The Monetary System

What is money?

What are its main functions?

Money is a commodity that is generally accepted as for payment for goods and services.

What was the barter system?

This commodity has to perform these three functions• Medium of exchange• Unit of account (similar to pounds, meters, joule)• Store of value (ability to store purchasing power)

WHAT IS MONEY?

Digress-

What is liquidity?

Whats the most liquid asset…….?

Idea: There is an inverse relationship between liquidty and the store of value….. How so?

Kinds of Money

1) Commodity Money- money taking the form of a commodity with some intrinsic value…

How does an object get intrinsic value?

2) Fiat money has no intrinsic value.

Monopoly money vs. acceptable money? Why does it have purchasing power?

Fiat money includes.• Currency• Deposits

Ques:

Suppose you were given the job of counting the amount of money circulating in the U.S. How would you do it?

Measures of Money: M1 and M2

M1 : currency ,traveler’s checks, plus checkable deposits owned by individuals and businesses.

M2 : consists of M1 plus savings deposits and small time deposits, money market funds, and other deposits.

Not included in money are-

Checks, Credit Cards, Debit Cards.

Why?

THE BANKING SYSTEM

The banking system consists of

1)The Federal Reserve – America’s central bank

2)Commercial banks- accepts deposits and issues loans

3) thrift institutions- loan associations, savings banks, and credit unions. Accept deposits and issue commercial, and home purchase loans.

4)money market fund - is a financial institution that obtains funds by selling shares and uses these funds to buy assets such as U.S. Treasury bills

THE BANKING SYSTEM

Types of Deposits:

• Checkable deposits

• Savings deposits

• Time deposits

Reserves:

Reserve Requirement:

Assets Liabilities

Reserves Deposits

Loans

Controlling the Money Supply

Defn:

Monetary Base- Bank reserves held at the FED.

The Fed uses three main policy tools to control interest rates and the money supply:• Required reserve ratios • Discount rate• Open market operations

The money multiplier :

How much a change in the monetary base changes the quantity of money.

The money multiplier = (1+c)/(r+c)

Can you imagine how this works?

Ex. Lets say Citi has desired reserve ratio of 100% vs BOA practices 10% reserve banking. Describe the impact on the money supply if Steve deposits his $100 in either bank?

Ex.2 If the FED wants to reduce the money supply, describe what would be done using the three policy tools available.

Examples

Ex) Suppose a bank received $1mil in deposits. What is the maximum loan amount and the increase in MS created with

i) 10% reserve requirement

ii) 50% reserve requirement

Ex) Mark has $200, in currency. The currency drain ratio is 10% and bank’s reserve requirement is 5%. Show i) how much is deposited in the bank ii) show the balance sheet of the bank iii) calculate the money multiplier iv) how much money is created from a $1 increase in the monetary base?

Ex) Amy keeps a deposit of $1000 in her bank a/c. If the reserve requirement is 10%, the currency drain ratio is 15%. Calculate how much Amy keeps as currency. Calculate the money multiplier.