Monetary System Study Notes

The Monetary System

Learning Outcomes

• Define the three functions of money: Medium of exchange, Unit of account, Store of value.

• Identify the responsibilities of the ECB and Central Bank.

• Explain the role of monetary policy in governing an economy.

Calculate the value of the money multiplier using the reserve ratio.

The meaning of money

• Money: set of assets in an economy that people use to buy goods and services from other people

• Liquidity: Measure of how easily an asset can be converted into cash.

The Functions of Money

1. Medium of Exchange:

   • Given by buyers to sellers when they want to purchase goods and services

2. Unit of Account:

   • Serves as a standard numerical unit of measurement to set prices and record debts.

3. Store of Value:

   • Items that people can use to transfer purchasing power from the present to the future

Kinds of Money

• Commodity Money:

  • Physical goods with intrinsic value (e.g., gold, silver).

    • intrinsic value - item would still have value even if it is not used as money

• Gold Standard: Paper money convertible to gold on demand

• Fiat Money:

  • Money without intrinsic value

  • used as money because of government decree (e.g., U.S. Dollar).

Money in the Economy

• Money Stock: Total quantity of money circulating in the economy.

  • Is a good indicator of economic activity and can be a leading indicator of future inflation

• Money Supply: paper bills and coins in the hands of the public

• Demand deposits : balances in bank accounts

depositors can access on demand by writing a cheque.

• Monetary policy : the setting of the money supply

Role of Central Bank:

• Oversees the banking system

  • Regulates money supply and ensures financial stability.

Central Bank Responsibilities

• European Central Bank (ECB):

  ROLES:

  • To manages the euro

  • implements EU monetary policy

  • Maintain price stability

Tools of Monetary Policy:

• Reserve Requirement: Percentage of deposits banks must hold in reserve.

• Open Market Operations: Selling/buying government securities to control money supply.

• Discount Rate: Interest rate charged to banks for loans from the central bank.

What does the ECB do?

• Sets interest rates

• Manages the eurozone’s foreign currency reserves

• Ensures that financial markets/institutions are supervised by national authorities

Money Supply Definitions

• Narrow Money Supply (M1): Currency in circulation plus immediate withdrawable deposits

  • (banknotes, coins and bank deposits that customers can withdraw quickly.

• Broad Money Supply (M2):

  • M1 plus deposits redeemable at up to 3 months and deposits with an agreed maturity of up to two years

• Broader money supply (M3/M3E)

  • M1 plus deposit account balances up to 2 years

  • Adds narrow money supply (M1) to other forms of money that can be readily converted to cash

Money Creation

• Fractional Reserve Banking:

  • Banks keep a fraction of deposits as reserves and lend out the remainder (reserves + loans = money supply).

• Reserve ratio : fraction of deposits that banks hold as reserves

• Minimum reserve requirements : the minimum amount of reserves that banks must hold

The Money Multiplier Effect

• Formula: Money Multiplier = 1/Reserve Ratio.

• Example: Original deposit = €100

  • First national lending = €90 (0.9 x €100)

  • Second national lending = €81 (0.9 x €90)

  • Third national lending = €72.90 (0.9 x €81)

  • Total money supply = €1,000

Loanable Funds Market

• Definition: Market where savers supply funds and borrowers demand funds for investment.

• Interest Rates:

  • Higher interest rates lead to lower quantity demanded for loans and higher quantity supplied.

Government Policies Affecting Saving and Investment

• Saving Incentives: Policies that increase saving supply shift the curve right, lowering interest rates.

• Investment Incentives: Policies increasing demand for loans shift the demand curve right.

• Budget Surplus : excess of tax revenue over government spending

• Budget Deficits: shortfall of tax revenue from government spending

Saving and Investment Identity

• Accounting Identity: S (saving) = I (investment).

• National savings can finance investment, indicating an economy's health.

• T = Taxes minus transfer payments

• Private Saving : (Y - T - C) Income that households have left after paying for taxes and consumption

• Public Saving: (T - G) Tax revenue that the government has left after paying for it’s spending

Learning Outcomes

• Three Functions of Money:

  • Medium of Exchange: Facilitates transactions.

  • Unit of Account: Measures and compares the value of goods and services.

  • Store of Value: Preserves purchasing power over time.

• Responsibilities of the ECB and Central Bank:

  • Manage monetary policy, currency supply, and ensure financial stability.

• Role of Monetary Policy:

  • Influences economic activity through interest rates and money supply management.

• Money Multiplier Calculation:

  • Formula: Money Multiplier = 1/Reserve Ratio.

  • Example: With a 10% reserve ratio, $100 deposit can generate $1,000 in the economy.