Ch30.pptx

To be used with Mankiw and Rashwan, Principles of Economics, Arab World Edition, 3rd edition, ISBN: 9781473749504 © Cengage Learning EMEA 2018.
Chapter 30
The Monetary System
N. Gregory Mankiw & Mohamed H. Rashwan
Economics
Principles of
Arab World Edition

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In this chapter, look for the answers to these
questions:
• What assets are considered “money”?
• What are the functions of money?
• What are the types of money?
• What role do banks play in the monetary
system?
• How do banks “create money”?

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INTRODUCTION:
What Money Is and Why It’s Important
 Without money, trade would require barter,
the exchange of one good or service for another.
 Every transaction would require a double
coincidence of wants—the unlikely occurrence that
two people each have a good the other wants.
 Most people would have to spend time searching for
others to trade with—a huge waste of resources.
 This searching is unnecessary with money,
the set of assets that people regularly use to buy
goods and services from other people.

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THE MEANING OF MONEY
 Money: the set of assets that people regularly use to
buy goods and services from other people.
 Economist’s refer to money as assets that are regularly
accepted by sellers in exchange for goods and services.
 As such it does not include shares in companies.
 Liquidity refers to the ease at which an asset can be
converted into the economy’s medium of exchange.

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The Functions of Money
 Medium of exchange: an item buyers give to
sellers when they want to purchase goods and
services.
 Unit of account: the yardstick people use to
post prices and record debts.
 Store of value: an item people can use to
transfer purchasing power from the present to
the future.

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The Kinds of Money
Commodity money: takes
the form of a commodity with
intrinsic value.
Examples: gold coins,
cigarettes in prisons.
Fiat money: money without
intrinsic value, used as money
because of government decree
For example: Kuwait Dinar.

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The Money in the Economy
 The money supply (or money stock) is the
quantity of money available in the economy.
 What assets should be considered part of the
money supply or money stock?
 Two candidates:
 Currency: the paper bills and coins in the hands of
the (non-bank) public.
 Demand deposits: balances in bank accounts that
depositors can access on demand by writing a check.

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CENTRAL BANKS
 Central bank: an institution that oversees the
banking system and regulates the money supply.
 Examples of central banks are: Central Bank of
Kuwait, Banque Du Libon (in Lebanon).
 Money supply refers to the quantity of money
circulating in the economy.
 Monetary policy: the setting of the money
supply by policymakers in the central bank.

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BANKS AND THE MONEY SUPPLY
 In simple terms a Central bank controls the supply of
money by buying and selling government bonds in
open-market operations.
 To make this explanation more complete we need to
include the role banks play in the monetary system.
 Much of the money supply is in demand deposits
which are held in banks. The behavior of banks can
influence the quantity of these deposits and therefore
the money supply.
 Let us now examine this further.

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The Simple Case of 100-Percent-
Reserve Banking
 If there were no banks then if the total quantity of money
was $100 that would also be the supply of money.
 Now assume there is one bank, called the First National
bank, whose role is solely to keep the depositors money
safe. The bank does not loan this money out so it is all
counted as reserves.
 Here is the balance sheet of the First National Bank. In this
example the bank does not influence money supply.

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Money Creation with Fractional-Reserve
Banking
 In a fractional reserve banking system, banks keep a
fraction of deposits as reserves and use the rest to make
loans.
 The central bank usually establishes reserve
requirements, regulations on the minimum amount of
reserves that banks must hold against deposits.
 Banks may hold more than this minimum amount
if they choose.
 The reserve ratio, R
= fraction of deposits that banks hold as reserves
= total reserves as a percentage of total deposits

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Money Creation with Fractional-Reserve
Banking
 Bank T-account: a simplified accounting
statement that shows a bank’s assets & liabilities.
 Example: FIRST NATIONAL BANK
Assets Liabilities
Reserves $ 10
Loans $ 90
Deposits $100
 Banks’ liabilities include deposits, assets include
loans & reserves.
 In this example, notice that R = $10/$100 = 10%.

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Banks and the Money Supply: An Example
Suppose $100 of currency is in circulation.
To determine banks’ impact on money supply,
we calculate the money supply in 3 different cases:
1. No banking system.
2. 100% reserve banking system: banks hold 100% of
deposits as reserves, make no loans.
3. Fractional reserve banking system. This looks at the
Money Multiplier

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CASE 1: No banking system
Public holds the $100 as currency.
Money supply = $100.

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CASE 2: 100% reserve banking system
Public deposits the $100 at First National Bank (FNB).
FIRST NATIONAL BANK
Assets Liabilities
Reserves $100
Loans $ 0
Deposits $100
FNB holds
100% of
deposit
as reserves:
Money supply
= currency + deposits = $0 + $100 = $100
In a 100% reserve banking system, banks do not affect
size of money supply.

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CASE 3: Fractional reserve banking system
Suppose R = 10%. FNB loans all but 10% of the deposit:
Depositors have $100 in deposits, borrowers have $90 in
currency.
Remember Money supply = C + D = $90 + $100 = $190
FIRST NATIONAL BANK
Assets Liabilities
Reserves $ 10
Loans $ 90
Deposits $100

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 How did the money supply suddenly grow?
 When banks make loans, they create money.
 The borrower gets:
 $90 in currency—an asset counted in the
money supply.
 $90 in new debt—a liability that does not have
an offsetting effect on the money supply.
A fractional reserve banking system creates money,
but not wealth.

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If R = 10% for SNB, it will loan all but 10% of the
deposit.
SECOND NATIONAL BANK
Assets Liabilities
Reserves $ 9
Loans $ 81
Deposits $ 90
Borrower deposits the $90 at Second National Bank.
Initially, SNB’s
T-account
looks like this:

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If R = 10% for TNB, it will loan all but 10% of the
deposit.
THIRD NATIONAL BANK
Assets Liabilities
Reserves $ 81
Loans $ 0
Deposits $ 81
SNB’s borrower deposits the $81 at Third National
Bank.
Initially, TNB’s
T-account
looks like this: $ 8.10
$72.90

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• The process continues, and money is created
with each new loan.
Original deposit =
FNB lending =
SNB lending =
TNB lending =
.
.
.
$ 100.00
$ 90.00
$ 81.00
$ 72.90
.
.
.
Total money supply = $1000.00
In this example,
$100 of reserves
generates $1000
of money.

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The Money Multiplier
 Money multiplier: the amount of money the
banking system generates with each dollar of
reserves
 The money multiplier equals 1/R.
 In our example,
R = 10%
money multiplier = 1/R = 10
$100 of reserves creates $1000 of money

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THE TOOLS OF MONETARY POLICY
 Earlier, we learned
money supply = money multiplier × bank reserves
 The central bank can change the money supply by
changing bank reserves or changing the money
multiplier.
 We shall now look at how a Central Bank can
influence the money multiplier.

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How the Central Bank Influences Reserves
 Open-Market Operations (OMOs): the purchase
and sale of government bonds by the central bank.
 If the central bank buys a government bond from the
public, the money supply increases.
 To decrease the money supply, the central bank sells
government bonds.

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 The central bank makes loans to banks, increasing
their reserves.
 Traditional method: adjusting the discount rate—the
interest rate on loans the central bank makes to banks—
to influence the amount of reserves banks borrow
 The more banks borrow, the more reserves they
have for funding new loans and increasing the
money supply.
 If the central bank lowers the discount rate it
charges to banks, the money supply increases.
 When the central bank raises the discount rate,
this decreases the money supply.

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 The central bank sets reserve requirements: regulations
on the minimum amount of reserves banks must hold
against deposits.
 Reducing reserve requirements would lower the reserve
ratio and increase the money supply.
 Increasing reserve requirements would raise the reserve
ratio and decrease the money supply.

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Problems Controlling the Money Supply
 If households hold more of their money as
currency, banks have fewer reserves,
make fewer loans, and money supply falls.
 If banks hold more reserves than required,
they make fewer loans, and money supply falls.
 Yet, the central bank can compensate for
household and bank behavior to retain fairly
precise control over the money supply.

S U M M A RY
• Money serves three functions: medium of
exchange, unit of account, and store of value.
• There are two types of money: commodity
money has intrinsic value; fiat money does not.
• Most countries use fiat money, which includes
currency and various types of bank deposits.

S U M M A RY
• In many countries there is a central bank which
is responsible for regulating the monetary
system.
• The central bank may control the money supply
mainly through open-market operations.
Purchasing government bonds increases the
money supply, selling government bonds
decreases it.

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