Government, Business and

Society
The Monetary System

The Monetary System

Medium of exchange
Barter System: double coincidence of wants
the unlikely occurrence that two people each
have a good or service that the other wants.
As money flows from person to person in the
economy, it facilitates production and trade,
thereby allowing each person to specialize in
what he or she does best and raising
everyones standard of living.

The Meaning of Money

Money

Set of assets in an economy that people regularly use to buy goods and
services from other people
Those few types of wealth that are regularly accepted by sellers in exchange of
goods and services

The functions of money

Medium of exchange

Item that buyers give to sellers when they want to purchase goods and services

Unit of account

Yardstick people use to post prices and record debts

Store of value

Item that people can use to transfer purchasing power from the present to the future

Wealth: total of all stores of value, including money and nonmonetary

assets (Time Value of Money)
Liquidity: Ease with which an asset can be converted into the economys
medium of exchange

The Kinds of Money

Commodity money
Money that takes the form of a commodity with
intrinsic value .

Intrinsic value
Item would have value even if it were not used as
money

Gold standard - Gold as money

Or paper money that is convertible into gold on
demand
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The Kinds of Money

Fiat money
Money without intrinsic value
Used as money because of government decree
To a large extent, the acceptance of fiat money
depends as much on expectations and social
convention as on government decree.

Money in the Economy (Money Stock)

Money stock
Quantity of money circulating in the economy has a powerful influence on many
economic variables.

At the core of monetary policy is regulation of the supply of money. - to keep the
value of money as stable as possible. This value is guaranteed by stabilizing the
money supply, which is measured by the central bank as M1, M2 and M3, each of
which is more broadly defined and less liquid than the previous one.
M1 = cash + coins + checking deposits + traveler's checks.
M2 =M1 +savings deposits+ small (i.e., under $100,000 certificates of deposit)
time deposits + money market deposits + money market mutual funds.
M3 = M2 +large (over $100,000) time deposits.
At any given point in time, the supply of money is a constant. This implies that the
current money supply curve is vertical. Because other measures of money supply
are based upon the most liquid M1, when we discuss the money supply, we focus
on M1. Insight gained from studying the expansion and contraction of M1 can be
applied to M2 and M3.

Money Stock in India

The Reserve Bank of India defines the monetary aggregates as:

M0 (Reserve Money) : Currency in circulation + Bankers deposits with the
RBI + Other deposits with the RBI = Net RBI credit to the Government +
RBI credit to the commercial sector + RBIs claims on banks + RBIs net
foreign assets + Governments currency liabilities to the public RBIs
net non-monetary liabilities.
M1 : Currency with the public + Deposit money of the public (Demand
deposits with the banking system + Other deposits with the RBI).
M2 : M1 + Savings deposits with Post office savings banks.
M3 : M1+ Time deposits with the banking system = Net bank credit
to the Government + Bank credit to the commercial sector + Net
foreign exchange assets of the banking sector + Governments currency
liabilities to the public Net non- monetary liabilities o f the banking
sector (Other than Time Deposits).
M4: M3 + All deposits with post office savings banks (excluding
National Savings Certificates).
Reserve Bank of India controls monetary policy tools like repo,
reverse repo, CRR, SLR to manage money supply in the economy.

Two Measures of the Money Stock for the U.S.

Economy

The two most widely followed measures of the money stock are M1 and M2. This
figure shows the size of each measure in 2009.
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Where is all the currency?

2009: $862 billion currency outstanding
Average adult: holds about $3,653 of currency
Much of the currency is held abroad
Much of the currency is held by drug dealers, tax
evaders, and other criminals

Currency not a particularly good way to hold

wealth
Can be lost or stolen
Doesnt earn interest
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India
Population= 1.22 Billion
M1 24237.40
M2 24701.67
M3 112200.55

80.15
1127.49
123.52

INR Billion
INR Billion
INR Billion

The Central Banking System

Central bank - Institution designed to

Issue of currency
Banker to Government
Bankers Bank and Supervisor
Controller of Credit and Money Supply- Monetary Policy
Exchange Control
Lander of Last Resort
Custodian of Foreign Exchange
Clearing House Function: facilitates banks transactions.
Collection and Publication of Data
Federal Reserve (Fed)- The central bank of the United States
Reserve Bank of India The Central bank of India

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Banks and the Money Supply

Reserves
Deposits that banks have received but have not
loaned out

The simple case of 100% reserve banking

All deposits are held as reserves
Banks do not influence the supply of money

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Fractional-Reserve Banking
Fractional-reserve banking
Banks hold only a fraction of deposits as reserves

Reserve ratio
Fraction of deposits that banks hold as reserves

Reserve requirement
Minimum amount of reserves that banks must
hold; set by the Central Bank

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Fractional-Reserve Banking
Excess reserve
Banks may hold reserves above the legal minimum

Example: First National Bank

Reserve ratio 10%

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Fractional-Reserve Banking
Banks hold only a fraction of deposits in
reserve
Banks create money
Assets
Liabilities

Increase in money supply

Does not create wealth

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The Money Multiplier

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The Money Multiplier

The money multiplier
Original deposit = $100.00
First National lending = $ 90.00 [= .9
$100.00]
Second National lending = $ 81.00 [= .9
$90.00]
Third National lending = $ 72.90 [= .9 $81.00]

Total money supply = $1,000.00

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The Money Multiplier

The money multiplier
Amount of money the banking system generates
with each uni of reserves
Reciprocal of the reserve ratio = 1/R

The higher the reserve ratio

The smaller the money multiplier

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Financial Crisis of 20082009

Bank capital
Resources a banks owners have put into the
institution
Used to generate profit

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Financial Crisis of 20082009

Leverage
Use of borrowed money to supplement existing
funds for purposes of investment

Leverage ratio
Ratio of assets to bank capital

Capital requirement
Government regulation specifying a minimum
amount of bank capital
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Financial Crisis of 20082009

If banks assets rise in value by 5%

Because some of the securities the bank was holding rose in price
$1,000 of assets would now be worth $1,050
Bank capital rises from $50 to $100
So, for a leverage rate of 20
A 5% increase in the value of assets
Increases the owners equity by 100%

If banks assets reduced in value by 5%

Because some people who borrowed from the bank default on their
loans
$1,000 of assets would be worth $950
Value of the owners equity falls to zero
So, for a leverage ratio of 20
A 5% fall in the value of the bank assets
Leads to a 100% fall in bank capital

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Financial Crisis of 20082009

Banks in 2008 and 2009
Shortage of capital

After they had incurred losses on some of their assets

Mortgage loans
Securities backed by mortgage loans

Reduce lending (credit crunch)

Contributed to a severe downturn in economic activity

U.S. Treasury and the Fed

Put many billions of dollars of public funds into the banking system
To increase the amount of bank capital

It temporarily made the U.S. taxpayer a part owner of many banks

Goal: to recapitalize the banking system
Bank lending could return to a more normal level
Occurred by late 2009

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Central Banks Tools of Monetary Control

Influences the quantity of reserves
Open-market operations
Central Bank lending to banks

Influences the reserve ratio

Reserve requirements
Paying interest on reserves

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Tools of Monetary Control

Open-market operations
Purchase and sale of government bonds
To increase the money supply
buys government bonds

To reduce the money supply

sells government bonds

Used more often

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Tools of Monetary Control

Central Bank lending to banks

To increase the money supply

Borrow from discount window and pay an interest rate called the
discount rate
Higher discount rate
Reduce the money supply

Smaller discount rate

Increase the money supply

Term Auction Facility

Sets a quantity of funds it wants to lend; eligible banks bid; loan go to the
highest bidder
Acceptable collateral
Pay the highest interest rate

Uses such lending not only to control the money supply but also help
financial institutions when they are in trouble.

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Tools of Monetary Control

Reserve requirements
Regulations on minimum amount of reserves that
banks must hold against deposits
An increase in reserve requirement
Decrease the money supply

A decrease in reserve requirement

Increase the money supply

Used rarely disrupt business of banking

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Tools of Monetary Control

Paying interest on reserves
The higher the interest rate on reserves
The more reserves banks will choose to hold

An increase in the interest rate on reserves

Increase the reserve ratio
Lower the money multiplier
Lower the money supply

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Instrument of Money Policy- India

Bank Rate:

Open Market Operations:

rate of interest at which the central bank lends to commercial banks. It is, in a way, cost of
borrowing. Cheap credit promotes investment whereas dear money discourages it. In a situation of
excess demand and inflationary pressure, central bank increases the bank rate. High bank rate forces
the commercial banks to raise the rate of interest which makes credit dear. As a result, demand for
loans and other purposes falls.
Thus, increase in bank rate by the central bank adversely affects credit creation by commercial banks.
A decrease in bank rate will have the opposite effect. Bank rate at which banks borrow from RBI is
called repo rate and rate at which banks park their surplus funds with RBI is Reverse Repo Rate .
These refer to buying and selling of government securities by central bank. This is done to influence
money supply in the country. Mind, sale of government securities to commercial banks means flow
of money into the central bank which reduces cash reserves. Consequently, credit availability of
commercial banks is curtailed / controlled. When central bank buys securities, it increases cash
reserves of the banks and their ability to give credit.

Cash Reserve Ratio (CRR):

Commercial banks are required under the law to keep a certain percentage of their total deposits
with the central bank in the form of cash reserves. This is called CRR. It is a powerful instrument to
control credit and lending capacity of the banks.
To curtail the credit giving capacity of the banks, central bank raises the CRR but when it wants to
enhance the credit giving powers of the bank, it reduces the CRR. Similarly, there is another measure
called Statutory Liquidity Ratio or SLR, every bank is required to keep a fixed percentage (ratio) of its
assets in cash called liquidity ratio. SLR is raised to reduce the ability of the banks to give credit. But
SLR is reduced when the situation in the economy demands expansion of credit.

Problems
The Central Banks control of the money
supply is Not precise
The Central Bank
Does not control the amount of money that
households choose to hold as deposits in banks
Does not control the amount that bankers choose
to lend

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Bank runs and the money supply

Bank runs
Depositors suspect that a bank may go bankrupt
Run to the bank to withdraw their deposits

Problem for banks under fractional-reserve banking

Cannot satisfy withdrawal requests from all depositors

When a bank run occurs

The bank - is forced to close its doors until some
bank loans are repaid
Or until some lender of last resort provides it with
the currency it needs to satisfy depositors
Complicate the control of the money supply
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Bank runs and the money supply

Great Depression, early 1930s
Wave of bank runs and bank closings
Households and bankers - more cautious
Households withdrew their deposits from banks
Bankers - responded to falling reserves

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Reducing bank loans,

Increased their reserve ratios
Smaller money multiplier
Decrease in money supply

Bank runs and the money supply

Bank runs today

Not a major problem

The federal / Central government

Guarantees the safety of deposits at most banks

Deposit Insurance Corporation (DIC)

No bank runs

Depositors are confident

DIC will make good on the deposits

Government deposit insurance

Cost:

Bankers - little incentive to avoid bad risks

Benefit:

A more stable banking system

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Call Rate
Call Rate
Interest rate at which banks make overnight loans
to one another
Lender has excess reserves
Borrower needs reserves

A change in call rate

Changes other interest rates

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