The Monetary System

PowerPoint
P P i t Slides
Slid prepared db by:
Andreea CHIRITESCU
Eastern Illinois University

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 1
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Meaning of Money

• Money
– Set of assets in an economy
– That people regularly use
– To buy goods and services from other
people
• The functions of money
– Medium of exchange
– Unit of account
– Store of value
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 2
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 The Meaning of Money
• Medium of exchange
– Item that buyers give to sellers
• When they want to purchase goods and
services
• Unit of account
– Yardstick p
people
p use to p
post p
prices and
record debts

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 3
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Meaning of Money

• Store of value
– Item that people can use to transfer
purchasing
pu c as g popower
e
• From the present to the future
• Liquidity
Li idit
– Ease with which an asset can be
converted into the economy’s medium of
exchange

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 4
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 The Kinds of Money
• Commodity money
– Money that takes the form of a commodity
with
t intrinsic
t s c value
a ue
• Intrinsic value
– Item would have value even if it were not
used as moneyy
• Gold standard - Gold as money
– Or paper money that is convertible into
gold on demand
g
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 5
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Kinds of Money

• Fiat money
– Money without intrinsic value
– Used as money because of government
decree
• Fiat
– Order or decree

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 6
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Money in the U.S. Economy
• Money stock
– Quantity of money circulating in the
eco o y
economy
• Currency
– Paper bills and coins in the hands of the
p
public
• Demand deposits
– Balances in bank accounts - depositors
can access on demand byy writing
g a check
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 7
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Money in the U.S. Economy

• Measures of money stock
– M1
• Demand deposits, Traveler’s
Traveler s checks
• Other checkable deposits, Currency
– M2
• Everything
y g in M1
• Savings deposits, Small time deposits
• Money market mutual funds
• A few minor categories

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 8
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Figure 1
Two Measures of the Money Stock for the U.S. Economy

The two most widely followed measures of the money stock are M1 and M2
M2. This
figure shows the size of each measure in 2009.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 9
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Where is all the currency?

• 2009:
2009 $862 billi
billion currency outstanding
t t di
– Average adult: holds about $3,653 of
currency
– Much
M h off th
the currency iis h
held
ld abroad
b d
– Much of the currencyy is held byy drug
g
dealers, tax evaders, and other criminals
• Currency – not a particularly good way to
hold wealth
– Can be lost or stolen
– Doesn’t earn interest
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 10
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Banks and the Money Supply
• Reserves
– Deposits that banks have received but
have
a e not
ot loaned
oa ed out
• The simple case of 100% reserve banking
– All deposits are held as reserves
• Banks do not influence the supply of money

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 11
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Fractional-Reserve Banking
• Fractional-reserve banking
– Banks hold only a fraction of deposits as
reserves
ese es
• Reserve ratio
– Fraction of deposits that banks hold as
reserves
• Reserve requirement
– Minimum amount of reserves that banks
must hold;; set byy the Fed
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 12
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Fractional-Reserve Banking
• Excess reserve
– Banks may hold reserves above the legal
minimum
u
• Example: First National Bank
– Reserve ratio 10%

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 13
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Fractional-Reserve Banking
• Banks hold only a fraction of deposits in
reserve
– Banks create money
• Assets
• Liabilities
Li biliti
– Increase in money
y supply
pp y
– Does not create wealth

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 14
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 The Money Multiplier

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 15
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Money Multiplier

• The money multiplier
– Original deposit = $100.00
– First National lending = $ 90.00 [=
[ .9 ×
$100.00]
– Second National lending = $ 8181.00
00 [= .9
9×
$90.00]
– Third National lending = $ 72.90 [= .9 ×
$81.00]]
–…
– Total money supply = $1 000 00
$1,000.00
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 16
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 The Money Multiplier
• The money multiplier
– Amount of money the banking system
generates
ge e ates with
t each
eac dollar
do a oof reserves
ese es
– Reciprocal of the reserve ratio = 1/R
• The higher the reserve ratio
– The smaller the money multiplier

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 17
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Financial Crisis of 2008–2009

• Bank capital
– Resources a bank’s owners have put into
tthe
e institution
st tut o
– Used to generate profit

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 18
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Fed’s Tools of Monetary Control
• Influences the quantity of reserves
– Open-market operations
– Fed lending to banks
• Influences the reserve ratio
– Reserve requirements
– Paying interest on reserves

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 19
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Fed’s Tools of Monetary Control

• Open-market operations
– Purchase and sale of U.S. government
bonds
bo ds by tthe
e Fed
ed
– To increase the money supply
• The
Th Fed
F db
buys U
U.S.
S government b
bonds
d
– To reduce the money
y supply
pp y
• The Fed sells U.S. government bonds
– Used more often

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 20
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Fed’s Tools of Monetary Control
• Fed lending to banks
• To increase the money supply
• Discount window
• At the discount rate
– Term Auction Facility
• To the highest bidder

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 21
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Fed’s Tools of Monetary Control

• The discount rate
– Interest rate on the loans that the Fed
makes
a es to ba
bankss
– Higher discount rate
• Reduce
R d the
h money supply
l
– Smaller discount rate
• Increase the money supply

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 22
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Fed’s Tools of Monetary Control
• Term Auction Facility
– The Fed sets a quantity of funds it wants
to lend
e d to ba
banks
s
– Eligible banks bid to borrow those funds
– Loans go to the highest eligible bidders
• Acceptable
p collateral
• Pay the highest interest rate

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 23
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Fed’s Tools of Monetary Control

• Reserve requirements
– Regulations on minimum amount of
reserves
ese es
• That banks must hold against deposits
– An
A iincrease iin reserve requirement
i t
• Decrease the money supply
– A decrease in reserve requirement
• Increase the money supply
– Used rarely – disrupt business of banking
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 24
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Fed’s Tools of Monetary Control
• Paying interest on reserves
– Since October 2008
– The higher the interest rate on reserves
• The more reserves banks will choose to hold
– An increase in the interest rate on
reserves
• Increase the reserve ratio
• Lower the money multiplier
• Lower the money supply

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 25
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.