Lecture 7

The Monetary System

(Ch:16; P.O.M.E)
ECO 104
Faculty: Asif Chowdhury

 Money is the accepted medium with which

people exchange goods & services. If there
existed no commonly accepted medium like
money, people would have to rely on Barter
Exchange. In barter system there arises the
problem of Double Coincidence of Wants & an
economy cant allocate resources efficiently. In
a system with an universally accepted
instrument like money, people can specialize
according to what they do best & the overall
standard of living of the economy improves.

The Meaning of Money:

Money: The set of assets in economy
that people regularly uses to buy
goods & services from other people.
Money doesnt reflect total wealth,
rather the part of wealth of a person
that can be used in exchange for
goods & services.

Functions of Money:
Money has three functions in an economy:
Medium of Exchange: An item that buyers give to
sellers when they want to purchase goods &
services.
Unit of Account: the yardstick people uses to post
prices & record debts.
Store of Value: an item that people can use to
transfer purchasing power from the present to the
future.
Liquidity: the ease with which an asset can be
converted into the economys medium of exchange.

Kind of Money:
Commodity Money: money that takes
the form of a commodity (eg. Gold)
Fiat Money: money without intrinsic
value that is used as money because
of government decree.

Categories of Money:
o Money Supply: Quantity of money circulating/
available in the economy.
Thinking in line with the definition of money,
instruments like currency & current account
deposits both come under the classification of
money. To measure the money supply in an
economy distinction needs to be drawn between
monetary assets & non-monetary assets. For the
purpose of this, two general categories , which
include a list of monetary assets, are identified:
M1: Current Account Balance, Travelers Check,
other Checkable Deposits, Currency.

 M2: Saving Deposits, Small Time

Deposits, Mutual Funds, M1.
Note that the listed assets vary
according to degree of liquidity.

The Federal Reserve

System:
The Federal Reserve is the agency that
regulates the system of money circulation in
the economy. Another term for the Fed is the
Central Bank.
Central Bank: An institution designed to
oversee the banking system & regulate the
quantity of money in the economy.
Responsibilities of the CB includes regulating
banks, ensuring health of the banking system.
The CB acts as the lender of last resort.

 The more important responsibility of the CB

involves controlling the money supply.
Monetary Policy: The setting of the money
supply by the policymakers in the Central
Bank.
Division of the Central Bank conducts Open
Market Operation to change money supply.
Open Market Operation: the purchase &
sell of government bonds.

 The Open Market Operation wing of

CB buys government bonds when
they want to increase money supply
in the economy & they sell
government bonds when they want
to decrease money supply in the
economy.

Banks & The Money Supply:

Banks can create money through the banking system.
Reserve: deposits that banks have received but have
not loaned out.
T-account: simplified accounting statement showing
changes in banks assets & liabilities.
Fractional Reserve Banking: a banking system in which
banks holds only a fraction of deposits as reserve.
Reserve Ratio: the fraction of deposits that bank holds
as reserve.
Money Multiplier: the amount of money the banking
system generates with each dollar of reserve.

CB Tools for Monetary Control:

The CB has three tools at its disposal for
controlling the money supply:
Open Market Operation : the purchase and
sale of government bonds by the CB ( affects
currency level & current account deposits.)
Reserve Requirement: Regulation on the
minimum amount of reserve that banks must
hold against deposits.
Discount Rate: the interest rate on the loans
that the CB makes to other banks.

 While controlling the money supply

the CB faces some problems since
the CB cant control the amount of
money the household deposits, also
it cant control the amount of money
the banks choose to lend out.
However it can mitigate the situation
by monitoring of the deposits &
reserves & taking appropriate actions
to maintain the money supply at a