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Chapter 5
Monetary System
© 2007 Thomson South-Western
THE MEANING OF MONEY
1. Money is anything that is generally
accepted in payment for goods or
services or in the repayment of debts.
Money is a stock concept.
THE MEANING OF MONEY
2. Income is a flow concept. Compare
1. Mehmet’s income is 1000 YTL/month. (flow)
2. Mehmet has 1000 YTL in his account. (stock)
3. Wealth is the total collection (stock) of
pieces of property that serve to store
value. Currency, gold, cars, houses, land,
stocks, bonds, yachts, antiques,
factories, hotels, etc. Some of these are
not money because they are not as liquid
as money.
The Functions of Money

Liquidity is the ease with which an asset
can be converted into cash.


Money is the most liquid asset because money
is the medium of exchange. Then, in the order
of decreasing liquidity comes gold, silver,
stocks, bonds, cars, houses, land, antique.
Liquidity is desirable because it takes time and
costs money to convert other assets into cash.
For example, think about selling a house:
takes time and need to pay commission to real
estate agent.
The Functions of Money

1.
Functions of Money:
Medium of exchange


A medium of exchange is anything that is
accepted as payment for goods and services.
Imagine an economy without money. Then
we have to use a barter (takas) system.
The Functions of Money
1. Medium of exchange (cont’d)


For example, I teach economics and I am
hungry. I need to buy bread. If there is no
money, how am I going to pay the baker? For
everything I want to buy, I need to find a
seller that wants to buy my services. This is
called double coincidence of wants. It
makes exchange very difficult.
Money makes exchange much easier than
barter because everybody accepts money as
payment.
The Functions of Money
2. Unit of Account

A unit of account is the yardstick people use
to measure value of goods and services.
What is the value of a projector if we cannot
use money as a measure of value? 20
computers? Then what is the value of a
computer?
The Functions of Money
3. Store of Value


A store of value is an item that people can
use to transfer purchasing power from the
present to the future.
Money is not the only asset to store value. In
fact money loses value because of inflation.
Gold, stocks, bonds, houses, land are better
stores of value because they increase in
value by the time. But then why do people
hold any money?
The Functions of Money
Because money is the most liquid of all
assets. Other assets are more difficult to
use in purchases.
 If inflation increases, people hold less
money. They buy other assets to store
value.

The Kinds of Money

Commodity money is a commodity with
intrinsic value (i.e. also provides other
services) that is used as money. More
common in history.


Examples: Gold, paper money convertible into gold,
silver, cigarettes in prison.
Fiat money is used as money only because
of government order.



It does not have any intrinsic value.
Fiat money is unbacked currency. It is not convertible
into a certain amount of precious metals as was the case
in “gold standard”.
Examples: Paper money today, checkable deposits.
Money Supply
Currency is the paper bills and coins
circulating in the hands of the public.
 But we can also use debit cards and credit
cards for payment. Are these also money?
In debit cards, payment is done from your
checking account deposit. In credit cards,
you are borrowing from the bank that
issued the card. So debit cards or checks
are money. But credit cards are not
money, they are credit.

Money Supply

Checkable deposits (checking account
deposits) are balances in bank accounts
that depositors can withdraw easily from
the ATM machines or write a check upon
them for payments.
Central Bank

Central Bank


It is designed to monitor the banking system.
It regulates the quantity of money in the
economy.
Central Bank.

Three Primary Functions of the Central
Bank



Regulates banks to ensure they follow laws
intended to promote safe and sound banking
practices. Prevent excessive risk taking by
commercial banks. Ex: required reserves
Acts as a lender of last resort, making discount
loans to banks.
Conducts monetary policy by controlling the
money supply.
Central Bank
The money supply refers to the quantity of
money available in the economy.
 Monetary policy is the management of the
money supply by policymakers in the
central bank.

Central Bank’s Policy Instruments

Open Market Operations


The money supply is the quantity of money
available in the economy.
The primary way in which the CB changes the
money supply is through open market
operations. The CB purchases and sells
government bonds. Does O.M.O. with the
banking system.
Central Bank’s Monetary Policy
Tools

Open-Market Operations


To increase the money supply, the Fed buys
government bonds from the banking system:
Open Market Purchase.
To decrease the money supply, the Fed sells
government bonds to the banking system:
Open Market Sale.
BANKS AND THE MONEY SUPPLY

Banks can influence
the quantity of
demand deposits in
the economy and
the money supply.
BANKS AND THE MONEY SUPPLY
Reserves are deposits that banks have
received from depositors but have not
loaned out to firms.
 In a fractional-reserve banking system,
banks hold only a fraction of the money
deposited as reserves and lend out the
rest of the money as loans (credit).

BANKS AND THE MONEY SUPPLY

The required
reserve ratio is the
fraction of deposits
that banks must
hold as reserves by
law.
Money Creation with FractionalReserve Banking
When a bank makes a loan from its
reserves, the money supply increases.
 The money supply is affected by the
amount deposited in banks and the
amount that banks lend.




Deposits into a bank are recorded as both
assets and liabilities.
The percentage of total deposits that a bank
has to keep as reserves at the CB is called the
required reserve ratio (RRR).
Loans become an asset to the bank.
Money Creation with FractionalReserve Banking

This T-Account
shows a bank
that…




First National Bank
Assets
accepts deposits,
Reserves
keeps a portion
$10.00
as reserves,
and lends out
Loans
the rest.
$90.00
Assumes that
RRR is 10%.
Total Assets
$100.00
Liabilities
Deposits
$100.00
Total Liabilities
$100.00
Money Creation with FractionalReserve Banking
When one bank loans money, that money
is generally deposited into another bank.
 This creates more deposits and more
reserves to be lent out.
 When a bank makes a loan from its
reserves, the money supply increases.

The Money Multiplier

How much money is eventually created by
the new deposit in this economy?
The Money Multiplier

The money multiplier is the amount of
money the banking system generates with
each lira increase of reserves.
The Money Multiplier
Increase in the Money Supply = $190.00!
First National Bank
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
Second National Bank
Assets
Reserves
$9.00
Liabilities
Deposits
$90.00
Loans
$90.00
Total Assets
Total Liabilities
$100.00
$100.00
$81.00
Total Assets
$90.00
Total Liabilities
$90.00
The Money Multiplier
Original deposit
= 100 TL
 1st N.B. Lending = 90.00 (=.9 x 100)
 2nd N.B. Lending = 81.00 (=.9 x 90)
 3rd N.B. Lending =
72.90 (=.9 x 81)
 … and on until there are just pennies left
to lend!
 Total money supply created by this 100 TL
deposit is 1000 TL (= (1/0.1) x 100)
The Money Multiplier
The money multiplier is the reciprocal of
the required reserve ratio (RRR):
Multiplier = 1/RRR
 Example:



With a reserve requirement, RRR = 20% or .2:
The money multiplier is 1/.2 = 5.
CB’s Tools of Monetary Policy

Interbank overnight (O/N) rate (called Federal
Funds Rate in US) is the interest rate on
overnight loans of reserves from one bank to
another. It is the price of reserves in the market
where banks borrow from each other’s accounts
at the CB overnight.


Primary instrument of CB’s monetary policy.
CB has three monetary policy tools to influence
the interbank overnight rate:



Open-market operations
Changing the reserve requirement
Changing the discount rate (MLR)
CB’s Tools of Monetary Policy

Open-Market Operations

CB conducts open market operations when it
buys government bonds from or sells
government bonds to the banking system:


When CB sells government bonds, reserves
decreases, money supply decreases and interbank
O/N rate increases: open market sale.
When CB buys government bonds, reserves increase,
money supply increases and interbank O/N rate
decreases: open market purchase
CB’s Tools of Monetary Policy

Reserve Requirements


CB also influences the money supply by
changing the required reserve ratio.
RRR is the minimum amount of reserves that
banks must hold as a percentage of total
deposits.
CB’s Tools of Monetary Control

Changing the Reserve Requirement


Increasing the RRR increases reserve demand
of banks, increases interbank O/N rate,
decreases the money supply.
Decreasing the RRR decreases reserve demand
of banks, decreases interbank O/N rate,
increases the money supply.
CB’s Tools of Monetary Control

Changing the Marginal Lending Rate
(Discount Rate)

The discount rate is the interest rate CB
charges banks for loans.


Increasing the discount rate makes it more expensive
to borrow from the CB, decreases the money supply.
Decreasing the discount rate makes it cheaper to
borrow the CB and possibly decrease the interbank
O/N rate and increases the money supply.
Problems in Controlling the Money
Supply
CB’s control of the money supply is not
precise.
 CB must deal with two problems that arise
due to fractional-reserve banking.



CB does not control the percentage of their
money that households choose to hold as
deposits in banks and the percentage they
want to hold as cash.
CB does not control the amount of money that
bankers choose to lend. Banks may hold more
than required reserves: excess reserves. CB
cannot control the amount of excess reserves.