27 The Monetary System For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The Meaning Of Money Bartering is the exchange of one good for another. Bartering requires a double coincidence of wants. Money is the set of assets in an economy that people regularly use to buy goods and services from other people. Money has three functions in the economy: Medium of exchange Unit of account Store of value For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The Functions of Money Medium of Exchange A medium of exchange is an item that buyers give to sellers when they want to purchase goods and services. A medium of exchange is anything that is readily acceptable as payment. Unit of Account A unit of account is the yardstick people use to post prices and record debts. Store of Value A store of value is an item that people can use to transfer purchasing power from the present to the future. Liquidity Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The Kinds of Money Commodity money takes the form of a commodity with intrinsic value. Examples: Gold, silver, cigarettes. Gold standard is a system in which the currency is based on the value of gold and where the currency can be converted to gold on demand. Fiat money is used as money because of government decree. It does not have intrinsic value. Examples: Coins, currency, current account deposits. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Money in the Economy Money stock refers to the quantity of money circulating in the economy. Currency is the paper bills and coins in the hands of the public. Demand deposits are balances in bank accounts that depositors can access on demand by writing a cheque or using a debit card. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Money in the Economy Measures of money stock M1 Demand deposits, Traveler’s checks Other checkable deposits, Currency M2 Everything in M1 Savings deposits, Small time deposits Money market mutual funds A few minor categories For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Figure 1a Three Measures of the Money Stock for the Euro Area in € billions For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The Role Of Central Banks A central bank is an institution designed to oversee the banking system and regulate the quantity of money in the economy. Whenever an economy relies on fiat money, there must be some agency that regulates the system. The agency is known as the central bank. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The Functions of Central Banks Two functions of a central bank are... Macroeconomic stability in maintaining stable growth and prices and through the avoidance of excessive and damaging swings in economic activity. The maintenance of stability in the financial system. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The Functions of Central Banks The Central Bank’s jobs Regulate banks and ensure the health of the banking system Monitors each bank’s financial condition Facilitates bank transactions - clearing checks Acts as a bank’s bank Central Bank – lender of last resort

The Functions of Central Banks The Central Bank’s jobs Control the money supply Quantity of money available in the economy Monetary policy Money supply Quantity of money available in economy Setting of the money supply

The Functions of Central Banks Open market operations refers to the purchase and sale of non- monetary assets from and to the banking sector by the central bank. To increase the money supply, the central bank buys bonds from the public. The amount of currency in the hands of the public is increased. To reduce the money supply, the central bank sells bonds to the public. The amount of currency in the hands of the public is reduced. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The Functions of Central Banks Liquidity is the cash needed to ensure transactions in the financial system are honoured. To maintain financial stability central banks supply liquidity to the rest of the banking system. The central bank can step in as a lender of the last resort. Central banks assess banks’ ability to meet different levels of financial stress and have the power to impose regulations. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

A Banks Balance Sheet Assets include reserves of cash, securities it holds, and loans. Liabilities include demand deposits, savings deposits, borrowings from other banks in the interbank market. Its assets must equal its liabilities plus equity capital. Bank capital Resources a bank’s owners have put into the institution Used to generate profit For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

A Banks Balance Sheet Capital requirement Government regulation specifying a minimum amount of bank capital

Banks And The Money Supply Most banks make profits by accepting deposits and making loans. The difference between the average interest a bank earns on its assets and the average interest rate paid on its liabilities is termed the spread. Banks hold a fraction of the money deposited as reserves and lend out the rest to make their profit. Note that banks operating under Islamic Sharia principles make profits from the sharing of risk and reward between lenders and borrowers. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Banks and the Money Supply Currency + Demand deposits Behavior of banks Can influence the quantity of demand deposits in the economy (and the money supply)

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

The Money Multiplier The money multiplier Amount of money the banking system generates with each dollar of reserves Reciprocal of the reserve ratio = 1/R The higher the reserve ratio The smaller the money multiplier

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

Fractional-Reserve Banking Excess reserve Banks may hold reserves above the legal minimum Example: First National Bank Reserve ratio 10%

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

The Money Multiplier

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

A Banks Balance Sheet Banks also buy and sell a range of assets including bonds. If a bond is purchased from a non-banking sector holder the funds are credited to the seller’s account. This increases the money supply. Equally, if banks sell bonds to the non-banking sector, the buyer’s account is debited with the sum paid and the money supply contracts. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

A Banks Balance Sheet A risk occurs if too many of a bank’s liabilities are short term and borrowers demand their money. Having more long-term debt helps reduce the risk. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

A Banks Balance Sheet Constraints on bank lending. The central bank increases lending rates to the banking system forcing banks to increase the interest rate on lending to maintain spreads. This leads to a reduction in the demand for loans. A reduction in interest rates would be expected to stimulate the demand for loans. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

A Banks Balance Sheet Credit risk is the risk banks take in making loans that borrowers will default. Systemic risk refers to the risk of failure across the whole of the financial sector rather than just to one or two institutions. Macroprundential policy limits the risk across the financial sector by focusing on improving ‘prudential’ standards of operation that enhance stability. Banks must be able to respond to both defaults (credit risk) and increased withdrawals (liquidity risk). The ratio of bank capital in relation to the rest of the bank’s assets is seen as a measure of the financial strength of a bank. It effectively acts as a cushion against financial shocks. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The Central Bank’s Tools Of Monetary Control A central bank has three main tools in its monetary toolbox: Open-market operations. Changing the refinancing rate. Quantitative easing. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Open-Market Operations A central bank conducts open-market operations when it buys government bonds from, or sells government bonds to the public: When the central bank buys government bonds, the money supply increases. The money supply decreases when the central bank sells government bonds. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

The Refinancing Rate The refinancing rate is the interest rate the CB lends on a short-term basis to the banking sector. Increasing the refinancing rate decreases the money supply. Decreasing the refinancing rate increases the money supply. In the USA, the refinancing rate is called the discount rate and in the UK it’s called the repo rate. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Quantitative Easing Having exhausted the use of lowering interest rates the central banks decided on quantitative easing. The purpose of QE is to put banks in a better position to be able to lend and in so doing help to boost demand. The process of QE involves the central bank buying assets. In selling assets to the central bank, institutions will hold more money in relation to other assets. They maintain their portfolios by using the money to buy bonds and shares of companies, which is in effect lending to firms. The issue is whether QE is working or how long it would take to see any measurable effects. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Summary The term money refers to assets that people regularly use to buy goods and services. Money serves three functions in an economy: as a medium of exchange, a unit of account, and a store of value. Commodity money is money that has intrinsic value. Fiat money is money without intrinsic value. It is the function of a central bank to control the money supply through open-market operations, or by changing the refinancing rate, or through quantitative easing. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017

Summary When banks loan out their deposits, they increase the quantity of money in the economy. Macroprundential policies are designed to reduce the risk of a bank run and defaulting. Quantitative easing is when the central bank injects money into banks in order to encourage lending. Because the central bank cannot control the amount bankers choose to lend or the amount households choose to deposit in banks, the central bank’s control of the money supply is imperfect. For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017