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Econ 100 Lecture 16 How money is created and controlled in an economy: The monetary system
Money – what is it and what is it not In everyday language, we frequently confuse money with income or wealth. Even though those three are related, money is neither income nor wealth exactly. People earn income and pay taxes out of it. What remains is their disposable income. Then they make consumption expenditures out of their disposable income. What remains is their saving. When people make saving, their wealth increases. Saving is simply the increase in wealth.
Now, wealth can be kept in different forms (assets): • Bonds • Shares of stock • Gold • Real estate • … and. . . • Money
Thus, when people save, their wealth will increase, which means that their total holdings of bonds, stocks, gold, real estate etc will increase more or less, together with their holdings of money. As people have their wealth increased, they have to decide how to split (the increase in) their wealth in these different forms (in different assets), including money. Money is held because of its special functions, which also define money.
Functions of money Money has the following three functions (anything or any asset that fulfills the following three functions is money): • Medium of exchange (or means of payment) • Unit of account • Store of value
Medium of exchange A medium of exchange is an item that buyers give to sellers when they purchase goods and services. The existence of a medium of exchange in an economy reduces costs of transaction greatly. In an barter economy, goods and services are not exchanged against a medium of exchange but against other goods and services, and therefore, transactions will be difficult to make because of the difficulties of finding the so-called “double coincidence of wants”. Because of these costs, a medium of exchange arises in any economy sooner or later even if no government issues any money.
Unit of account In a barter economy, prices of goods and services are expressed in terms of other goods and services that they are exchanged for. For example, the price of 1 kg of apples can be 2 kg of oranges, or the price of 1 kg of oranges can be 0. 5 kg of apples. In a money economy, all prices are expressed in monetary units, which again greatly simplifies price comparisons as well as accounting. In the above example, the price of apples could be 8 TL per kg and that of oranges 4 TL per kg. Similarly, the amounts of loans and repayments of loans are also measured in monetary units.
Store of value A store of value is an item people can use to transfer purchasing power from the present to the future. Money is one of the items that can serve as a store of value, but it is not a very one because it earns a relatively low (or no) rate of return and it loses its purchasing power during periods of inflation of prices of goods and services. Other assets such as bonds and stocks are much better as a store of value because they are expected to earn some interest or dividends and to appreciate over time so that their purchasing power is expected to increase. (But they are risky because it may not increase. )
Liquidity is defined as the degree of ease with which an asset can be converted to the medium of exchange in a given economy. By definition, money is the most liquid asset in the economy. Other assets vary in their liquidity. Bonds are stocks are relatively liquid assets because they can be converted to cash (or sold) with relatively small cost whereas selling a house at the desired price may take many weeks or months or you sell it at a much lower value than its market price which means a loss or cost indicating significant difficulty in converting it to cash.
Why people hold money So money is the most liquid asset in the economy but it is not the best store of value. In other words, it is very meaningful to keep some amount of money to have the convenience of money in making payments, but keeping too much of it has an opportunity cost (loss of purchasing power in inflationary periods and loss of possibly high return). Therefore people hold some amount of money to use it as the medium of exchange but they try to balance its liquidity against its limited usefulness as a store of value, which means that they try not to keep to much of it so that they can hold other assets that serve better as a store of value.
Properties of money Anything that has relatively more of the following characteristics will be more likely to be used as money: • Commonly accepted in exchanges • Easily transportable • Divisible • Durable Throughout history, things ranging from sea shells, stones, and metal blocks to salt and precious metals like gold, silver, and copper have been observed to be used as money.
Kinds of money Commodity money • A commodity with intrinsic value that is used as money Fiat money • Something that has no intrinsic value but has been issued as money and used as money by a government decree
Money in modern economies In a modern economy, money takes two basic forms: • Currency (or cash): metal coins and paper money • Bank deposits (or accounts) We also use cheques, debit cards, or credit cards in making payments but they are not money. Why? They are each nothing but a method of transferring money between bank accounts.
How to measure the amount of money available in the economy When we say money consists of currency and bank accounts, that may already sound a little arbitrary because bonds and shares of stock also have some liquidity, but currency and bank accounts can directly be used in exchanges whereas bonds and shares of stock need to be first converted to cash before they are used in making payments. So liquidity is very critical in what we count as money. But there are different types of bank accounts (or deposits that can be held with other financial institutions) and they have different degrees of liquidity. So what accounts should be included in the definition of money and what accounts should not?
There is no perfect answer to this question. Consequently, economists define and measure different amounts (or quantities) of money. Some of them include relatively more liquid assets only (narrow definition or narrow measure of money), some others include some relatively less liquid assets in addition to those more liquid assets (broad definition or broad measure of money). Apart from this, the definitions of money stock differ from country to country because the properties and the relative liquidity of each different asset differ across countries.
In USA, some of the definitions or measures of money include (in their simplified versions): • M 1 = currency in the hands of the non-bank public + demand deposits • M 2 = M 1 + saving accounts + small time deposits • M 3 = M 2 + large time deposits whereas in Turkey, we have • M 1 = currency in the hands of the non-bank public + vadesiz mevduat • M 2 = M 1 + vadeli mevduat
These different definitions and the corresponding measures of the stock of money or the quantity of money available in the economy are also called “monetary aggregates”, or “measures of money supply”, or simply “quantity of money” or “money supply”.
Central bank The monetary system in an economy is regulated by an agency called in general the “central bank” although it may have different names in different countries. In USA, it is called the “Federal Reserve” or the “Fed”. In Europe, it is called the “European Central Bank”. In England, it is called the “Bank of England”. In Japan, the “Bank of Japan”. In Turkey, “Türkiye Cumhuriyeti Merkez Bankası”. The main function of a central bank is to control the money supply in that economy.
The central bank can directly affect (increase or decrease) the amount of currency in an economy. It can also (somewhat indirectly, as we will see why) affect and control the money supply in the economy. It has several tools to do that, and the set of actions that the central bank can take by using these tools in order to affect the money supply is called “monetary policy”.
The importance of monetary policy The amount of money available in an economy affects the real interest rate and the real GDP (hence unemployment) in the short run and the price level (hence inflation) in the long run. Increases in production and employment in the short run may disappear over the long run, leaving a relatively large rate of inflation in their places. For this reason, central banks are mostly seen as being in charge of guarding economic stability (in general) and price (or inflation) stability (in particular).
Banks and the money supply The central bank can control the money supply indirectly because the money supply consists of currency and deposits, and more deposits are created as people choose to open more deposits in banks and banks choose to extend more loans to firms and people who then deposit the funds borrowed in other bank deposits until they spend them. Consequently, the money supply becomes a multiple of the currency directly controlled by the central bank. To see the relation between the money supply and the currency directly controlled by the central bank, let us define. . .
C = currency in the hands of the non-bank public R = bank reserves (held either in branches or with the central bank) D = bank deposits C/D = currency ratio R/D = reserve ratio When the central bank injects more currency into the system, it will be held either by people as cash in their pockets or vaults or by banks as reserves, so it will be equal to the sum of C and R, or what is called the “monetary base”:
B = C + R = (C/D) D + (R/D) D = (C/D + R/D) D whereas the money supply will consist of the sum of currency (in the hands of the people) and deposits, so M = C + D = (C/D) D + D = (C/D + 1) D Therefore, M / B = (C/D + 1) / (C/D + R/D) Or, by defining m as the so-called “money multiplier” such that M = m B, m = (C/D + 1) / (C/D + R/D)
Notice that if the reserve ratio, R/D, is equal to 1, then R = D, banks hold all deposits as reserves in which case m = 1, or M = B, regardless of the currency ratio, C/D. The amount of money available is equal to the quantity of currency. If, on the other hand, banks keep some of the deposits as reserves and loan out the rest, R < D, which means that R/D < 1, then we have m > 1 regardless of the currency ratio, C/D.
For example, suppose that banks keep 10% of deposits as reserves so that R/D = 0. 1. Furthermore, let people keep 1 TL of cash for every TL they keep in deposits, so that C/D = 1/1 = 1. Then m = (C/D+1) / (C/D+R/D) = (1+1)/(1+0. 1) = 2 / 1. 1 ≈ 1. 82 Or let people keep 1 TL of cash for every 2 TL they keep in deposits, so that C/D = 1/2 = 0. 5. Then m = (C/D+1) / (C/D+R/D) = (0. 5+1)/(0. 5+0. 1) = 1. 5 / 0. 6 = 2. 5 In both cases, m > 1 or M > B and more money is available in the system then the amount of currency.
Multiple expansion of deposits It is useful to realize that, when money is created by banks, that happens through a chain process in which one bank extends loans and the borrower deposits it in a(nother) bank and these steps repeat themselves. This process is called “multiple expansion of deposits”. To show this process occurs, let us suppose again that the reserve ratio is 0. 1, the currency ratio is 0. 5, so that m = 2. 5, and the central banks increases the amount of currency in the system by 150 TL by buying some bonds at a price of 150 TL from Mr. X, some member of the public. In this case, B increases by 150 and M increases by 2. 5 x 150 = 375. But how exactly does this happen?
Start again with the central bank paying 150 TL to Mr. X. Since the currency ratio is 0. 5, Mr. X keeps 50 TL as currency and deposits the rest (100 TL) in Bank 1. When Mr. X deposits the amount 100 TL in Bank 1, Bank 1 keeps 10% of it as reserves (10 TL) and loans out the rest (90 TL) to Mr. Y. Again since the currency ratio is 0. 5, Mr. Y keeps 30 TL as currency and deposits the rest (60 TL) in Bank 2 keeps 10% of it as reserves (6 TL) and loans out the rest (54 TL) to Mr. Z keeps 18 TL as currency and deposits the rest (36 TL) in Bank 3 keeps 10% of it as reserves (3. 6 TL) and loans out the rest (32. 4 TL) to Mr. U keeps. . . and deposits. . . and so on.
The whole process will continue until the initial 150 TL, the new amount of currency injected, is fully distributed among people and banks as new currency held by people and new reserves held by banks, and in the end, new currency in the hands of the people, new reserves, and new deposits will be C = 50 + 30 + 18 + … = 125 D = 100 + 60 + 36 + … = 250 R = 10 + 6 + 3. 6 + … = 25 so that M = C + D = 125 + 250 = 375 and B = C + R = 125 + 25 = 150. Note that M/B = 375/150 = 2. 5 = m.
The central bank's tools of monetary control The central bank has three main tools to use as it tries to control the money supply: • Open-market operations • The refinancing rate • Reserve requirements
Open-market operations Open market operations are purchases or sales of government bonds from or to the public (people, firms, banks) by the central bank. When the central bank wants to increase the money supply, it creates currency and buys with it bonds from the public. After the purchase, the extra currency paid by the central bank in exchange for the bonds is in the hands of the public. Money supply increases. When the central bank wants to decrease the money supply, it sells bonds to the public. After the sale, the currency paid by the buyers in exchange for the bonds is out of the hands of the public. Money supply decreases.
The refinancing rate The central bank sets an interest rate at which it will be willing to lend commercial banks on a short-term basis. This interest rate is called the “refinancing rate” by the European Central Bank, the “repo rate” by the Bank of England, the “discount rate” by the Federal Reserve etc. As the central bank lends money to a commercial bank, it does so by increasing the reserves held by the commercial bank with the central bank, which are part of the total reserves held by commercial banks. So, the reserves and consequently the monetary base increases. As the monetary base increases, the money supply also increases through the money multiplier.
As the central bank wants to increase the money supply, one thing it can do is to decrease the refinancing rate. This will make the commercial banks increase their lending because they will be able to borrow at a relatively low interest rate in case their reserves are too low. As the lending by commercial banks increases, the money supply will also increase. Conversely, if the central bank wants to decrease money supply, it can increase the refinancing rate. This will make the commercial banks be more careful in their lending because they will have to pay a high interest rate as they borrow from the central bank in case their reserves are too low. As the lending by commercial banks decreases, the money supply will also decrease.
The way the central bank extends loans to commercial banks is usually through open market operations accompanied by a repurchase agreement (or “repo”). This means that the central bank buys bonds from the commercial bank and the commercial bank agrees to buy them back at a specified date. The difference between the price the commercial bank sells the bonds to the central bank and the price at which it agrees to buy them back, expressed as a percentage of the selling price, is the interest rate the central will be charging the commercial bank and is set equal to the refinancing rate set by the central bank.
Reserve requirements are the minimum amount of reserves as a fraction of different kinds of deposits in a bank (to kept over a specified period of time). The central bank can set also reserve requirements (minimum value of the reserve ratio) to affect the money supply. If reserve requirements are (and hence the actual reserve ratio is) increased, banks have to hold more reserves, extend less loans, money supply decreases (because the money multiplier is decreased). If reserve requirements are decreased, banks have to hold less reserves, extend more loans, money supply increases (because the money multiplier is increased).
In principle, reserve requirements can change the money supply even if the amount currency is not changed, and provide an alternative method of controlling the money supply. But central bank usually do not change the reserve requirements frequently because they do not want to risk creating an unstable working environment for banks.
Problems in controlling the money supply The central bank can control the money supply but not precisely. The reason is that, once again, some money is created by banks. There are two reasons why the central bank's control of the money supply is not perfect: • The central bank cannot control the amount of money people choose to keep as currency in their hands and as deposits in banks, • The central bank cannot control the amount of money banks choose to lend (and so the amount of excess reserves).