet
Assets include reserves of cash, securities it holds, and loans.
Liabilities include demand deposits, savings deposits, borrowings from other banks in the interbank market. Its assets must equal its liabilities plus equity capital.
Bank capital
Resources a bank’s owners have put into the institution
Used to generate profit
For use with Mankiw and Taylor, Economics 4th edition © Cengage EMEA 2017

15. A Banks Balance Sheet Capital requirement
Government regulation specifying a minimum amount of bank capital

16. Banks And The Money Supply
Most banks make profits by accepting deposits and making loans.
The difference between the average interest a bank earns on its assets and the average interest rate paid on its liabilities is termed the spread.
Banks hold a fraction of the money deposited as reserves and lend out the rest to make their profit.
Note that banks operating under Islamic Sharia principles make profits from the sharing of risk and reward between lenders and borrowers.
For use with Mankiw and Taylor, Economics 4th edition © Cengage EMEA 2017

17. Banks and the Money Supply
Currency + Demand deposits
Behavior of banks
Can influence the quantity of demand deposits in the economy (and the money supply)

18. 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

19. The Money Multiplier 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. Fractional-Reserve Banking
Banks hold only a fraction of deposits as reserves
Reserve ratio
Fraction of deposits that banks hold as reserves
Reserve requirement
Minimum amount of reserves that banks must hold; set by the Central Bank

21. Fractional-Reserve Banking
Excess reserve
Banks may hold reserves above the legal minimum
Example: First National Bank
Reserve ratio 10%

22. Fractional-Reserve Banking
Banks hold only a fraction of deposits in reserve
Banks create money
Assets
Liabilities
Increase in money supply
Does not create wealth

23. The Money Multiplier

24. The Money Multiplier The money multiplier Original deposit = $100.00
First National lending = $ [= .9 × $100.00]
Second National lending = $ [= .9 × $90.00]
Third National lending = $ [= .9 × $81.00] …
Total money supply = $1,000.00

25. The Central Bank’s Tools Of Monetary Control
A central bank has three main tools in its monetary toolbox:
Open-market operations.
Changing the refinancing rate.
Quantitative easing.
For use with Mankiw and Taylor, Economics 4th edition © Cengage EMEA 2017

26. Open-Market Operations
A central bank conducts open-market operations when it buys government bonds from, or sells government bonds to the public:
When the central bank buys government bonds, the money supply increases.
The money supply decreases when the central bank sells government bonds.
For use with Mankiw and Taylor, Economics 4th edition © Cengage EMEA 2017

27. The Refinancing Rate
The refinancing rate is the interest rate the CB lends on a short-term basis to the banking sector.
Increasing the refinancing rate decreases the money supply.
Decreasing the refinancing rate increases the money supply.
In the USA, the refinancing rate is called the discount rate and in the UK it’s called the repo rate.
For use with Mankiw and Taylor, Economics 4th edition © Cengage EMEA 2017

28. Quantitative Easing
Having exhausted the use of lowering interest rates the central banks decided on quantitative easing.
The purpose of QE is to put banks in a better position to be able to lend and in so doing help to boost demand.
The process of QE involves the central bank buying assets.
In selling assets to the central bank, institutions will hold more money in relation to other assets.
They maintain their portfolios by using the money to buy bonds and shares of companies, which is in effect lending to firms.
The issue is whether QE is working or how long it would take to see any measurable effects.
For use with Mankiw and Taylor, Economics 4th edition © Cengage EMEA 2017

29. Summary
The term money refers to assets that people regularly use to buy goods and services.
Money serves three functions in an economy: as a medium of exchange, a unit of account, and a store of value.
Commodity money is money that has intrinsic value.
Fiat money is money without intrinsic value.
It is the function of a central bank to control the money supply through open-market operations, or by changing the refinancing rate, or through quantitative easing.
For use with Mankiw and Taylor, Economics 4th edition © Cengage EMEA 2017

30. Summary
When banks loan out their deposits, they increase the quantity of money in the economy.
Macroprundential policies are designed to reduce the risk of a bank run and defaulting.
Quantitative easing is when the central bank injects money into banks in order to encourage lending.
Because the central bank cannot control the amount bankers choose to lend or the amount households choose to deposit in banks, the central bank’s control of the money supply is imperfect.
For use with Mankiw and Taylor, Economics 4th edition © Cengage EMEA 2017