1. Chapter Four1 CHAPTER 4 The Monetary System: What It Is and How It Works A PowerPoint  Tutorial To Accompany MACROECONOMICS, 8th Edition N. Gregory Mankiw Tutorial written by: Mannig J. Simidian B.A. in Economics with Distinction, Duke University M.P.A., Harvard University Kennedy School of Government M.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management

2. Chapter Four2 Stock of assets Used for transactions A type of wealth Money As a medium of exchange, money is used to buy goods and services. The ease at which an asset can be converted into a medium of exchange and used to buy other things is sometimes called an asset’s liquidity. Money is the economy’s most liquid asset.

3. Chapter Four3 Inflation is an increase in the average level of prices, and a price is the rate at which money is exchanged for a good or service. Here is a great illustration of the power of inflation: In 1970, the New York Times cost 15 cents, the median price of a single-family home was $23,400, and the average wage in manufacturing was $3.36 per hour. In 2008, the Times cost $1.50, the price of a home was $183,300, and the average wage was $19.85 per hour.

4. Chapter Four4 It serves as a store of value, unit of account, and a medium of exchange. The ease with which money is converted into other things such as goods and services--is sometimes called money’s liquidity.

5. Chapter Four5 Money is the yardstick with which we measure economic transactions. Without it, we would be forced to barter. However, barter requires the double coincidence of wants—the unlikely situation of two people, each having a good that the other wants at the right time and place to make an exchange.

6. Chapter Four6 Fiat money is money by declaration. It has no intrinsic value. Commodity money is money that has intrinsic value. When people use gold as money, the economy is said to be on a gold standard.

7. Chapter Four7 The government may get involved in the monetary system to help people reduce transaction costs. Using gold as a currency is costly because the purity and weight has to be verified. Also, coins are more widely recognized than gold bullion. The government then accepts gold from the public in exchange for gold-certificates— pieces of paper that can be redeemed for actual gold. If people trust that the government will give them the gold upon request, then the currency will be just as valuable as the gold itself—plus, it is easier to carry around the paper than the gold. The end result is that because no one redeems the gold anymore and everyone accepts the paper, they will have value and serve as money.

8. Chapter Four8 The money supply is the quantity of money available in an economy. The control over the money supply is called monetary policy. In the United States, monetary policy is conducted in a partially independent institution called the central bank. The central bank in the U.S. is called the Federal Reserve, or the Fed.

9. Chapter Four9 To expand the money supply: The Federal Reserve buys U.S. Treasury Bonds and pays for them with new money. To reduce the money supply: The Federal Reserve sells U.S. Treasury Bonds and receives the existing dollars and then destroys them. The bearer of the United States Treasury bond is hereby promised the repayment of the principle value plus the interest which it incurs through the terms stated thereof. The United States will justly repay its bearers in its entirety and will not default under any circumstances. Signature of the President ___________________ US. Treasury Bond

10. Chapter Four10 The Federal Reserve controls the money supply in 3 ways: Conducting Open Market Operations (buying and selling U.S. Treasury bonds). Changing the Reserve requirements (never really used). Changing the Discount rate which member banks (not meeting the reserve requirements) pay to borrow from the Fed. The bearer of the United States Treasury bond is hereby promised the repayment of the principle value plus the interest which it incurs through the terms stated thereof. The United States will justly repay its bearers in its entirety and will not default under any circumstances. Signature of the President ___________________ US. Treasury Bond

11. Chapter Four11 How the Quantity of Money is Measured ? Currency (C) Checking accounts Cash M1 + plus money market mutual fund balances, savings deposits, and small time deposits (M2) Demand Deposits (M1)

12. Chapter Four12 M = C + D Money Supply Currency Demand Deposits In this chapter, we’ll see that the money supply is determined not only by the Federal Reserve, but also by the behavior of households (which hold money) and banks (where money is held).

13. Chapter Four13 The deposits that banks have received but have not lent out are called reserves. Consider the case where all deposits are held as reserves: banks accept deposits, place the money in reserve, and leave the money there until the depositor makes a withdrawal or writes a check against the balance. In a 100-percent-reserve banking system, all deposits are held in reserve; thus the banking system does not affect the supply of money. A Sample 100-Percent-Reserve Bank Balance Sheet AssetsLiabilities Reserves $1,000 Deposits $1,000

14. Chapter Four14 Firstbank Balance Sheet Secondbank Balance Sheet Thirdbank Balance Sheet Assets Liabilities Reserves $200 Deposits $1,000 Loans $800 Reserves $128 Deposits $640 Loans $512 Reserves $160 Deposits $800 Loans $640 Assume each bank maintains a reserve-deposit ratio (rr) of 20 percent and that the initial deposit is $1,000. Mathematically, the amount of money the original $1000 deposit creates is: Original Deposit=$1,000 Firstbank Lending= (1- rr)  $1,000 Secondbank Lending= (1- rr) 2  $1,000 Thirdbank Lending= (1- rr) 3  $1,000 Fourthbank Lending= (1- rr) 4  $1,000 Total Money Supply = [1 + (1-rr) + (1-rr) 2 + (1-rr) 3 + …]  $,1000 = (1/rr)  $1,000 = (1/.2)  $1,000 = $5,000 Money and Liquidity Creation (but not wealth creation) Money and Liquidity Creation (but not wealth creation)... The process of transferring funds from savers to borrowers is called financial intermediation. The process of transferring funds from savers to borrowers is called financial intermediation.

15. Chapter Four15 Money Store of value Unit of account Medium of exchange Fiat money Commodity money Gold Standard Money supply Monetary policy Central bank Federal Reserve Open-market operations Currency Demand deposits Reserves 100-percent-reserve banking Balance sheet Fractional-reserve banking Financial intermediation Bank capital Leverage Capital requirement Monetary base Reserve-deposit ratio Currency-deposit ratio Money multiplier High-powered money Discount rate Reserve requirements Excess reserves Interest on reserves