06 The Monetary System

Lecture from: 21.10.2025 | Video: Video ETHZ

Introduction: Student Preferences and Job Search

A recent survey revealed interesting insights into student priorities:

• Key Insight: While salary is crucial, 1 in 6 students prioritize other factors.
• Values Matter: Students are willing to sacrifice ~7% of salary for a “green job”.

This highlights that job search is a complex matching process. However, salary remains the common denominator, serving as a segue into the mechanism that underpins all transactions: the monetary system.

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Recapping the Financial System

The Market for Loanable Funds was introduced as a model to coordinate saving and investment.

Component	Description	Slope Reason
Supply (Savers)	Households with extra income lending it out.	Upward: Higher interest rates incentivize saving.
Demand (Borrowers)	Firms/households borrowing for investment.	Downward: Higher interest rates increase the cost of borrowing.
Price	Real Interest Rate ($r$)	Balances supply and demand.

Government Policy Effects

Policies shift these curves, altering the equilibrium interest rate and investment level.

1. Saving Incentives (Tax Cut on Interest): Supply shifts right $\to$ Interest rate falls, Investment rises.
2. Investment Incentives (Tax Credit): Demand shifts right $\to$ Interest rate rises, Saving rises.
3. Budget Deficits ($G>T$): Government borrowing absorbs available funds. Supply shifts left $\to$ Interest rate rises, Investment falls. This is crowding out.

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The Monetary System

Previous analyses assumed a “real” economy (potatoes traded for potatoes). Now, money is introduced.

The Meaning of Money

Money is the set of assets in an economy regularly used to buy goods and services. Without it, a barter economy would exist, requiring a double coincidence of wants (finding someone who has what is wanted AND wants what is offered). Money solves this efficiency problem.

The Three Functions of Money

Function	Description	Example
1. Medium of Exchange	Item given to sellers when purchasing goods.	Paying CHF 5 for coffee.
2. Unit of Account	Yardstick used to post prices and record debts.	”This coffee costs CHF 5.”
3. Store of Value	Item used to transfer purchasing power to the future.	Keeping CHF 100 in a wallet.

Liquidity

Liquidity describes how easily an asset can be converted into the medium of exchange. Money is the most liquid asset. A house is illiquid, converting it to cash takes time and effort.

Kinds of Money

1. Commodity Money: Has intrinsic value (e.g., gold, cigarettes in prisons).
2. Fiat Money: No intrinsic value; used as money by government decree (e.g., Swiss Franc notes). Valid because it is generally accepted.

Measuring the Money Supply

The quantity of money is measured using monetary aggregates:

• M0 (Monetary Base): Currency + Bank Reserves (controlled by Central Bank).
• M1: M0 + Demand Deposits (most liquid).
• M2: M1 + Savings Deposits (slightly less liquid).
• M3: M2 + Large time deposits (broadest measure).

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The Central Bank

The Central Bank (CB) regulates the system (e.g., SNB in Switzerland, ECB in Eurozone).

Primary Functions:

1. Financial Stability: Acting as a “banker’s bank” and Lender of Last Resort to prevent panics.
2. Monetary Policy: Controlling the money supply to achieve goals like price stability.

Tools of Monetary Control

The CB influences the money supply using three main tools:

1. Open-Market Operations (Primary Tool): Buying/selling government bonds.
   • To increase money supply: Buy bonds (injects cash).
   • To decrease money supply: Sell bonds (removes cash).
2. Reserve Requirements: Regulations on minimum reserves banks must hold. Lower requirements $\to$ banks lend more $\to$ money supply rises.
3. Discount Rate: Interest rate on loans from CB to banks. Lower rate $\to$ banks borrow more $\to$ money supply rises.

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Banks and Money Creation

Central banks control the monetary base, but commercial banks create money through fractional-reserve banking.

The Mechanism

Banks hold only a fraction of deposits as reserves ($R$) and lend out the rest.

1. Deposit of $100.ReserveRatio$R = 10%$.
2. Bank holds $10,lends$90.
3. Borrower spends $90$\rightarrow$ deposited in Bank B.
4. Bank B holds $9,lends$81.
5. Process continues…

The initial $100 creates a chain of new deposits. The total amount of money generated is determined by the Money Multiplier.

$$\text{Money Multiplier}=\frac{1}{R}$$

If $R=10\%$ (0.1), the multiplier is 10. A $100depositgenerates$1,000 of money.

The Breakdown During Crises

The money multiplier relies on banks being willing to lend.

• Normal Times: Multiplier is stable.
• 2008 Crisis: Assessing high risk, banks held onto massive excess reserves instead of lending.
• Result: The Central Bank tripled the monetary base (QE), but the money supply (M2) barely moved because the multiplier collapsed. You can lead a horse to water, but you can’t make it drink.

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Continue here: 07 Inflation, International Trade