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MacroLecture7
Money and the Monetary System
Lecture Highlights
Definition of money and describe its
functions
The functions of banks
The functions of central bank
How banks create money and how the
central bank controls the quantity of
money
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Money and the Monetary System
Definition of money: any commodity or token
that is generally accepted as a means of
payment.
A commodity or token: money is always
something that can be recognized and that
can be divided up into small parts.
Generally accepted: money is generally
accepted it can be used to buy anything
and everything.
Means of payment: a method of settling a debt.
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Functions of Money
(1) Medium of exchange
(2) Unit of account
(3) Store of value
Medium of exchange
An object that is generally accepted in return for goods
and services. Money is a medium of exchange.
Without money, you would have to exchange goods
and services directly for other goods and services
barter system. Barter requires a double coincidence
of wants.
4
Contd.
Unit of account
An agreed-upon measure for stating the prices
of goods and services.
Store of value
Any commodity or token that can be held and
exchanged later for goods and services.
Money acts as a store of value. The more
stable the value of a commodity or token,
the better it can act as a store of value and
the more useful it is as money.

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Money today
Money in the world today is called fiat
money.
The word fiat means decree or order.
Todays money is money because the
law decrees or orders it to be money.
The objects that we use as money today
are currency, deposits at banks and
other financial institutions.
6
Contd.
Currency the notes/ paper money and coins.
Deposits deposits at banks, credit unions,
saving banks, loan-associations are also
money.
Currency in a bank is NOT money.
Forms of money
Bank deposits
Currency outside the banks
Currency inside the banks is NOT money
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Deposits are money but
checks are not
Ex. When Ali buys some products from
Company X, he has $500 in his deposit
account, and Company X has $3,000 in his
deposit account. Both of them at the B-C
Bank.
Total deposits of Ali and Company X are
$3,500.
Ali writes a check for $200. Company X takes
the check to the bank and deposit it.The B-C
Bank credits Company Xs account and
debits Alis account.
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Contd.
B-C Bank Alis account
Date Item Debit Credit Balance
_______________________________________________
June 1 2001 opening balance $500
June 11 2001 Company X 200 300
_______________________________________________
B-C Bank Company Xs account
Date Item Debit Credit Balance
_______________________________________________
June 1 2001 opening balance $3,000
June 11 2001 Alis check 200 3,200
_______________________________________________
B-C Bank credits Company Xs account and debits Alis account.
Company Xs deposit increases from $3,000 to $3,200.
Alis deposit decreases from $500 to $300.
Total deposits of Ali & Company Xs are still the same: $3,500.
This transaction has transferred money from Ali to Company X. the Check itself was
never money.
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Contd.
Credit cards is not money. It is a special type of ID
card.
Debit cards is not money.
Official Measures of Money M1 and M2
M1 currency held outside banks and travelers check
plus checkable deposits. M1 does not include
currency inside the banks.
M2 M1 plus savings deposits and small time
deposits, money market funds and other deposits.
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Are M1 and M2 really money?
Money is a generally accepted means of payment.
Currency and checkable deposits serve this purpose
M1 is money.
What about M2?
Some of the savings deposits in M2 are means of
payment. You can use the ATM to transfer funds
directly from your savings account to pay your
purchase.
Other saving deposits, time deposits and money
market funds are not means of payment.
So all of M1 is money, but only part of M2 is money.
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The Monetary System
- Consists of the central bank (CB), commercial
banks and other institutions that accept deposits
and that provide the services that enable people
and businesses to make and receive payments.
Commercial banks a firm that is chartered by the
authority to accept deposits and make loans.
Thrift institutions savings and loan association,
saving banks and credit union.
Money market funds a financial institution that
obtains funds by selling shares and uses these
funds to buy assets.
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Central Banks Policy Instruments
Required reserve ratios
Discount rate
Open market operations
Required reserve ratios
Banks hold reserves. Banks and financial institutions are required to hold
a minimum percentage of deposits as reserves. This minimum
percentage is known as a required reserve ratio.
Discount rate
The interest rate at which the central bank stands ready to lend reserves
to commercial banks.
Open market operations (OMO)
The purchase or sale of government securities treasury bills and bonds
by the central bank in the open market.
The monetary base the sum of coins, notes, and banks reserves at the
central bank.
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How the central banks policy
instruments work?
Rr the CB can force the banks to hold a
larger qty of monetary base.
discount rate the CB can make it
more costly for the banks to borrow
reserves.
By selling securities in the open market,
the CB can decrease the monetary
base.
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How banks create money
Creating a bank involves 8 steps
Obtain a charter (license) to operate a commercial
bank.
Raise some financial capital.
Buy some equipment and computer programs.
Accept deposits.
Establish a reserve account at the CB.
Clear checks.
Buy government securities.
Making loans.
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Raising financial capital
You can open your bank with $200,000, so
Bank XYZ creates 2,000 shares, each worth
$100 and sells these shares in local
community.
Bank XYZs Balance Sheet
assets liabilities
__________________________________
Cash 200,000 owners equity 200,000
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Buying equipment
You buy some equipment, data base software
etc. these items cost you $200,000.
Bank XYZs Balance Sheet
Assets Liabilities
____________________________________
Cash 0
Equipment 200,000 owners equity 200,000
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Accepting deposits
The bank has accepted $120,000 of deposits.
Bank XYZs Balance Sheet
Assets Liabilities
_________________________________________
Cash 120,000 Checkable deposits 120,000
Equipment 200,000 owners equity 200,000
_________________________________________
Deposits at Bank XYZ are now part of the money supply. But the
qty of money has not increased.
Suppose that these deposits are currency:
Currency outside the banks has decreased by $120,000 and
checkable deposit have increased by $120,000.
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Establishing a reserve account
Bank XYZ must establish a reserve account at central bank. Bank
XYZ opens an account at the CB all its cash.
Bank XYZs Balance Sheet
Assets Liabilities
_________________________________________________
Cash 0 Checkable deposits 120,000
Reserves at CB 120,000
Equipment 200,000 Owners equity 200,000
_________________________________________________
Reserves: actual and required
Banks dont keep all the money that people have deposited.
The proportion of a banks total deposits that are held in reserves =
reserve ratio.
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Contd.
Bank XYZs reserves are $120,000 and deposits are
$120,000 reserve ratio is 100%.
Suppose that the required reserve ratio (Rr) is 25%.
A banks required reserves
= 120,000 X 25/100 = $30,000
Excess reserves = actual reserves required reserves
In this example:
Excess reserves = 120,000 30,000
= 90,000
Whenever banks have excess reserves, they are able
to make loans.
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Clearing checks
Bank XYZs depositors want to make and receive
payments by check.
When Bank XYZs depositor say EnAhmad writes a
check for $20,000 to buy some computers from
Visions PCs, which has a checkable deposit at
Bank ABC.
Funds must move from Ahmads account to visions
account at bank ABC.
Bank XYZ loses reserves
Bank ABC gains reserves
When Visions PCs banks Ahmads check, Bank ABC
sends the check to the central bank.
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Contd.
Clearing a check
Central bank
Assets liabilities
________________________________________
Bank ABC reserves + 20,000
Bank XYZ reserves - 20,000
________________________________________
Bank ABC
Assets Liabilities
_____________________________________________
Reserves at CB 20,000 checkable deposits 20,000
_____________________________________________
Bank XYZ
Assets Liabilities
_________________________________________________
Reserves at CB - 20,000 Checkable deposits - 20,000
_________________________________________________
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Making interbank loans and
buying government securities
Bank XYZ buys $60,000 of government securities from Bank ABC and pays by check.
The CB increases Bank ABCs reserves by $60,000 and decreases Bank XYZs reserves
by the same amount
Change in CBs balance sheet
Assets Liabilities
_______________________________________
Bank ABC reserves + 60,000
Bank XYZ reserves - 60,000
_______________________________________
Bank ABC reserves have increased and its government securities have decreased by
$60,000.
Change in Bank ABC Balance Sheet
Assets Liabilities
________________________________________________
Reserves at CB 60,000
Government securities 60,000
_________________________________________________

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Contd.
Bank XYZ reserves have decreased and its government securities have increased by the
$60,000.
Change in Bank XYZ balance sheet.
Assets Liabilities
_______________________________________
Reserves at CB - 60,000
Government securities +60,000
_______________________________________
Bank XYZ balance sheet
Assets Liabilities
________________________________________
Reserves at CB 40,000 Checkable deposits 100,000
Govt. securities 60,000 Owners equity 200,000
Equipment 200,000
Total assets 300,000 Total liabilities 300,000
________________________________________________
With deposits of $100,000 Rr = 25%. Bank XYZ must hold a minimum of $25,000 in
reserves. Currently the bank has $40,000 in reserves, Bank XYZ can make loans.
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Making Loans
With reserves of $40,000 Rr = $25,000.
Bank XYZ has excess reserves of $15,000. the bank decides to make loans of
this amount.
Bank XYZ balance sheet
Assets Liabilities
_____________________________________________
Reserves at CB 40,000 checkable deposits 115,000
govt,securities 60,000 owners equity 200,000
Loans 15,000
Equipment 200,000
Total assets 315,000 total liabilities 315,000
_____________________________________________
The qty of money rises by $15,000. because deposits have increased, its
required reserves have also increased.
Reserves = 25% of $115,000 = $28,750
The bank now has excess reserves = 40,000 28,750 = $11,250
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The Limits to money creation
What is happening in the process of money creation by a banking system in which each bank has Rr
of 25%.
The multiple creation of bank deposits.

Round the Sequence
Deposit 100,000 Reserves Loans Deposits
Bank 1 R = 25,000 L = 75,000 25,000 75,000 100,000
Deposit 75,000
Bank 2 R = 18,750 L = 56,250 43,750 131,250 175,000
Deposit 56,250
Bank 3 R = 14,063 L = 42,187 57,813 173,437 231,250
Deposit 42,187
Bank 4 R = 10,547 L = 31,640 68,360 205,077 273,437
. . . .
. . . .
100,000 300,000 400,000
________________________________________________________
When a bank receives deposits, it keeps 25% in reserves and lends 75%. The amount loaned becomes
a new deposit at another bank. The next bank keeps 25% and lends 75% and the process will
continue until no more excess reserves. In this example an additional $100,000 of reserves
creates an additional $400,000 of deposits.


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Contd.
At each stage/ round, the loan is 75% (0.75) of the previous loan and the
deposit is 0.75 of the previous deposit.
In this case L = 0.75. The complete sequence is
1 + L + L
2
+ L
3
+ L
4
+ . = 1
___
1 L
0 < L < 1
The total increase in deposits is the sum of the above sequence multiplied
by the initial increase in reserves
1
_____ X initial increase in reserves
1 L
The total increase in deposits is
100000 + 75000 + 56250 + 42187 + ..
= 100000[1 + 0.75 + 0.5625 + 0.42187+ ]
= 100000[1 + 0.75 + 0.75
2
+ 0.75
3
+ ]
= 100000[ 1/(1 0.75)] = 100000 X 1/0.25 = 100000 X 4 = 400000
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The Deposit Multiplier
The number by which an increase in bank reserves is multiplied to find the
resulting increase in bank deposits.
Deposits = deposit multiplier X reserves
Deposit multiplier = deposits
_________
reserves
= 1
_________________
reserves/deposits
= 1
____
Rr
In this example, Rr = 25% = 0.25
Deposit multiplier = 1
____ = 4
0.25
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Influencing the quantity of money
Central bank constantly monitors and
adjusts the qty. of money in the
economy.
To change the qty. of money, the central
bank use any of its 3 tools:
(i) Reserve requirement ratio (Rr)
(ii) Discount rate
(iii) Open market operation (OMO)

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Contd.
(i) If the CB increases the Rr, the banks must increase their
reserves and decrease their lending the qty. of money.
if the CB decreases the Rr, the banks can decrease their
reserves and increase their lending the qty. of money.

(ii) If the CB increases the discount rate, the banks must pay a
higher price for any reserves that they borrow from the CB
the banks are less willing to borrow reserves and prefer
to decrease their lending the qty. of money .
If the CB decreases the discount rate, the banks pay a lower price
for reserves that they borrow from the CB. The banks willing
to borrow reserves and lending
Discount rate qty. of money .

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Contd.
(iii) An open market operation
An open market purchase
Increases bank reserves
Increases the monetary base
Monetary base = CB notes, coins, and banks reserves at the CB.
An open market purchase the banks reserves at the CB.
If the CB buys securities from the banks, the qty. of deposits (and
the qty. of money) does not change.
If the CB buys securities from the public, the qty. of deposits (and
the qty. of money) increases by the same amount as the
increase in bank reserves.

An open market sale the qty. of money.
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The Money Multiplier
The number by which a change in the monetary base is multiplied to
find the resulting change in the qty. of money.

Qty. of money = money multiplier X monetary base
e.g. monetary base = size of the open market purchase
Qty.of money = 2.5 X 100000 = 250000
money multiplier monetary base
The money multiplier is determined by the banks Rr and the currency drain
(currency held outside the banks)
If Rr = 10% of deposits currency drain = 33.33% of money
When the banks lend $100,000, no excess reserves R, $33,333 drains off as
currency and $$66,667 remains in the banks as reserves and deposits.
Additional deposits = $66,667
Rr = 10% Reserve $6,667
Excess Reserves = $60,000 = 0.6 of the original $100,000 of excess reserves.
In the 2
nd
round of lending, the banks lend 0.6 of the amount they loaned in
the 1
st
round.

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Contd.
This proportion L = 0.6
In the 3
rd
round the banks lend 0.62 = 0.36 of the original amount ($36,000)
Qty. of money created = 1
____ X open market purchase
1 L
= 100,000 X 1
_____
1 0.6
= 100,000 X 1/0.4
= 100,000 X 2.5 = $250,000
L can be calculated from the currency drain (C) and Rr.
If C = 0.33 ; Rr = 0.1
When the banks lend $1, $C is held as currency and $(1 C) remains on deposit.
Banks must hold $Rr of reserves for each $1 of deposits Banks can lend $(1 Rr) of
each $1 on deposit.
When $(1 C) remains on deposit, banks can lend $(1 C)(1 Rr)
L = (1 C)(1 Rr) = (1 0.33)(1 0.1) = 0.6
When C money multiplier