Chapter 8 The Monetary System

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The Problem With Bartering
Bartering is the exchange of one good for another.
◦ Bartering requires a double coincidence of wants.

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The Meaning Of Money
Money is the set of assets in an economy that people regularly
use to buy goods and services from other people.

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The Functions of Money
Money has three functions in the economy:
① Medium of exchange
② Unit of account
③ Store of value

①Medium 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.

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The Functions of Money
② Unit of Account
◦ A unit of account is the yardstick people use to post
prices and record debts.
③ 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.

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The Kinds of Money
Commodity money takes the form of a
commodity with intrinsic value.
◦ Examples: Gold, silver, cigarettes.

Fiat money is used as money because of

government decree.
◦ It does not have intrinsic value.
◦ Examples: Coins, currency, current account
deposits.

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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.

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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.
The money supply is the quantity of money available in
the economy.

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The Functions of Central Banks
Monetary policy is the set of actions taken by
the central bank in order to affect the money
supply.
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.

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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.

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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.

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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.

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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.
 A bank must keep reserves which are deposits
that banks have received but have not loaned out
in order to cover possible withdrawals.

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 A Bank’s Balance Sheet
 Banks actively find ways of making new loans.
• In granting a private loan, the bank credits the account of the borrower
with the funds.
o At the point a new loan is agreed, new money is created and the
money supply increases.
o These new loans represent assets to the bank.
o Note the borrower will have to pay the loan plus interest to the bank.
o At the same time liabilities increase by the same amount.
• In this way the bank’s balance sheet also expands.
• When bank loans are repaid the money supply contracts.

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A Bank’s Balance Sheet
 Banks also buy and sell a range of assets
including bonds.
• If a bond is purchased from a non-banking sector
holder, the funds are credited to the seller’s
account.
• This increases the money supply.
• Equally, if banks sell bonds to the non-banking
sector, the buyer’s account is debited with the
sum paid and the money supply contracts.

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A Bank’s Balance Sheet
 A risk occurs if too many of a bank’s liabilities
are short term and borrowers demand their
money.
 Having more long-term debt helps reduce the
risk.

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A Bank’s Balance Sheet
 Constraints on bank lending.
• The central bank increases lending rates to the
banking system forcing banks to increase the
interest rate on lending to maintain spreads.
• This leads to a reduction in the demand for loans.
• A reduction in interest rates would be expected to
stimulate the demand for loans.

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A Bank’s Balance Sheet
 Systemic risk refers to the risk of failure across the
whole of the financial sector rather than just to one or
two institutions.
 Macroprundential policy limits the risk across the
financial sector by focusing on improving ‘prudential’
standards of operation that enhance stability.
• Banks must be able to respond to both defaults (credit risk)
and increased withdrawals (liquidity risk).
• The ratio of this capital in relation to the rest of the bank’s
assets is seen as a measure of the financial strength of a
bank. It effectively acts as a cushion against financial shocks.

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 Banks and The Money Supply
Reserves are deposits that banks have
received but have not loaned out.
In a fractional reserve banking system,
banks hold a fraction of the money
deposited as reserves and lend out the
rest.
Money Creation

When a bank makes a loan from its

reserves, the money supply increases.
 Money Creation
The money supply is affected by the amount deposited in banks
and the amount that banks loan.
 Deposits into a bank are recorded as both assets and
liabilities.
 The fraction of total deposits that a bank has to keep as
reserves is called the reserve ratio.
 Loans become an asset to the bank.
 Money Creation
This T-Account shows a First National Bank
bank that… Assets Liabilities
¼accepts deposits,
¼keeps a portion as Reserves Deposits
reserves, $10.00 $100.00

¼and lends out the rest. Loans

It assumes a reserve $90.00
ratio of 10%. Total Assets Total Liabilities
$100.00 $100.00
 Money Creation
When one bank loans money, that money is
generally deposited into another bank.
This creates more deposits and more
reserves to be lent out.
When a bank makes a loan from its reserves,
the money supply increases.
Money Creation

First National Bank Second National Bank

Assets Liabilities Assets Liabilities

Reserves Deposits Reserves Deposits

$10.00 $100.00 $9.00 $90.00

Loans Loans
$90.00 $81.00

Total Assets Total Liabilities Total Assets Total Liabilities

$100.00 $100.00 $90.00 $90.00

Money Supply = $190.00!

The Money Multiplier

How much money is eventually

created in this economy?

?
 The Money Multiplier

How much money is eventually

created in this economy?
Original deposit =$100.00
First National lending =$ 90.00 [=0.9 x $100.00]
Second National lending =$ 81.00 [=0.9 x $90.00]
Third National lending =$ 72.90 [=0.9 x $81.00]
¯ ¯
¯ ¯
Total money supply = $1,000
 The Money Multiplier
The money multiplier is the reciprocal of the
reserve ratio:
M = 1/R
With a reserve requirement, R = 20% or 1/5,
The multiplier is 5.
RBI’s Tools of Monetary Control

The RBI has three tools in its monetary

toolbox:
 Open-market operations
 Changing the reserve requirement
 Changing the discount rate
 Open-Market Operations
The RBI conducts open-market operations
when it buys government bonds from or
sells government bonds to the public:
 When the RBI buys government bonds, the money supply
increases.
 The money supply decreases when the RBI sells government
bonds.
Changing the Reserve
Requirement Rate

The reserve requirement is the amount (%)

of a bank’s total reserves that may not be
loaned out.
 Increasing the reserve requirement decreases the money
supply.
 Decreasing the reserve requirement increases the money
supply.
Changing the Discount Rate

The discount rate is the interest rate the

RBI charges banks for loans.
 Increasingthe discount rate decreases the money supply.
 Decreasing the discount rate increases the money supply.
 Problems in Controlling the
Money Supply
The RBI’s control of the money supply is not precise.
The RBI must wrestle with two problems that arise due to
fractional-reserve banking.
 The RBI does not control the amount of money that
households choose to hold as deposits in banks.
 The RBI does not control the amount of money that
bankers choose to lend.
Summary
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.
Summary
It controls the money supply through open-
market operations or by changing reserve
requirements or the discount rate.
Summary
When banks loan out their deposits, they
increase the quantity of money in the
economy.
Because the RBI cannot control the amount
bankers choose to lend or the amount
households choose to deposit in banks, the
RBI’s control of the money supply is
imperfect.