MacroLecture7Money and the Monetary SystemLecture HighlightsDefinition of money and describe its functionsThe functions of banksThe functions of central bankHow banks create money and how the central bank controls the quantity of money

Money and the Monetary SystemDefinition 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.

Functions of Money(1) Medium of exchange(2) Unit of account(3) Store of valueMedium of exchangeAn 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.

Contd.Unit of accountAn agreed-upon measure for stating the prices of goods and services.Store of valueAny 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.

Money todayMoney 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.

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 moneyBank depositsCurrency outside the banksCurrency inside the banks is NOT money

Deposits are money but checks are notEx. 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.

Contd.B-C Bank Alis account Date Item Debit Credit Balance_______________________________________________ June 1 2001 opening balance $500June 11 2001 Company X 200 300_______________________________________________ B-C Bank Company Xs account Date Item Debit Credit Balance_______________________________________________ June 1 2001 opening balance $3,000June 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.

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 M2M1 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.

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.

The Monetary SystemConsists 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.

Central Banks Policy InstrumentsRequired reserve ratiosDiscount rateOpen market operationsRequired reserve ratiosBanks 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 rateThe 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.

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.

How banks create moneyCreating a bank involves 8 stepsObtain 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.

Raising financial capitalYou 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

Buying equipmentYou buy some equipment, data base software etc. these items cost you $200,000.Bank XYZs Balance Sheet Assets Liabilities____________________________________ Cash 0Equipment 200,000 owners equity 200,000

Accepting depositsThe bank has accepted $120,000 of deposits.Bank XYZs Balance Sheet Assets Liabilities_________________________________________ Cash 120,000 Checkable deposits 120,000Equipment 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.

Establishing a reserve accountBank 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 120,000Reserves at CB 120,000Equipment 200,000 Owners equity 200,000_________________________________________________ Reserves: actual and requiredBanks dont keep all the money that people have deposited.The proportion of a banks total deposits that are held in reserves = reserve ratio.

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 = $30,000Excess reserves = actual reserves required reservesIn this example:Excess reserves = 120,000 30,000 = 90,000Whenever banks have excess reserves, they are able to make loans.

Clearing checksBank 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 reservesBank ABC gains reservesWhen Visions PCs banks Ahmads check, Bank ABC sends the check to the central bank.

Contd.Clearing a checkCentral 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_________________________________________________

Making interbank loans and buying government securitiesBank 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 amountChange 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 60,000Government securities 60,000_________________________________________________

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 - 60,000Government securities +60,000_______________________________________ Bank XYZ balance sheet Assets Liabilities________________________________________ Reserves at CB 40,000 Checkable deposits 100,000Govt. securities 60,000 Owners equity 200,000Equipment 200,000Total 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.

Making LoansWith 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 115,000govt,securities 60,000 owners equity 200,000Loans 15,000Equipment 200,000Total 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 = $28,750The bank now has excess reserves = 40,000 28,750 = $11,250

The Limits to money creationWhat 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 DepositsBank 1 R = 25,000 L = 75,000 25,000 75,000 100,000 Deposit 75,000Bank 2 R = 18,750 L = 56,250 43,750 131,250 175,000 Deposit 56,250Bank 3 R = 14,063 L = 42,187 57,813 173,437 231,250 Deposit 42,187Bank 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.

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 is1 + L + L2 + L3 + L4 + . = 1 ___ 1 L0 < L < 1The 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 LThe total increase in deposits is100000 + 75000 + 56250 + 42187 + ..= 100000[1 + 0.75 + 0.5625 + 0.42187+ ]= 100000[1 + 0.75 + 0.752 + 0.753 + ]= 100000[ 1/(1 0.75)] = 100000 X 1/0.25 = 100000 X 4 = 400000

The Deposit MultiplierThe number by which an increase in bank reserves is multiplied to find the resulting increase in bank deposits.Deposits = deposit multiplier X reservesDeposit multiplier = deposits _________ reserves = 1 _________________ reserves/deposits = 1 ____ RrIn this example, Rr = 25% = 0.25Deposit multiplier = 1 ____ = 4 0.25

Influencing the quantity of moneyCentral 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:Reserve requirement ratio (Rr)Discount rateOpen market operation (OMO)

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 lendingDiscount rate qty. of money .

Contd.(iii) An open market operationAn open market purchaseIncreases bank reservesIncreases the monetary baseMonetary 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.

The Money MultiplierThe 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 basee.g. monetary base = size of the open market purchaseQty.of money = 2.5 X 100000 = 250000 money multiplier monetary baseThe 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 moneyWhen 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 = $66,667Rr = 10% Reserve $6,667 Excess Reserves = $60,000 = 0.6 of the original $100,000 of excess reserves.In the 2nd round of lending, the banks lend 0.6 of the amount they loaned in the 1st round.

Contd.This proportion L = 0.6In the 3rd 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 = $250,000L can be calculated from the currency drain (C) and Rr.If C = 0.33 ; Rr = 0.1When 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) = 0.6When C money multiplier