The Monetary System Sherif Khalifa Sherif Khalifa () The Monetary System 1 / 33
Money is the set of assets in an economy that people use to buy goods and services from other people. Money is the stock of assets that can be used to make transactions. Sherif Khalifa () The Monetary System 2 / 33
In a barter economy, trade requires the double coincidence of wants, the unlikely happenstance of two people each having a good that the other wants at the right time and place to make an exchange. Without money, trade would require barter which is the exchange of one good or service for another. Every transaction would require a double coincidence of wants or the unlikely occurrence that two people each have a good the other wants. Most people would have to spend time searching for others to trade with, which is a waste of scarce resources. Sherif Khalifa () The Monetary System 3 / 33
A medium of exchange is an item that buyers give to sellers when they purchase goods and services. As a medium of exchange, money is what we use to buy goods and services. Because money is the medium of exchange, it is the economy s most liquid asset. A unit of account is the yardstick people use to post prices and record debts. As a unit of account, money provides the terms in which prices are quoted and debts are recorded. A store of value is an item that people can use to transfer purchasing power from the present to the future. Money is not a perfect store of value, because if prices are increasing the amount you can buy with a given quantity of money is decreasing. Sherif Khalifa () The Monetary System 4 / 33
Commodity money is money that takes the form of a commodity with intrinsic value. Intrinsic value means that the item would have value even if it were not used as money. Sherif Khalifa () The Monetary System 5 / 33
Fiat money is money without intrinsic value, used as money because of government decree. A fiat is an order or decree, and fiat money is established by government decree. Sherif Khalifa () The Monetary System 6 / 33
M1 is a measure of money supply. M1 includes currency, demand deposits, traveler s checks, and other checkable deposits. Currency includes 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. Sherif Khalifa () The Monetary System 7 / 33
Central Bank A Central Bank is an institution designed to oversee the banking system, ensure the health of the banking system as a lender of last resort, and control the quantity of money in the economy. Monetary policy is the setting of the money supply by policy makers in the central bank. Money supply is the quantity of money available in the economy. Sherif Khalifa () The Monetary System 8 / 33
Central Bank The Federal Reserve is the Central bank of the United States. Board of Governors (7 members), located in Washington, DC. 12 regional Fed banks, located around the United States. Federal Open Market Committee (FOMC), includes the Board of Governors and presidents of some of the regional Fed banks. Sherif Khalifa () The Monetary System 9 / 33
Open Market Operations Open market operations are the purchase and sale of government bonds by the Federal Reserve. To increase the money supply, the Fed buys bonds from the public in the bond markets. The dollars the Fed pays for the bonds increase the number of dollars in the economy. To decrease the money supply, the Fed sells bonds to the public in the bond markets. The public pays for these bonds which decreases the amount of money in circulation. Sherif Khalifa () The Monetary System 10 / 33
Open Market Operations US. Treasury Bond 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 Federal Reserve Sherif Khalifa () The Monetary System 11 / 33
Open Market Operations US. Treasury Bond 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 Federal Reserve Sherif Khalifa () The Monetary System 12 / 33
Reserve Requirements Fractional reserve banking is a banking system in which banks hold only a fraction of deposits as reserves. The fraction of total deposits that a bank holds as reserves is called the reserve ratio. The Central Bank sets a minimum amount of reserves that banks must hold called a reserve requirement. Banks may hold reserves above the legal minimum called excess reserves. Sherif Khalifa () The Monetary System 13 / 33
Reserve Requirements First Bank Assets Liabilities Reserves $100 Deposits $100 Money supply=demand deposits+currency=$100+$0=$100. Sherif Khalifa () The Monetary System 14 / 33
Reserve Requirements First Bank Assets Liabilities Reserves $10 Deposits $100 Loans $90 Money supply=demand deposits+currency=$100+$90=$190. Sherif Khalifa () The Monetary System 15 / 33
Reserve Requirements Second Bank Assets Liabilities Reserves $9 Deposits $90 Loans $81 Money supply=demand deposits+currency=$100+$90+$81=$271. Sherif Khalifa () The Monetary System 16 / 33
Reserve Requirements Third Bank Assets Liabilities Reserves $8.1 Deposits $81 Loans $72.9 Money supply=demand deposits+currency=$100+$90+$81+$72.9=$344 Sherif Khalifa () The Monetary System 17 / 33
Reserve Requirements Money multiplier is the amount of money the banking system generates with each dollar of reserves. The money multiplier is the reciprocal of the reserve ratio. Reserve ratio=10%. Money multiplier = 1 Reserve ratio = 1 0.1 = 10 You deposit $100 in a bank Final money supply = Initial money supply x Money multiplier = $100x10 = $1000 Sherif Khalifa () The Monetary System 18 / 33
Reserve Requirements Reserve ratio=5%. Money multiplier = = You deposit $100 in a bank 1 Reserve ratio 1 0.05 = 20 Final money supply = Initial money supply x Money multiplier = $100x20 = $2000 Sherif Khalifa () The Monetary System 19 / 33
Reserve Requirements An increase in reserve requirements means that banks must hold more reserves, and can loan out less of each dollar that is deposited. As a result it increases the reserve ratio, decreases the money multiplier and decreases the money supply. A decrease in the reserve requirements means that banks must hold less reserves, and can loan out more of each dollar that is deposited. As a result it decreases the reserve ratio, increases the money multiplier and increases the money supply. Sherif Khalifa () The Monetary System 20 / 33
A bank borrows from the Central Bank when it has few reserves to meet its reserve requirements. This is because it made too many loans or experienced unexpectedly high withdrawals. A higher discount rate discourages banks from borrowing from the Central Bank. An increase in the discount rate decreases the quantity of reserves in the banking system, which in turn decreases the money supply. A lower discount rate encourages banks to borrow from the Central Bank. A decrease in the discount rate increases the quantity of reserves in the banking system, which in turn increases the money supply. Sherif Khalifa () The Monetary System 21 / 33 Monetary System The Discount Rate The discount rate is the interest rate on the loans that the Central Bank makes to banks.
Classical Theory of Inflation Inflation is more about the value of money than about the value of products. Inflation is an economy-wide phenomenon that concerns the value of the economy s medium of exchange. An increase in the price level means a lower value of money, because each dollar buys a smaller quantity of goods and services. If P measures the number of dollars needed to buy a basket of goods and services, then the quantity of goods and services that can be bought with $1 equals 1 P. Sherif Khalifa () The Monetary System 22 / 33
Classical Theory of Inflation The supply and demand for money determines the value of money. The Central Bank, with the banking system, determines the supply of money. The demand for money reflects how much wealth people want to hold in liquid form. The higher prices are, the more money the typical transaction requires, and the more money people will choose to hold. In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply. Sherif Khalifa () The Monetary System 23 / 33
Classical Theory of Inflation Value of Money, 1/P As the value of 1 money rises, the price level falls. 1 Price Level, P ¾ 1.33 ½ 2 ¼ 4 CHAPTER 17 MONEY GROWTH AND INFLATION Quantity of Money Sherif Khalifa () The Monetary System 24 / 33
Classical Theory of Inflation Value of Money, 1/P 1 MS 1 Price Level, P 1 ¾ ½ ¼ The Fed sets MS at some fixed value, regardless of P. 1.33 2 4 $1000 Quantity of Money Sherif CHAPTER Khalifa () 17 MONEY GROWTH The AND Monetary INFLATION System 25 / 33
Classical Theory of Inflation Value of Money, 1/P 1 ¾ ½ ¼ A fall in value of money (or increase in P) increases the quantity of money demanded: MD 1 Price Level, P 1 1.33 2 4 Quantity of Money Sherif Khalifa () The Monetary System 26 / 33
Classical Theory of Inflation Value of Money, 1/P 1 MS 1 P adjusts to equate quantity of money demanded with money supply. Price Level, P 1 eq m value of money ¾ ½ ¼ A MD 1 1.33 2 4 eq m price level $1000 Quantity of Money Sherif CHAPTER Khalifa () 17 MONEY GROWTH TheAND Monetary INFLATION System 27 / 33
Classical Theory of Inflation Value of Money, 1/P MS 1 MS 2 Price Level, P 1 1 ¾ 1.33 ½ A 2 ¼ B MD 1 4 $1000 $2000 Quantity of Money Sherif Khalifa () The Monetary System 28 / 33
Classical Theory of Inflation As the Central Bank increases money supply, people have more dollars than they want. The injection of money causes increases in the demand for goods and services. The economy s ability to supply goods and services has not changed. The greater the demand for goods and services causes the prices of goods and services to increase. The increase in the price level increases the quantity of money demanded because people are using more dollars for every transaction. Sherif Khalifa () The Monetary System 29 / 33
Classical Theory of Inflation V: Velocity of money. M: Money supply. P: Price Level. Y: Real GDP. PY: Nominal GDP. MxV = PxY % M + % V = % P + % Y Sherif Khalifa () The Monetary System 30 / 33
Classical Theory of Inflation Economy produces 100 pizzas in a year for $10 each. The quantity of money is $50. V = 10x100 = 20 50 People spend a total of $1000 per year on pizza. For this $1000 of spending to take place with only $50 of money, each dollar bill must change hands on average 20 times per year. Sherif Khalifa () The Monetary System 31 / 33
Classical Theory of Inflation U.S. Nominal GDP, M2, and Velocity (1960=100) 1960 2005 2500 2000 Velocity is fairly stable over time. 1500 1000 Nominal GDP M2 500 Velocity 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Sherif Khalifa () The Monetary System 32 / 33
Classical Theory of Inflation The velocity of money is stable over time. The economy s output of goods and services is determined by factors of production and the available technology. When the Central Bank alters M, these changes are reflected in changes in the price level P. When the Central Bank increases the money supply, the result is a high rate of inflation. Sherif Khalifa () The Monetary System 33 / 33