Introduction to

Money and Monetary Policy

What is Money?
Money not to be confused with wealth or income.
Money is the set of assets used in transactions.
Liquidity is ease with which an asset can be converted into money.
Functions of Money:
Medium of Exchange - facilitates transactions.
Unit of Account - used to quote prices.
Store of Value - transfer purchasing power to future.
Types of Money:
Commodity Money - has intrinsic value.
Fiat Money - value by government decree.

2
Money Measures in the U.S.

Money in U.S. is fiat money.

Three main measures (Values for Jan. 2007) -
C = Currency = $750.5 bn
M1 = C + Travelers Checks + Demand Deposits + Other Checkable
Deposits = $1,371.4 bn
M2 = M1 + Savings Deposits + Small Time Deposits + Money Mkt.
Mutual Funds = $7,081.0 bn

3
 The Money Supply Process
Central bank affects Money Supply through Open Market Operations.
Commercial banks important in Money Supply process.
Money Supply = Currency + Deposits at Banks
Commercial Bank activities:
Accept Deposits : Hold Reserves : Make Loans
Reserves are deposits received but not lent out.
Bank activities summarized by a Bank Balance Sheet
ASSETS LIABILITIES
Reserves Deposits
Loans
Fractional Reserve Banking
BANK ONE Reserve Requirement
Assets Liabilities rr = .2
Reserves $200 Deposits $1,000 D 1 M=+$1,000
Loans $800

BANK TWO
Money Multiplier Assets Liabilities
Process Reserves $160 Deposits $800

Loans $640

BANK THREE D 2 M=(1-rr)(1000) = 800

Assets Liabilities
Reserves $128 Deposits $640

Loans $512 D 3 M=(1-rr)2(1000) = 640

Banks and Money Creation
Banks accept deposits, hold a fraction MONEY CREATION PROCESS
in reserve, then lend out rest. Original Deposit = 1,000
Reserve-deposits ratio minimum is Bank One Lending = (1-rr)x1000
regulated: reserve requirement, rr. Bank Two Lending = (1-rr)2 x1000
New loans made create new deposits, Bank Three Lending = (1-rr)3 x1000
increasing the money supply. and so on _____________
This process is known as financial Total D Ms = [1 + (1-rr) + (1-rr)2
intermediation. + (1-rr)3 + ] x $1,000
= (1/rr) x $1,000 = $5,000
In a fractional reserve banking system, banks
create money.
Instruments of Monetary Policy
Open Market Operations
Purchase or sale of govt bonds by the central bank.
Open Market purchase of bonds by central bank increases monetary base,
and so the money supply.
Reserve Requirements
Govt regulates banks minimum reserve-deposit ratios.
Increase in reserve requirements will lower money multiplier and so
decrease money supply.
Discount Rate
Interest rate on reserves borrowed from central bank.
Lower rate, cheaper borrowed reserves, more banks borrow, thus
increasing money supply.
More Complicated Model of Money Supply
Fractional Reserve Banking and MS
Exogenous Variables of Money Supply Model
Monetary Base, B = Currency, C + Reserves, R.
Reserve-Deposit Ratio, rr: fraction of deposits held as reserves.
Currency-Deposit Ratio, cr: Currency holdings as % of deposits
Definitions:
Monetary Base: B = C + R Money Supply: M = C + D
dividing: M/B = [C + D]/[C+R]
rearranging: M/B = [C/D + 1]/[C/D + R/D]
Model of Ms: M = cr + 1 x B = mm x B
cr + rr
where mm is called the Money Multiplier.
Chapter 18-3