Macroeconomics

The Monetary System

 What is Money?
• Money is the set of assets in an economy that people
regularly use to buy goods and services from other
people.
• Money is whatever is generally accepted in exchange
for goods and services — accepted not as an object to
be consumed but as an object that represents a
temporary abode of purchasing power to be used for
buying still other goods and services.
— Milton Friedman (1992)

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The Functions of Money

• Money has three functions in the economy:

• Medium of exchange
• Unit of account
• Store of value

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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.

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The Functions of Money

• 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.

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The Kinds of Money

• Commodity money takes the form of a

commodity with intrinsic value.
• Examples: Gold, silver, cigarettes.

• Fiat money is used as money because of

government decree.
• It does not have intrinsic value.
• Examples: Coins, currency, check deposits.

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 16 th
Why is Money Valuable? edition
Gwartney-Stroup
Sobel-Macpherson

• The main thing that makes money valuable is the same

thing that generates value for other commodities:
• the demand (for money) relative to its supply.

• People demand money because it reduces the transaction

cost of exchange.

• If the purchasing power of money is to remain stable over

time, its supply must be limited.
• When the supply of money grows rapidly relative to
goods and services, its purchasing power will fall.
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Money 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 check.

© 2007 Thomson South-Western

 16 th
edition

How the Money Supply is Measured Gwartney-Stroup

Sobel-Macpherson

• Two basic measurements of the money supply are M1 and M2.

• The components of M1 are:
• currency,
• checking deposits (including demand deposits and
interest-earning checking deposits), and,
• traveler's checks.
• M2 (a broader measure of money) includes:
• M1,
• savings deposits,
• time deposits, and,
• money market mutual funds.
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 Ambiguities in the
Meaning and Measurement
of the Money Supply

16 th
edition
Gwartney-Stroup
Sobel-Macpherson

Copyright ©2017 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page
 16 th
edition

The Changing Nature of Money Gwartney-Stroup

Sobel-Macpherson

• In the past, economists have often used the growth rate

of the money supply to measure the direction of monetary
policy.
• Rapid growth was indicative of expansionary monetary
policy, while,
• slow growth (or a contraction in the money supply)
was indicative of restrictive policy.
• Recent financial innovations and structural changes have
changed the nature of money and reduced the reliability
of money growth figures as an indicator of monetary
policy.

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The Changing Nature of 16 th
edition

Money in Recent Decades Gwartney-Stroup

Sobel-Macpherson

• Widespread use of the dollar abroad:

At least one-half and perhaps as much as two-thirds of U.S.
currency is held abroad. These dollars are included
in the M1 money supply even though they are not circulating in
the U.S..

• Substitution of electronic payments for checks and cash:

Increased use of debit cards & various forms of electronic
money have reduced the demand for currency. Like other
changes in the nature of money, these innovations have
reduced the reliability of the money supply figures as an
indicator of monetary policy.

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 Figure 1 Two Measures of the Money Stock for the U.S.
Economy
Billions
of Dollars
M2
$6,398
• Savings deposits
• Small time deposits
• Money market
mutual funds
• A few minor categories
($5,035 billion)

M1
$1,363
• Demand deposits
• Everything in M1
• Traveler’s checks
($1,363 billion)
• Other checkable deposits
($664 billion)
• Currency
($699 billion)
0
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 The central bank

 Monetary policy is conducted by a country’s

central bank.

 In the U.S.,
the central bank
is called the
Federal Reserve
(“the Fed”).

The Federal Reserve Building

Washington, DC
slide 14
Regulators of the Financial System in Bangladesh
• Bangladesh Bank acts as the Central Bank of Bangladesh
which was established on December 16, 1971 through the
enactment of Bangladesh Bank Order 1972- President’s Order
No. 127 of 1972 (Amended in 2003).

• The general superintendence and direction of the affairs and

business of BB have been entrusted to a 9 members' Board of
Directors which is headed by the Governor who is the Chief
Executive Officer of this institution as well. BB has 45
departments and 10 branch offices.

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The functions of BB
The main functions of BB are (Section 7A of BB Order, 1972) -
•to formulate and implement monetary policy;
•to formulate and implement intervention policies in the foreign
exchange market;
•to give advice to the Government on the interaction of monetary
policy with fiscal and exchange rate policy, on the impact of
various policy measures on the economy and to propose legislative
measures it considers necessary or appropriate to attain its
objectives and perform its functions;
•to hold and manage the official foreign reserves of Bangladesh;
•to promote, regulate and ensure a secure and efficient payment
system, including the issue of bank notes;
•to regulate and supervise banking companies and financial
institutions.
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The Monetary policyof Central Bank
Monetary policy
The main objectives of monetary policy of Bangladesh Bank are:
•Price stability both internal & external
•Sustainable growth & development
•High employment
•Economic and efficient use of resources
•Stability of financial & payment system
Bangladesh Bank declares the monetary policy by issuing
Monetary Policy Statement (MPS) twice (January and July) in a
year. The tools and instruments for implementation of monetary
policy in Bangladesh are Bank Rate, Open Market Operations
(OMO), Repurchase agreements (Repo) & Reverse Repo,
Statutory Reserve Requirements (SLR & CRR).
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BANKS AND THE MONEY SUPPLY

• Banks can influence

the quantity of
demand deposits in
the economy and the
money supply.

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BANKS AND THE MONEY SUPPLY

• Reserves are deposits that banks have received

but have not loaned out.
• In a fractional-reserve banking system, banks
hold a fraction of the money deposited as
reserves and lend out the rest.

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BANKS AND THE MONEY SUPPLY

• The reserve ratio is

the fraction of
deposits that banks
hold as reserves.

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Money Creation with Fractional-Reserve
Banking
• When a bank makes a loan from its reserves,
the money supply increases.
• The money supply is affected by the amount
deposited in banks and the amount that banks
loan.
• Deposits into a bank are recorded as both assets and
liabilities.
• The fraction of total deposits that a bank has to keep
as reserves is called the reserve ratio.
• Loans become an asset to the bank.

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Banking Money Creation with Fractional-
Reserve
• This T-Account First National Bank
shows a bank that…
Assets Liabilities
• accepts deposits,
• keeps a portion Reserves Deposits
as reserves, $10.00 $100.00
• and lends out
the rest. Loans
$90.00
• It assumes a
reserve ratio Total Assets Total Liabilities
of 10%. $100.00 $100.00

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Money Creation with Fractional-Reserve
Banking

• When one bank loans money, that money is

generally deposited into another bank.

• This creates more deposits and more reserves to

be lent out.

• When a bank makes a loan from its reserves,

the money supply increases.

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The Money Multiplier

• How much money is eventually created by the

new deposit in this economy?

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The Money Multiplier

• The money multiplier is the amount of money

the banking system generates with each dollar
of reserves.

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The Money Multiplier

Increase in the Money Supply = $190.00!

First National Bank Second National Bank
Assets Liabilities Assets Liabilities

Reserves Deposits Reserves Deposits

$10.00 $100.00 $9.00 $90.00

Loans Loans
$90.00 $81.00

Total Assets Total Liabilities Total Assets Total Liabilities

$100.00 $100.00 $90.00 $90.00

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The Money Multiplier

Original deposit = $100.00

• 1st Natl. Lending = 90.00 (=.9 x $100.00)
• 2nd Natl. Lending = 81.00 (=.9 x $ 90.00)
• 3rd Natl. Lending = 72.90 (=.9 x $ 81.00)
• … and on until there are just pennies left to
lend!
• Total money created by this $100.00 deposit is
$1000.00. (= 1/.1 x $100.00)

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The Money Multiplier

• The money multiplier is the reciprocal of the

reserve ratio:
M = 1/R
• Example:
• With a reserve requirement, R = 20% or .2:
• The money multiplier is 1/.2 = 5.

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