▪ Macroeconomics

▪ N. Gregory Mankiw

The Monetary
System: What
It Is and How It
Works
Presentation Slides

▪ © 2019 Worth Publishers, all rights

reserved
 IN THIS CHAPTER, YOU WILL LEARN:

▪ The definition, functions, and

types of money
▪ How banks “create” money?
▪ What a central bank is and
how it controls the money
supply

CHAPTER 4 The Monetary System 1

 WHAT IS MONEY?

CHAPTER 4 The Monetary System 2

 Money: Definition

Money is the stock

of assets that can be
readily used to make
transactions.

CHAPTER 4 The Monetary System 3

 Money: Functions

1. medium of exchange
we use it to buy stuff
2. store of value
transfers purchasing power from the present to
the future
3. unit of account
the common unit by which everyone measures
prices and values

CHAPTER 4 The Monetary System 4

 1. medium of exchange
▪ As a medium of exchange, money is what people
use to buy goods and services.
▪ Example : When you walk into stores, you are
confident that the shopkeepers will accept your
money in exchange for the items you are selling.
▪ The ease with which an asset can be converted into
the medium of exchange and used to buy other
things is called the asset’s liquidity.
▪ Because money is the medium of exchange, it is
the economy’s most liquid asset.

CHAPTER 4 The Monetary System 5

 2. store of value
▪ As a store of value, money is a way to transfer
purchasing power from the present to the future.
▪ Money retains its value over time, so you need not
spend all your money as soon as you receive it.
▪ Example : If you work today and earn $100, you can
hold the money and spend it tomorrow, next week, or
next month.
▪ Money is not a perfect store of value: if prices are
rising, the amount you can buy with any given quantity of
money is falling.
▪ Even so, people hold money because they can trade it
for goods and services at some time in the future.
CHAPTER 4 The Monetary System 6
 3. unit of account

▪ As a unit of account, money provides the terms

in which people quote prices and record debts.
▪ A unit of account is the standard denomination
of money used by investors, economists, and
accountants to measure value.
▪ Example : Km are a unit of measure for length in
the same way that dollars are a unit of account
for value (a VW car costs $30,000,).

CHAPTER 4 The Monetary System 7

 Money: Types

1. Fiat money

2. Commodity money

CHAPTER 4 The Monetary System 8

 1. Fiat Money

▪ Fiat currency is a type of money that has no

intrinsic value and cannot be converted into a
valuable resource.
▪ Example: the paper currency we use
▪ Fiat money is money that authority, generally a
government, has ordered to be accepted as a
medium of exchange which makes it a legal
instrument for all transaction purposes.
▪ Fiat money is the basis of all modern money
systems.
CHAPTER 4 The Monetary System 9
 1. Commodity money

▪ Commodity money : is money that has value apart

from its use as money. It has an intrinsic value.
▪ Gold and silver (coins) are the most widely used forms of
commodity money. Gold and silver can be used as
jewelry and for some industrial purposes, so they have
value apart from their use as money.
▪ Cigarettes in a prison camps (Textbook p.129, case
study on money in a POW camps and how cigarettes
are used as money in POW camps during WWII)
▪ When people use gold as money, the monetary system
economy is said to be on a gold standard.

CHAPTER 4 The Monetary System 10

NOW YOU TRY
Discussion Question
Which of these are money?
a. Currency
b. Checks
c. Deposits in checking accounts
(“demand deposits”)
d. Credit cards
e. Certificates of deposit
(“time deposits”)

11
 NOW YOU TRY
Discussion Question
a. yes
b. No, not the checks themselves, but the funds in
checking accounts are money.
c. yes (see b)
d. No, credit cards are a means of deferring
payment.
e. No, CDs are a store of value, and they are
measured in money units. They are not readily
spendable, though.
CHAPTER 4 The Monetary System 12
 The money supply &
monetary policy : definitions

▪ Money supply : is the quantity of money

available in the economy.
▪ Monetary policy : is the control over the
money supply.

CHAPTER 4 The Monetary System 13

 What Counts as Money?
The quantity of money, amount of money, and supply
of money all refer to the same thing:
▪ The total value of all assets in the economy that can
be used as money (e.g. checks, debit cards, etc are
also be counted as money).
▪ It is denoted M
▪ The dollar value of the currency we carry, C, should
clearly be counted as money
▪ Example : when we do our shopping, we use checks
and debit cards exactly the way we use currency.
Therefore, the dollars that we can spend this way should
also be counted as money.

CHAPTER 4 The Monetary System 14

 The Quantity of Money
▪ There are several prominent measures of the
quantity of money (M)
▪ Two common measures of the quantity of money
in an economy are M1 and M2
Where:
▪ M1: includes currency in circulation, checkable deposits, and
traveler’s checks.
▪ M2 : includes M1 and other deposits such as small savings
deposits (less than $100,000), as well as accounts such as
money market mutual funds (MMMFs) that place limits on the
number or the amounts of the checks that can be written in a
certain period.

CHAPTER 4 The Monetary System 15

 ROLE OF BANKS
IN
THE MONETARY
SYSTEM
CHAPTER 4 The Monetary System 16
 The central bank and monetary control
▪ Monetary policy is conducted by a country’s
central bank.

▪ The U.S.’
central bank
is called the The Federal Reserve
Federal Reserve Building Washington, DC
(“the Fed”).

▪ To control the money supply, the Fed uses

open market operations, the purchase and sale
of government bonds.

CHAPTER 4 The Monetary System 17

Money supply measures, July 2017
(billions of $)

amount
symbol assets included
($ billions)
C Currency 1,486
C + demand deposits,
M1 travelers’ checks, 3,528
other checkable deposits
M1 plus retail money market
mutual fund balances,
M2 savings deposits (including money 13,602
market deposit accounts), and
small-time deposits.
 Money supply measures

▪ The most important thing that you should get

from the previous slide is the following:
▪ Each successive measure of the money supply
is BIGGER and LESS LIQUID than the one it
follows (for example: checking account deposits
(in M1 but not C) are less liquid than currency.
▪ Money market deposit account and savings
account balances (in M2 but not M1) are less
liquid than demand deposits.

CHAPTER 4 The Monetary System 19

 Banks’ role in the monetary system

▪ The money supply equals currency plus

demand (checking account) deposits:
M = C + D
▪ Since the money supply includes demand
deposits, the banking system plays an
important role.

CHAPTER 4 The Monetary System 20

 Banks’ Liabilities :
how do banks get money?
▪ Banks take deposits (D) from depositors
▪ Banks also borrow money (by selling bonds).
This is called their debt
▪ The owners of a bank must also invest their own
money in their bank. This is called the bank’s
capital (or, equity)
▪ Total bank liabilities = deposits + debt
▪ Total bank funds = liabilities + capital
CHAPTER 4 The Monetary System 21
 Banks’ Assets:
what do banks do with their money?
▪ Some of the banks’ funds are kept in the banks’
vaults as reserves (R)
▪ Banks’ funds are also used to make loans
▪ The interest charged is a source of income
▪ … and also to make securities purchases
▪ This too is a source of income
▪ Total bank assets = reserves + loans + securities purchases

CHAPTER 4 The Monetary System 22

 Bank’s Balance Sheet
▪ The bank obtains resources from its owners, who provide capital,
and also by taking in deposits and issuing debt.
▪ It uses these resources in three ways.
▪ Some funds are held as reserves;
▪ some are used to make bank loans;
▪ and some are used to buy financial securities, such
as government or corporate bonds.
The bank allocates its resources among these asset classes,
taking into account the risk and return that each offers.
The reserves, loans, and securities on the left side of the
balance sheet must equal, in total, the deposits, debt, and
capital on the right side of the balance sheet.

CHAPTER 4 The Monetary System 23

 CENTRAL BANKS’
INFLUENCE

CHAPTER 4 The Monetary System 24

 The Central Bank’s Influence

▪ We will now build an algebraic model of

the central bank’s influence on the
monetary system of a country.

CHAPTER 4 The Monetary System 25

 The Central Bank’s Influence

▪ Our first equation is one we have seen already:

M=C+D

▪ All three variables – money supply, currency

held by the public, and demand deposits – will
be considered endogenous

CHAPTER 4 The Monetary System 26

 Monetary Base

▪ The monetary base (B) : is the total number of

dollars held
▪ by the public as currency (C) or
▪ by banks as reserves (R)
▪ So, our second equation is B = C + R
A country’s monetary base is directly determined
by its central bank
B is exogenous; C and R are endogenous

CHAPTER 4 The Monetary System 27

 Money Multiplier
▪ Currency–deposit Ratio (cr):is the amount of currency C
people hold as a fraction of their holdings of demand deposits D.

cr = C/D
It reflects the preferences of households about the form of money
they wish to hold.
▪ Reserve–deposit Ratio (rr) : is the fraction of deposits that
banks hold in reserve.
rr = R/D
It reflects the preferences of households about the form of money
they wish to hold.
Although C and R are endogenous, cr and rr will be
considered exogenous.

CHAPTER 4 The Monetary System 28

 A model of the money supply
exogenous variables (B, rr, and cr)
▪ Monetary base, B = C + R
controlled by the central bank

▪ Reserve-deposit ratio, rr = R/D

depends on regulations & bank policies

▪ Currency-deposit ratio, cr = C/D

depends on households’ preferences
endogenous variables (R, C, D and M)

CHAPTER 4 The Monetary System 29

 Solving for the money supply:

▪ The point of all the next slides algebra is

to express the Money Supply in terms of
the three exogenous variables described
on the preceding slide (B, rr, and cr).

CHAPTER 4 The Monetary System 30

 Solving for the money supply:
C +D
M = C +D = B = m B
B
where
C +D
m = given that : B = C + R
B

=
C +D
=
(C D ) + (D D ) given that :
rr = R/D
C +R (C D ) + (R D ) &
cr + 1 cr = C/D
=
cr + rr
CHAPTER 4 The Monetary System 31
 Solving for the money supply:
cr + 1 , we obtain : M = cr + 1 x B
So, m =
cr + rr cr + rr
▪ This equation shows how the money supply
depends on the three exogenous variables (B, rr,
and cr)
▪ We can now see that the money supply is
proportional to the monetary base.
▪ The factor of proportionality, (cr+1)/(cr+rr), is
denoted m and is called the money multiplier.

CHAPTER 4 The Monetary System 32

 The money multiplier
cr + 1
M = m B, where m =
cr + rr
▪ Note that 0 < rr < 1, it must be that m > 1
▪ If monetary base changes by ΔB,
then ΔM = m × ΔB
▪ m is the money multiplier,
the increase in the money supply resulting from a
one-dollar increase in the monetary base.
Means that each dollar of the monetary base
produces m dollars of money.
CHAPTER 4 The Monetary System 33
NOW YOU TRY
The money multiplier
cr + 1
M = m B , where m =
cr + rr
Suppose households decide to hold more of their
money as currency and less in the form of demand
deposits.
1. Determine the impact on money supply.
2. Explain the intuition for your result.

34
 SOLUTION
The money multiplier
Note :
▪ An increase in cr raises both the numerator and
denominator of the expression for m.
▪ But since rr < 1, the denominator is smaller than the
numerator,
▪ So, a given increase in cr will increase the
denominator proportionally more than the numerator,
causing a decrease in m.

CHAPTER 1 The Science of Macroeconomics 35

SOLUTION
The money multiplier
Impact of an increase in the currency-deposit ratio
Δcr > 0.
1. An increase in cr increases the denominator
of m proportionally more than the numerator.
So m falls, causing M to fall.
2. If households deposit less of their money,
then banks can’t make as many loans,
so the banking system won’t be able to
create as much money.

36
 The money supply depends on what ?
▪ Here’s a numerical example. Suppose that the monetary
base B is $800 billion, the reserve–deposit ratio rr is 0.1,
and the currency–deposit ratio cr is 0.8.
▪ In this case, the money multiplier is:

Each dollar of the monetary base generates two dollars of

money, so the total money supply is :
M = 2.0 x $800 billion = $1,600 billion.
▪ We can now see how changes in the three exogenous
variables (B, rr, and cr )cause the money supply to change.

CHAPTER 1 The Science of Macroeconomics 37

 The money supply depends on :
1. The money supply is proportional to the monetary base (B).
Thus, an increase in the monetary base increases the
money supply by the same percentage.
2. The lower the reserve–deposit ratio, the more loans banks make,
and the more money banks create from every dollar of reserves.
Thus, a decrease in the reserve–deposit ratio raises the
money multiplier and the money supply.
3. The lower the currency–deposit ratio, the fewer dollars of the
monetary base the public holds as currency, the more base
dollars banks hold as reserves, and the more money banks can
create.
Thus, a decrease in the currency–deposit ratio raises the
money multiplier and the money supply.

CHAPTER 1 The Science of Macroeconomics 38

 The instruments of monetary policy
The Fed can change the monetary base using:
▪ the open market operations : (the Fed’s
preferred method of monetary control).
To increase the base, the Fed could buy
government bonds, paying with new dollars.
▪ the discount rate : the interest rate the Fed
charges on loans to banks.
To increase the base, the Fed could lower the
discount rate, encouraging banks to borrow
more reserves.

CHAPTER 4 The Monetary System 39

 Open-market & Discount Rate :
Definitions
▪ Open-market operations are the purchases and sales of government
bonds (securities) in the open market by the Federal Reserve (Fed).
open market operations is one of the Fed's policy tools frequently
used to expand the money supply and support economic activity or
contract the money supply and slow that activity.
▪ The discount rate : Banks can borrow from the Fed in various ways.
Traditionally, banks have borrowed at the Fed’s so-called discount
window; the discount rate is the interest rate that the Fed charges on
these loans.
The lower the discount rate, the cheaper are borrowed reserves,
and the more banks borrow at the Fed’s discount window. Hence, a
reduction in the discount rate raises the monetary base and the
money supply.

CHAPTER 4 The Monetary System 40

 The instruments of monetary policy
The Fed can change the reserve-deposit ratio
using :
▪ reserve requirements: Fed regulations that
impose a minimum reserve-deposit ratio.
To reduce the reserve-deposit ratio,
the Fed could reduce reserve requirements.

▪ interest on reserves: the Fed pays interest on

bank reserves deposited with the Fed.
To reduce the reserve-deposit ratio,
the Fed could pay a lower interest rate on
reserves.
CHAPTER 4 The Monetary System 41
 Reserve Requirements &
Interest On Reserves : Definitions
▪ Reserve requirements: Regulations imposed on banks by the central bank
that specify a minimum reserve–deposit ratio.
An increase in reserve requirements tends to raise the reserve –
deposit ratio and thus lower the money multiplier and the money supply.
Changes in reserve requirements are the least frequently used of
the Fed’s policy instruments.
Reserves above the minimum required are called excess reserves.
▪ Interest on reserves : The central bank’s policy of paying banks an interest
rate for the deposits that they hold as reserves.
That is, when a bank holds reserves on deposit at the Fed, the Fed
now pays the bank interest on those deposits.
This change gives the Fed another tool with which to influence the
economy. The higher the interest rate on reserves, the more reserves
banks will choose to hold.

CHAPTER 4 The Monetary System 42

 CHAPTER SUMMARY

Money
▪ def: the stock of assets used for transactions
▪ functions: medium of exchange, store of value,
unit of account
▪ types: commodity money (has intrinsic value),
fiat money (no intrinsic value)
▪ money supply controlled by central bank

43
 CHAPTER SUMMARY
Fractional reserve banking creates money because
each dollar of reserves generates many dollars of
demand deposits.
The money supply depends on the:
▪ monetary base
▪ currency-deposit ratio
▪ reserve ratio
The Fed can control the money supply with:
▪ open market operations
▪ the reserve requirement
▪ the discount rate
▪ interest on reserves 44
 CHAPTER SUMMARY

Bank capital, leverage, capital requirements

▪ Bank capital is the owners’ equity in the bank.
▪ Because banks are highly leveraged, a small
decline in the value of bank assets can have a
huge impact on bank capital.
▪ Bank regulators require that banks hold sufficient
capital to ensure that depositors can be repaid.

45