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Lecture 6: The Monetary System
Principles of Macroeconomics
Prof. Dr. Jan-Egbert Sturm
Fall Term 2009
General Information
22.9.
Introduction
Ch. 1,2
29.9.
National Accounting
Ch. 10, 11
6.10.
Production and Growth
Ch. 12
13.10.
Saving and Investment
Ch. 13
20.10.
Unemployment
Ch. 15
27.10.
The Monetary System
Ch. 16, 17
3.11.
International Trade (incl. Basic Concepts of Supply, Demand,
Welfare)
Ch. 3, 7, 9
10.11.
Open Economy Macro
Ch. 18
17.11.
Open Economy Macro
Ch. 19
24.11.
Aggregate Demand and Aggregate Supply
Ch. 20
1.12.
Monetary and Fiscal Policy
Ch. 21
8.12.
Phillips Curve
Ch. 22
15.12.
Summing up: The Financial Crisis
Principles of Macroeconomics - Lecture 6
Fall Term 2009
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THE MEANING OF MONEY
Money is the set of assets in an economy that people
regularly use to buy goods and services from other
people.
Principles of Macroeconomics - Lecture 6
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The Functions of Money
ƒ Medium of Exchange
ƒ A medium of exchange is an item that buyers give to sellers
when they want to purchase goods and services.
ƒ A medium of exchange is anything that is readily acceptable as
payment.
ƒ Unit of Account
ƒ A unit of account is the yardstick people use to post prices and
record debts.
ƒ Store of Value
ƒ A store of value is an item that people can use to transfer
purchasing power from the present to the future.
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The Liquidity of an Asset
ƒ Liquidity is the ease with which an asset can be converted
into the economy’s medium of exchange.
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The Kinds of Money
ƒ Commodity money takes the form of a commodity with
intrinsic value.
ƒ Examples: Gold, silver, cigarettes.
ƒ Fiat money is used as money because of government decree.
ƒ It does not have intrinsic value.
ƒ Examples: Coins, currency, check deposits.
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Money in the Economy
ƒ Currency is the paper bills and coins in the hands of the
public.
ƒ Demand deposits are balances in bank accounts that
depositors can access on demand by writing a check.
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Measuring the Quantity of Money
ƒ There are many assets that have some money-characteristics:
ƒ currency, checking accounts, saving accounts,
money market funds, etc.
ƒ There is no single precise measure of money!
ƒ Many different measures,
which move more or less together
ƒ We will often act as if there is just one: M
ƒ Which is assumed to be controlled by the Central Bank
Principles of Macroeconomics - Lecture 6
Fall Term 2009
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Money supply measures
Symbol Assets included
M0
M1
M2
M3
Sources: SNB, ECB
Currency
M0 + demand deposits, travelers'
checks, other checkable deposits
M1 + small time deposits, savings
deposits, money market deposit
accounts
M2 + large time deposits,
repurchase agreements,institutional
money market mutual fund
balances, debt securities
Switzerland, 1.1.08
Amount (in blns) ratio to M0
SFr. 47
SFr. 271
Euro area, 1.1.08
Amount (in blns) ratio to M0
5.8
€ 707
€ 3,838
5.4
SFr. 446
9.5
€ 7,356
10.4
SFr. 624
13.3
€ 8,664
12.3
Principles of Macroeconomics - Lecture 6
Fall Term 2009
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Money supply measures, Euro area, 1.1.2008
10,000
9,000
8,000
7,000
Billions of Euros
Repurchase agreements
Money market funds
Debt securities
Short-term
deposits
6,000
5,000
4,000
M2
Overnight
deposits
3,000
2,000
M1
1,000
0
Source: ECB
Currency
M0
M0
M1
M2
Principles of Macroeconomics - Lecture 6
M3
Fall Term 2009
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Money supply in the euro area
10,000
in billions of Euros
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
90
91
92
93
94
95
96
97
98
M1
Source: ECB
99
00
M2
01
02
03
04
05
06
07
08
09
M3
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Money supply in the euro area
9,500
in billions of Euros
4,500
9,400
4,400
9,300
4,300
9,200
4,200
9,100
4,100
9,000
4,000
8,900
3,900
8,800
3,800
8,700
3,700
08
09
M3
Source: ECB
M1
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What about the recent increase in money supply?
Central Bank
Bank 1
Bank 2
Firm
Household
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Growth in money supply in the euro area
16
% (VJV)
14
12
10
8
6
4
2
1
2
3
4
5
6
7
8
9
10
11
12
1
2
3
4
5
6
7
8
9
10
11
12
1
2
3
4
5
6
7
8
9
10
11
12
0
07
08
M1
Source: ECB
M2
09
M3
Principles of Macroeconomics - Lecture 6
Fall Term 2009
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Functions of a Central Bank
ƒ Two Primary Functions of Central Banks
ƒ Act as a banker’s bank, making loans to banks
and as a lender of last resort.
ƒ Conducts monetary policy
– by controlling the money supply
– by controlling the internal value of the currency
(price stability)
– by controlling the external value of the currency
(exchange rate)
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The Central Bank’s Tools of Monetary Control
ƒ Open-Market Operations
ƒ The CB conducts open-market operations when it buys government
bonds from or sells government bonds to the public:
– When the CB buys government bonds, the money supply increases.
– The money supply decreases when the CB sells government bonds.
ƒ Reserve Requirements
ƒ Reserve requirements are regulations on the minimum amount of
reserves that banks must hold against deposits.
– Increasing the reserve requirement decreases the money supply.
– Decreasing the reserve requirement increases the money supply.
ƒ The Discount Rate
ƒ The discount rate is the interest rate the CB charges banks for loans.
– Increasing the discount rate decreases the money supply.
– Decreasing the discount rate increases the money supply.
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Fall Term 2009
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Monetary policy rates in Switzerland
4.5
%
%
4.5
4.0
4.0
3.5
3.5
3.0
3.0
2.5
2.5
2.0
2.0
1.5
1.5
1.0
1.0
0.5
0.5
0.0
0.0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Swiss target 3 month LIBOR (lower rate)
Swiss 3 month LIBOR
Swiss target 3 month LIBOR (upper rate)
Source: SNB
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Problems in Controlling the Money Supply
ƒ The CB’s control of the money supply is not precise.
ƒ The CB must wrestle with two problems that arise due to
fractional-reserve banking.
ƒ The CB does not control the amount of money
that households choose to hold as deposits in banks.
ƒ The CB does not control the amount of money
that bankers choose to lend
and/or the private sector chooses to borrow.
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BANKS AND THE MONEY SUPPLY
ƒ Banks can influence the
quantity of demand deposits
in the economy and the
money supply.
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BANKS AND THE MONEY SUPPLY
ƒ Reserves are deposits that banks have received but have not
loaned out.
ƒ In a fractional-reserve banking system, banks hold a fraction
of the money deposited as reserves and lend out the rest.
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BANKS AND THE MONEY SUPPLY
ƒ The reserve ratio is the
fraction of deposits that
banks hold as reserves.
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Money Creation with Fractional-Reserve Banking
ƒ When a bank makes a loan from its reserves,
the money supply increases.
ƒ The money supply is affected by the amount deposited in
banks and the amount that banks loan.
ƒ Deposits into a bank are recorded as liabilities.
ƒ The fraction of total deposits that a bank has to keep as reserves
is called the reserve ratio.
ƒ Loans become an asset to the bank.
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Banking Money Creation with Fractional-Reserve
ƒ
This T-Account shows a bank
that…
ƒ
ƒ
ƒ
ƒ
ƒ
accepts deposits,
keeps a portion
as reserves,
and lends out
the rest.
It assumes a
reserve ratio
of 10%.
Increase in money
supply $ 90.00
First National Bank
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
$90.00
Total Assets
$100.00
Total Liabilities
$100.00
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Money Creation with Fractional-Reserve Banking
ƒ When one bank loans money, that money is generally
deposited into another bank.
ƒ This creates more deposits and more reserves to be lent out.
ƒ When a bank makes a loan from its reserves, the money
supply increases.
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The Money Multiplier
ƒ How much money is eventually created by the new deposit in
this economy?
ƒ The money multiplier is the amount of money the banking
system generates with each dollar of reserves.
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The Money Multiplier
Increase in the Money Supply = $81.00!
First National Bank
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
Second National Bank
Assets
Reserves
$9.00
Liabilities
Deposits
$90.00
Loans
$90.00
Total Assets
Total Liabilities
$100.00
$100.00
$81.00
Total Assets
$90.00
Total Liabilities
$90.00
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The Money Multiplier
Original deposit
= $100.00
ƒ 1st Natl. Lending = 90.00 (=.9 x $100.00)
ƒ 2nd Natl. Lending = 81.00 (=.9 x $ 90.00)
ƒ 3rd Natl. Lending = 72.90 (=.9 x $ 81.00)
ƒ … and on until there are just pennies left to lend!
ƒ Total money created by this $100.00 deposit in the banking
sector is $900.00 (= 1/0.10 x $100.00 - $100.00)
ƒ Total money in the system is $1’000.00
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The Money Multiplier
ƒ The money multiplier is the reciprocal of the reserve ratio:
Money Multiplier = 1/R
ƒ Example:
ƒ With a reserve requirement, R = 20% or .2:
ƒ The money multiplier is 1/.2 = 5.
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Money Growth and Inflation
ƒ The Meaning of Money
ƒ Money is the set of assets in an economy that people regularly
use to buy goods and services from other people.
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THE CLASSICAL THEORY OF INFLATION
ƒ Inflation is an increase in the overall level of prices.
ƒ Hyperinflation is an extraordinarily high rate of inflation.
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Inflation: some historical aspects
ƒ Over the past 60 years, prices in the U.S. have risen on
average about 5 percent per year.
ƒ Deflation, meaning decreasing average prices,
occurred regularly in the U.S. in the nineteenth century.
ƒ Hyperinflation refers to high rates of inflation such as
Germany experienced in the 1920s.
ƒ In the 1970s prices rose by 7 percent per year.
ƒ During the 1990s, prices rose at an average rate of 2 percent
per year.
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Inflation in Switzerland since 1970
16
% (y-o-y)
% (y-o-y)
16
14
14
12
12
10
10
8
8
6
6
4
4
2
2
0
0
-2
-2
-4
-4
0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9
70-74
Source: BFS
75-79
80-84
85-89
90-94
95-99
00-04
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05-09
Fall Term 2009
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The Level of Prices and the Value of Money
ƒ The quantity theory of money is used to explain the long-run
determinants of the price level and the inflation rate.
ƒ Inflation is an economy-wide phenomenon that concerns the
value of the economy’s medium of exchange.
ƒ When the overall price level rises, the value of money falls.
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Money Supply, Money Demand,
and Monetary Equilibrium
ƒ The money supply is a policy variable that is controlled by the
CB.
ƒ Through instruments such as open-market operations, the CB
directly controls the quantity of money supplied.
ƒ Money demand has several determinants, including interest
rates and the average level of prices in the economy.
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Money Supply, Money Demand,
and Monetary Equilibrium
ƒ People hold money because it is the medium of exchange.
ƒ The amount of money people choose to hold depends on the
prices of goods and services.
ƒ In the long run, the overall level of prices adjusts to the level
at which the demand for money equals the supply.
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Fall Term 2009
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How the Supply and Demand for Money Determine the
Equilibrium Price Level
Value of
Money, 1/P
(High)
Price
Level, P
Money supply
1
1
3
1.33
/4
12
/
Equilibrium
value of
money
(Low)
A
(Low)
2
Equilibrium
price level
14
4
/
Money
demand
0
Quantity fixed
by the CB
Quantity of Money
Principles of Macroeconomics - Lecture 6
(High)
Fall Term 2009
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An Increase in the Money Supply
Value of
Money, 1/P
(High)
MS1
MS2
1
1
1. An increase
in the money
supply . . .
3
2. . . . decreases
the value of
money . . .
Price
Level, P
/4
12
/
A
/
1.33
2
B
14
(Low)
3. . . . and
increases
the price
level.
4
Money
demand
(High)
(Low)
0
M1
M2
Quantity of
Money
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Fall Term 2009
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The Effects of a Monetary Injection
ƒ The Quantity Theory of Money
ƒ How the price level is determined
and why it might change over time
is called the quantity theory of money.
– The quantity of money available in the economy
determines the value of money.
– The primary cause of inflation
is the growth in the quantity of money.
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The Classical Dichotomy and Monetary Neutrality
ƒ Nominal variables are variables measured in monetary units.
ƒ Real variables are variables measured in physical units.
ƒ According to Hume and others, real economic variables do
not change with changes in the money supply.
ƒ According to the classical dichotomy,
different forces influence real and nominal variables.
ƒ Changes in the money supply affect nominal variables
but not real variables.
ƒ The irrelevance of monetary changes for real variables
is called monetary neutrality.
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Velocity and the Quantity Equation
ƒ The velocity of money refers to the speed at which the typical
dollar bill travels around the economy from wallet to wallet.
V = (P × Y)/M
where:
V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
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Fall Term 2009
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Velocity and the Quantity Equation
ƒ Rewriting the equation gives the quantity equation:
M×V=P×Y
ƒ The quantity equation relates the quantity of money (M)
to the nominal value of output
(P × Y).
ƒ The quantity equation shows that an increase
in the quantity of money in an economy
must be reflected in one of three other variables:
ƒ The price level must rise,
ƒ the quantity of output must rise, or
ƒ the velocity of money must fall.
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Summary
ƒ The term money refers to assets that people regularly use to
buy goods and services.
ƒ Money serves three functions in an economy: as a medium of
exchange, a unit of account, and a store of value.
ƒ Commodity money is money that has intrinsic value.
ƒ Fiat money is money without intrinsic value.
ƒ The central bank regulates the monetary system.
ƒ It controls the money supply through open-market operations
or by changing reserve requirements or the discount rate.
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Summary
ƒ When banks loan out their deposits, they increase the
quantity of money in the economy.
ƒ Because the CB cannot control the amount bankers choose to
lend or the amount households choose to deposit in banks,
the CB’s control of the money supply is imperfect.
ƒ The overall level of prices in an economy adjusts to bring
money supply and money demand into balance.
ƒ When the central bank increases the supply of money, it
causes the price level to rise.
ƒ Persistent growth in the quantity of money supplied leads to
continuing inflation.
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