Chapter 2
Money and the Monetary
System
© 2011 John Wiley and Sons
Chapter Outcomes
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
Describe the three ways in which
money is transferred from savers to
businesses
Identify the major components of the
monetary system
Describe the functions of money
Give a brief review of the
development of money in the U.S.
2
Chapter Outcomes
(Continued)




Describe major types of money
market securities
Briefly explain the M1, M2, and M3
definitions of the money supply
Explain possible relationships
between money supply and economic
activity
Comment on developments in the
international monetary system
3
Process of Moving Savings into
Investments


Surplus Economic Unit:
generates more money than it
spends resulting in excess money
Deficit Economic Unit:
generates less money than it spends
resulting in a need for additional
money
4
Savings-Investment Process
Direct Transfers:
Money
Savers
Business
Firm
Securities
Indirect Transfers:
Savers
Money
Securities
Savers
Money
Institution
Securities
Investment
Banking Firm
Financial
Institution
Money
Securities
Money
Firm’s
Securities
Business
Firm
Business
Firm
5
Participants in the U.S.
Monetary System
CENTRAL BANK:
 Defines and Regulates Money Supply
 Facilitates the Transferring of Money
BANKING SYSTEM:
 Creates Money
 Transfers Money
 Provides Financial Intermediation
 Processes/Clears Checks
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The U.S. Monetary System
Central Bank
Federal Reserve System
Board of Governors
Federal Reserve Banks
Facilitates transfer of
money through check
processing/clearing
Defines and regulates
money supply
Banking System:
1. Creates money
2. Transfers money
3. Provides financial intermediation
4. Processes/clears checks
First
Bank
Other
Banks
Last
Bank
7
U.S. Central Bank



Federal Reserve System [often
referred to as the “Fed”]
Board of Governors
Federal Reserve Banks
8
Central Bank Activities


Defines and regulates money supply
Facilitates the transferring of money
through check processing and
clearing
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Importance and Functions of
Money
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
Real Assets:
direct ownership of land, buildings or
homes, equipment, inventories,
durable goods, and precious metals
Financial Assets:
money, debt securities & contracts,
and equity securities backed by real
assets & earning power of issuers
10
Some Basic Definitions
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
MONEY:
anything generally accepted as
payment for goods, services, & debts
BARTER:
exchange of goods or services
without using money
LIQUIDITY:
ease and low cost of exchanging an
asset for money
11
Functions of Money

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
MEDIUM OF EXCHANGE:
the basic function of money
STORE OF VALUE:
money can be held for some period
of time, without losing its value,
before it is spent
STANDARD OF VALUE:
exists when prices and debts are
stated in terms of the monetary unit
12
Development of Money in the U.S.
Historical Types of U.S. Coins:
 FULL-BODIED MONEY:
coins that contain the same value in
metal as their face value
 TOKEN COINS:
coins containing metal of less value
than their stated value
13
Development of Money in the U.S.
Historical Types of Paper Currency:
 REPRESENTATIVE FULL-BODIED
MONEY:
paper money fully backed by a
precious metal
 FIAT MONEY:
legal tender proclaimed to be money
by law--not backed by precious metal
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Deposit Money in the U.S.


CREDIT MONEY:
money worth more than what it is
made of--backed by the creditworthiness of issuer
DEPOSIT MONEY:
special type of credit money backed
by the depository institution that
issued the deposit
15
Alternatives to “Paper Checks”


AUTOMATIC TRANSFER SERVICE
(ATS) ACCOUNTS:
Provide for direct deposits to, and
payments from, checkable deposit
accounts
DEBIT CARDS:
Provide for immediate direct transfer
of deposit amounts & can be used to
make cash withdrawals from ATMs
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Money Market Securities


Money Markets:
markets where debt securities with
maturities of one year or less are
originated (primary markets) or
traded (secondary markets)
Money Market Securities:
debt securities with maturities of one
year or less
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Money Market Securities


Treasury Bill:
short-term debt obligation issued by
the U.S. federal government
Negotiable Certificate of Deposit:
short-term debt instrument issued by
depository institutions that can be
traded in the secondary money
markets
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Money Market Securities
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
Commercial Paper:
short-term unsecured note issued by
a high credit-quality corporation
Banker’s Acceptance:
promise of future payment issued by
an importing firm and guaranteed by
a bank
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Money Market Securities


Repurchase Agreement:
short-term debt security where the
seller agrees to repurchase the
security at a specified price and date
Federal Funds:
very short-term loans between
depository institutions with excess
funds and those needing funds
20
Measures of the U.S. Money Supply
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
M1 Money Supply
M2 Money Supply
M3 Money Supply
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Components of the M1 Definition
of the Money Supply


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Currency
Traveler’s Checks
Demand Deposits at Banks
Other Checkable Deposits at
Depository Institutions
22
Components of the M2 Definition
of the Money Supply
M1 Money Supply plus:
 Savings Accounts
 Small-Denomination Time Deposits
 Money Market Deposit Accounts
(MMDAs)
 Retail Money Market Mutual Funds
(MMMFs)
23
Components of the M3 Definition
of the Money Supply
M2 Money Supply plus:
 Large-Denomination Time Deposits
 Institutional Money Market Mutual
Funds
 Repurchase Agreements (Overnight
and Term)
 Eurodollars (Overnight and Term)
Held by U.S. Residents
24
Money Supply and Economic
Activity


MONETARISTS’ VIEW:
amount of money in circulation
determines the level of economic
activity
KEYNESIANS’ VIEW:
change in money supply first causes
a change in interest rates which then,
in turn, alters the demand for goods
and services
25
Monetarists’ View
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BASIC EQUATION: MS x VM = GDP
GROSS DOMESTIC PRODUCT (GDP):
Measures the output of goods and
services in an economy
MONEY SUPPLY (MS):
Usually defined in terms of M1 or M2
VELOCITY OF MONEY (VM):
The rate of circulation of the money
supply
26
Another View of GDP
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BASIC EQUATION: RO x PL = GDP
GROSS DOMESTIC PRODUCT (GDP):
Measures the output of goods and
services in an economy
REAL OUTPUT (RO):
Units of goods and services
PRICE LEVEL (PL):
Average price of goods and services
27
Two Views of GDP Combined
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TWO BASIC EQUATIONS:
MS x VM = GDP
RO x PL = GDP
THE EQUATIONS COMBINED:
MS x VM = RO x PL
NOMINAL GDP INCREASES WITH:
>An increase in money supply and/or
velocity of money
>An increase in real output and/or price
level
28
International Monetary System



Historically:
Tied to the gold standard
Bretton Woods System (1944):
Agreement to use fixed or pegged
exchange rates tied to the U.S. dollar
or gold
Early 1970s:
Development of a flexible or floating
exchange rate system
29
International Monetary System
Terms


CURRENCY EXCHANGE RATE:
Value of one currency relative to
another
EURO:
A single currency that replaced the
individual currencies of initially
twelve member countries of the
European Union
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Web Links
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www.frbsf.org
www.federalreserve.gov
www.stlouisfed.org
www.treas.gov
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