1. Econ 202
Lecture 4
The monetary system

2. 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

3. 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

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

5. 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
...

6. 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
...

7. 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

8. 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?

9. 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

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

11. 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

12. 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”.

13. 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.

14. 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)

15. 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.