This chapter discusses the monetary system, including how money moves from savers to businesses through direct and indirect transfers. It identifies the key participants in the US monetary system as the central bank (Federal Reserve System) and the banking system. The chapter also covers the functions and development of money in the US, measures of the money supply, and relationships between money supply and economic activity. It concludes with an overview of developments in the international monetary system.

1. Chapter 2
Money and the Monetary
System
© 2011 John Wiley and Sons

2. 2
Chapter Outcomes
 Describe the three ways in which
money is transferred from savers to
businesses
 Identify the major components of the
monetary system
 Describe the functions of money
 Give a brief review of the
development of money in the U.S.

3. 3
Chapter Outcomes
(Continued)
 Describe major types of money
market securities
 Briefly explain the M1, M2, and M3
definitions of the money supply
 Explain possible relationships
between money supply and economic
activity
 Comment on developments in the
international monetary system

4. Process of Moving Savings into
Investments
 Surplus Economic Unit:
generates more money than it
spends resulting in excess money
 Deficit Economic Unit:
generates less money than it spends
resulting in a need for additional
money
4

5. 5
Savings-Investment Process
Money
Securities
Money Money
Money Money
Securities
Firm’s
Securities
Securities
Institution
Securities
Investment
Banking Firm
Direct Transfers:
Savers Business
Firm
Indirect Transfers:
Savers Business
Firm
Savers Financial Business
Institution Firm

6. 6
Participants in the U.S.
Monetary System
CENTRAL BANK:
 Defines and Regulates Money Supply
 Facilitates the Transferring of Money
BANKING SYSTEM:
 Creates Money
 Transfers Money
 Provides Financial Intermediation
 Processes/Clears Checks

7. 7
The U.S. Monetary System
Central Bank
Federal Reserve System
Board of Governors
Federal Reserve Banks
Defines and regulates
money supply
Facilitates transfer of
money through check
processing/clearing
Banking System:
1. Creates money
2. Transfers money
3. Provides financial intermediation
4. Processes/clears checks
Other
Banks
First
Bank
Last
Bank

8. 8
U.S. Central Bank
 Federal Reserve System [often
referred to as the “Fed”]
 Board of Governors
 Federal Reserve Banks

9. 9
Central Bank Activities
 Defines and regulates money supply
 Facilitates the transferring of money
through check processing and
clearing

10. Importance and Functions of
Money
 Real Assets:
direct ownership of land, buildings or
homes, equipment, inventories,
durable goods, and precious metals
 Financial Assets:
money, debt securities & contracts,
and equity securities backed by real
assets & earning power of issuers
10

11. 11
Some Basic Definitions
 MONEY:
anything generally accepted as
payment for goods, services, & debts
 BARTER:
exchange of goods or services
without using money
 LIQUIDITY:
ease and low cost of exchanging an
asset for money

12. 12
Functions of Money
 MEDIUM OF EXCHANGE:
the basic function of money
 STORE OF VALUE:
money can be held for some period
of time, without losing its value,
before it is spent
 STANDARD OF VALUE:
exists when prices and debts are
stated in terms of the monetary unit

13. 13
Development of Money in the U.S.
Historical Types of U.S. Coins:
 FULL-BODIED MONEY:
coins that contain the same value in
metal as their face value
 TOKEN COINS:
coins containing metal of less value
than their stated value

14. 14
Development of Money in the U.S.
Historical Types of Paper Currency:
 REPRESENTATIVE FULL-BODIED
MONEY:
paper money fully backed by a
precious metal
 FIAT MONEY:
legal tender proclaimed to be money
by law--not backed by precious metal

15. 15
Deposit Money in the U.S.
 CREDIT MONEY:
money worth more than what it is
made of--backed by the credit-
worthiness of issuer
 DEPOSIT MONEY:
special type of credit money backed
by the depository institution that
issued the deposit

16. 16
Alternatives to “Paper Checks”
 AUTOMATIC TRANSFER SERVICE
(ATS) ACCOUNTS:
Provide for direct deposits to, and
payments from, checkable deposit
accounts
 DEBIT CARDS:
Provide for immediate direct transfer
of deposit amounts & can be used to
make cash withdrawals from ATMs

17. Money Market Securities
 Money Markets:
markets where debt securities with
maturities of one year or less are
originated (primary markets) or
traded (secondary markets)
 Money Market Securities:
debt securities with maturities of one
year or less
17

18. Money Market Securities
 Treasury Bill:
short-term debt obligation issued by
the U.S. federal government
 Negotiable Certificate of Deposit:
short-term debt instrument issued by
depository institutions that can be
traded in the secondary money
markets
18

19. Money Market Securities
 Commercial Paper:
short-term unsecured note issued by
a high credit-quality corporation
 Banker’s Acceptance:
promise of future payment issued by
an importing firm and guaranteed by
a bank
19

20. Money Market Securities
 Repurchase Agreement:
short-term debt security where the
seller agrees to repurchase the
security at a specified price and date
 Federal Funds:
very short-term loans between
depository institutions with excess
funds and those needing funds
20

21. Measures of the U.S. Money Supply
 M1 Money Supply
 M2 Money Supply
 M3 Money Supply
21

22. 22
Components of the M1 Definition
of the Money Supply
 Currency
 Traveler’s Checks
 Demand Deposits at Banks
 Other Checkable Deposits at
Depository Institutions

23. 23
Components of the M2 Definition
of the Money Supply
M1 Money Supply plus:
 Savings Accounts
 Small-Denomination Time Deposits
 Money Market Deposit Accounts
(MMDAs)
 Retail Money Market Mutual Funds
(MMMFs)

24. 24
Components of the M3 Definition
of the Money Supply
M2 Money Supply plus:
 Large-Denomination Time Deposits
 Institutional Money Market Mutual
Funds
 Repurchase Agreements (Overnight
and Term)
 Eurodollars (Overnight and Term)
Held by U.S. Residents

25. 25
Money Supply and Economic
Activity
 MONETARISTS’ VIEW:
amount of money in circulation
determines the level of economic
activity
 KEYNESIANS’ VIEW:
change in money supply first causes
a change in interest rates which then,
in turn, alters the demand for goods
and services

26. 26
Monetarists’ View
 BASIC EQUATION: MS x VM = GDP
 GROSS DOMESTIC PRODUCT (GDP):
Measures the output of goods and
services in an economy
 MONEY SUPPLY (MS):
Usually defined in terms of M1 or M2
 VELOCITY OF MONEY (VM):
The rate of circulation of the money
supply

27. 27
Another View of GDP
 BASIC EQUATION: RO x PL = GDP
 GROSS DOMESTIC PRODUCT (GDP):
Measures the output of goods and
services in an economy
 REAL OUTPUT (RO):
Units of goods and services
 PRICE LEVEL (PL):
Average price of goods and services

28. 28
Two Views of GDP Combined
 TWO BASIC EQUATIONS:
MS x VM = GDP
RO x PL = GDP
 THE EQUATIONS COMBINED:
MS x VM = RO x PL
 NOMINAL GDP INCREASES WITH:
>An increase in money supply and/or
velocity of money
>An increase in real output and/or price
level

29. 29
International Monetary System
 Historically:
Tied to the gold standard
 Bretton Woods System (1944):
Agreement to use fixed or pegged
exchange rates tied to the U.S. dollar
or gold
 Early 1970s:
Development of a flexible or floating
exchange rate system

30. 30
International Monetary System
Terms
 CURRENCY EXCHANGE RATE:
Value of one currency relative to
another
 EURO:
A single currency that replaced the
individual currencies of initially
twelve member countries of the
European Union

31. 31
Web Links
 www.frbsf.org
 www.federalreserve.gov
 www.stlouisfed.org
 www.treas.gov