Unit 13 Money and Banks The Monetary System

Unit 13. Money and Banks. The Monetary System IES Lluís de Requesens (Molins de Rei) Batxillerat Social Economics (CLIL) – Innovació en Llengües Estrangeres Jordi Franch Parella

Money is the medium of exchange generally accepted in the society It has three functions: Medium of exchange Store of value Unit of account Kinds of money: Commodity money (it has intrinsic value: gold, silver. . . ) Fiat money (used as money because of government decree)

Banks Banks receive people's saving in the form of deposits and lend it In a fractional-reserve banking system, banks hold only a fraction of the money deposited and lend the rest. It does mean that banks multiply the money (1/r) created by the Central Bank Deposits are liabilities of the banks, whereas reserves and loans are assets

Monetary Policy The main objective of the Central Banks is to control inflation For doing this, it needs to control the monetary supply ( M 1, M 2, M 3. . . ) But the Central Bank has control only on three instruments: The discount rate The reserve requirement Open-market operations

Monetary Policy Open-market operations When the Central Bank buys government bonds, the money supply increases When the Central Bank sells government bonds, the money supply decreases Reserve requirement Increasing the reserve ratio decreases the money supply Decreasing the reserve ratio increases the money supply

Monetary Policy The discount rate is the interest rate the Central Bank charges banks for loans Increasing the discount rate decreases the money supply Decreasing the discount rate increases the money supply The Central Bank doesn't control the money supply Money that families choose to hold Money that banks choose to lend

Monetary Policy Inflation is the persistent increase in the general level of prices M · V = P · Y (Quantity theory of money) Δ M --> Δ P An increase in the money supply --> the overall price level rises --> the value of money falls The easiest way to increase the money supply is when the Central Bank buys government bonds

Monetary Policy According to some economists (since Hume) monetary changes don't affect real variables (monetary neutrality) However, the process by which the money increases does change real variables (income distribution, relative prices. . . )