Ch. 4

Chapter 4
Chapter 4 The Monetary System
• 4-1 What is money?

• 4-2 The role of banks in
the monetary system
• 4-3 How the central
banks influence the
money supply
4-1 Role of money
• Three functions of money

• A store of value
• A unit of account
• A medium of exchange
Origin of money
• Double coincidence of wants and Adam Smith

• Debts existed before money and became the origin of
finance
Debt: The First 5000 Years, 2011

The types of money
• Commodity money
• Gold standard
• Gold exchange standard
• Fiat money
• Money does not have intrinsic value, but government enforces
it as legal tender.
• Virtual currency
Double coincident of wants
Young-i has Apple but wants Banana
Chulsoo has Pear but wants Apple
Puppy has Banana but wants Pear

Barter economy or pure exchange
P P
A B
Money, credit system and digital currency and double
coincident of wants
A B
P
The development of fiat money
• To reduce the transaction cost the government minted gold coins,

easier use than the gold bullion. If people believe the
government’s promise to redeem the paper bills for gold, the bills
are just as valuable as the gold itself. As long as everyone
continues to accept the paper bills in exchange, they will have
value and serve money.
Money in unusual form 1
• Money in a POW Camp
• RA Radford, ” The Economic
Organization of a POW,” Economica
1945.
• Money and social

convention on the Island
of Yap
• Norman Angell, The
Story of Money, 1929
Stokes
• Mackerel Economics in Prison Leads to Appreciation for Oily Fillets WSJ Oct 2, 2008
• … There's been a mackerel economy in federal prisons since about 2004, former
inmates and some prison consultants say. That's when federal prisons prohibited
smoking and, by default, the cigarette pack, which was the earlier gold standard.
Prisoners need a proxy for the dollar because they're not allowed to possess cash. …
After the smokes disappeared, inmates turned to other items on the commissary
menu to use as currency. … Mackerel is hot in prisons in the U.S., but not so much
anywhere else. … Unlike those more expensive delicacies, former prisoners say, the
mack is a good stand-in for the greenback because each pouch costs about $1 and
few -- other than weight-lifters craving protein -- want to eat it. … There are
shortages world-wide, in terms of the catch. Combined with the weak dollar, that's
led to a surging mack. Now, a pouch of mackerel sells for more than $1 in most
commissaries.
• MMT is a heterodox macroeconomic theory that describes
currency as a public monopoly for the government and
Chartalism unemployment as evidence that a currency monopolist is

overly restricting the supply of money needed to pay taxes
and
and satisfy savings desires.
• MMT advocates argue that the government should use fiscal
Modern policy to achieve full employment, creating new money to

fund government purchases.
Monetary • The government spending can grow the economy to its

full capacity, enrich the private sector, eliminate
Theory
unemployment, and finance major programs such as
universal healthcare, free college tuition, and green
energy.
(MMT) • Once the economy reaches full employment the resulting

inflation can be addressed by raising taxes and issuing bonds
to remove excess money.
Critics on MMT
• Money financed government expenditure can easily lead to inflation.

• Korea in the early 1960s
• Inflation did not occur despite $1 trillion QE because other monetary
indicators such as M1 did not increase together. If cash were really
printed by $1 trillion then it would be a different story.
• Hyperinflation episodes
• The government may not create free goods and services.
Crypto currency
• Cryptocurrency or block chain-

based digital currency:
decentralized monetary system
supported by public ledger or
block chain
• Currency that doesn't depend on
trust
• Distrust of the government that
monopolizes the sovereignty
• Cryptocurrency may only serve a

https://coinmarketcap.com
store of value
From
commodity
money to fiat
money
Platform-
based digital
currency
• digital currency used on
the third party payment
and social network
platform
• Stable coin
Central bank
digital currency
(CBDC)
• CBDC potentially
competes with each of
the three existing
forms of money.
• It raises the question

of how the CBDC will
position itself with the
existing forms of
money, supplement or
replacement?
How the quantity of money is controlled: monetary
policy
• Central bank
• Federal Reserve System
• European Central Bank
• Bank of England
• Bank of Japan
• Reserve Bank of Australia
• People’s Bank of China
• Bank of Korea
Monetary policy
• Central banks enforce monetary policy while controlling their

balance sheets.
• As the central bank increases its assets, the money supply increases
accordingly. Conversely, when assets are reduced, the money supply
decreases. Consequently, you may assume that the central bank’s capital
does not matter
• The money supply is a part of the central bank’s liabilities
• Monetary policy may be through the open market, but there are a
variety of instruments available through the central bank window
Central banks’ mandates
• They define the main objectives of the central banks as

prescribed by law.
• Achieve macro-policy goals such as price stability and financial
stability, promoting sustainable and stable economic growth,
maintaining full employment, defending the international value of
the domestic currency
• Protect the financial system as a lender of last resort
How the quantity of money is measures: Monetary
aggregates
• Base money = Cash + Reserves

• M1 = Cash + Demand deposits
• M2 = M1 + Saving deposits
Source: STL. FED

Korea’s
monetary
aggregates
(billion won,
BOK)
FYI Credit cards
and debit cards
4-2 The role of commercial banks in the monetary
system
• 100% reserve banking
• Banks are like cash depositories.
• Fractional reserve banking

• Banks create money by making loans
The 1st bank balance sheet (BS) The 2nd bank BS The 3rd bank BS
Assets Liabilities Assets Liabilities Assets Liabilities
Reserves +200 Deposits +1000 Reserves +160 Deposits +800 Reserves +128 Deposits +640
Loans +800 Loans +640 Loans +512
Reserve deposit ratio 20%

Fractional banking and money creation
• Increase in deposit at commercial banks

2 3
1
1,000 + 0.8 × 1,000 + 0.8 × 1,000 + 0.8 × 1,000 + ⋯ = × 1,000 = 5,000
1 − 0.8
• In a system of fractional-reserve banking banks create money
M1 = Currency + Demand Deposits
• Loan making is a driving force of creating money
• The process of transferring funds from savers to borrowers is called financial
intermediation
Bank capital , leverage and capital requirements
• Why is the soundness of the banks so important?

• If the value of assets (A) fall by 1%, then capital (K) falls to 40
• If A falls by 5%, then K falls to zero
• If A falls by 10%, then it becomes insolvent since K=-50
Commercial bank BS
Assets Liabilities and equity
Reserves 200 Deposits 750
Loans 500 Debt 200
Securities 300 Capital 50
Leverage ratio = 1000/50 = 20

Reserve deposit ratio = 200/750
How central
banks influence
the money
supply
𝑀 = 𝑚𝑀𝐵
Monetary base, M1 and M2
During 2009.1-2018.6 M1<BM

→ 𝑚 < 1 → 𝑟𝑟 ↑ 𝑐𝑟 ↑
Source: STL. FED

Korea’s MB,
M1 and M2
(billion won,
BOK)
How the quantity of money is controlled
Central bank balance sheet (BS) Central bank balance sheet (BS)
Assets Liabilities and capital Assets Liabilities and capital
1. Foreign assets 1. Reserve money
1. Net Foreign assets 1. Reserve money
2. Domestic assets Currency in circulation
Reserves of commercial banks
2. Net Domestic assets Currency in circulation
Reserves of commercial banks
2. Foreign liabilities
2. Non-monetary liabilities
3. Domestic liabilities
Central bank securities
4. Non-monetary liabilities
Others
Central bank securities
Others
Capital Capital
The instruments
of monetary
policy
Composition of assets of FED
• Securities, premiums paid on

securities bought, discounts,
Repurchase agreements, loans
• Central bank liquidity swaps
Source: STL. FED

Composition of liabilities of FED
• Federal Reserve Notes

• Reverse Repurchase Agreements
• Deposits
Source: STL. FED

Composition
of assets of
BOK (billion
won, BOK)
Composition
of liabilities of
BOK (billion
won, BOK)
Problems in
monetary
control
Bank failures and the money
supply in the 1930s

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Chapter 4

Chapter 4 The Monetary System

• 4-1 What is money?

• Three functions of money

• Double coincidence of wants and Adam Smith

Debt: The First 5000 Years, 2011

Young-i has Apple but wants Banana

Chulsoo has Pear but wants Apple

Puppy has Banana but wants Pear

• To reduce the transaction cost the government minted gold coins,

• Money and social

Chartalism unemployment as evidence that a currency monopolist is

• MMT advocates argue that the government should use fiscal

Modern policy to achieve full employment, creating new money to

Monetary • The government spending can grow the economy to its

(MMT) • Once the economy reaches full employment the resulting

• Money financed government expenditure can easily lead to inflation.

• Cryptocurrency or block chain-

• Cryptocurrency may only serve a

• It raises the question

• Central banks enforce monetary policy while controlling their

• They define the main objectives of the central banks as

• Base money = Cash + Reserves

Source: STL. FED

• Fractional reserve banking

Loans +800 Loans +640 Loans +512

Reserve deposit ratio 20%

• Increase in deposit at commercial banks

• Why is the soundness of the banks so important?

Leverage ratio = 1000/50 = 20

During 2009.1-2018.6 M1<BM

Source: STL. FED

• Securities, premiums paid on

Source: STL. FED

• Federal Reserve Notes

Source: STL. FED

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