Econ 202 Lecture 4 The monetary system

Functions of money Any asset that serves the following three functions would be money: medium of exchange (or a means of payment) store of value unit of account

Properties of money It will be more likely for an asset to be commonly accepted as a means of payment if that asset is durable divisible transportable

Types of money Money can be said to be of two types: commodity money fiat money

Forms of money Throughout history, various objects have been used as money in different time periods and in different countries or environments: Precious metals (gold, silver, copper) Large metal or stone blocks Sea shells Salt Cigarettes ...

Forms of money in a modern society In a modern economy, money takes two basic forms: Currency (coins or paper money) Deposits (or bank accounts) Demand deposits or checkable accounts Saving accounts Time deposits Money market mutual funds, money market deposit accounts ...

Some things that are NOT money Although the following things are involved in making payments, they are not (and should not be counted as) money, once accounts or deposits behind these things are taken into account as money: Checks Debit cards (cards that are used to withdraw and transfer funds from a bank account right when the payment is made) Credit cards

Quantity of money Because money consists of currency and deposits, the quantity of money available at a point in time in an economy can be defined as (and measured by) M = C + D where C is the total amount of currency held outside of the banks (by non-bank public). But not all deposits are used by the same ease (and therefore by the same frequency) in making payments. So which deposits or accounts should be included in D above?

Definitions of quantity of money (Measures of money suppy) The quantity of money is measured (in USA) by using the following definitions going from the more narrow (and liquid) to the broader (and more liquid) measures of money: M1 = C + demand deposits and other checkable accounts M2 = M1 + saving accounts + money market mutual funds + money market deposit accounts + small time deposits M3 = M2 + large time deposits

Definitions of quantity of money (Turkey) M1 = C + vadesiz mevduat M2 = M1 + vadeli mevduat

The monetary system The monetary system basically consists of the following components: People and firms hold C and D Banks Liabilities = D + … Assets = C held in the banks + accounts held with the central bank + loans + … = Reserves + Loans + … where R includes C held in the banks and accounts held with the central bank The central bank controls reserves

The central bank's controls The central bank uses open market operations the interest rate at which banks can borrow from the central bank reserve requirements to control the amount of reserves. Therefore this is the amount that the central bank can directly control (together with the amount of currency issued by the Treasury): B = C + R called the “monetary base” or “high-powered money”.

The relationship between M and B The money supply M can be shown to be a multiple of the monetary base B: M = m B where m is called the “money multiplier” and is given by mm = (cr + 1) / (cr + rr) where cr is the “currency ratio”, equal to C / D and rr is the “reserve ratio”, equal to R / D.

Notice that money multiplier increases (and the same amount of currency and reserves) can create a larger money supply if the reserve ratio is smaller (because people hold larger deposits and banks can extend more loans for any given amount of reserves) or the currency ratio is smaller (because people hold larger deposits and banks can extend more loans for any given amount of currency)

Problems in monetary control Money multiplier is a convenient tool to track some of the difficulties in how the central bank controls the amount of money available in the system. Two of these difficulties would be: Uncertainty about how people will split their money between C and D Uncertainty about how much of excess reserves banks will hold Therefore, the value of the money multiplier is not certain and, consequently, it can not be known exactly how much more money will be created by increasing the monetary base (or reserves) by a given amount.