MONEY AND

PRICES IN THE
LONG RUN
Chapter 29
The Monetary System
THE MEANING OF MONEY
 Money the set of assets in an economy that people regularly use to buy
goods and services from other people.

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THE MEANING OF MONEY: THE FUNCTIONS OF MONEY

 Money has three functions in the economy:

 Medium of exchange
 Money is the item that buyers give to sellers when they want to purchase goods and
services
 Unit of account
 Money is the yardstick people use to post prices and record debts
 Store of value
 Money is an item that people can use to transfer purchasing power from the present to
the future
THE MEANING OF MONEY: THE FUNCTIONS OF MONEY

 Every asset has some amount of liquidity.

 Liquidity is the ease with which an asset can be converted into the economy’s
medium of exchange.
 As money is the economy’s medium of exchange, it is the most liquid of all
assets.

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THE MEANING OF MONEY:
KINDS OF MONEY
 Commodity money:
 Takes the form of a commodity with intrinsic value
 Examples: gold coins, cigarettes in prisoner of war camps

 Fiat money:
 Money without intrinsic value, used as money because of government decree
 Example: the U.S. dollar

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 THE MEANING OF MONEY: MONEY IN THE
ECONOMY
 The quantity of money in an economy needs to be measured.
(money supply)
 A basic measure, M1, is obtained by adding:
 Currency: the paper bills and coins in the hands of the public
 Demand deposits: balances in bank accounts that depositors can use as
payment by writing a check. (checking account)
 Nowadays, M2 is more widely used.
 M3, M2 +central bank reserve
M1,M2 AND M3
M1 M2 M3
• Currency • M1 • M2
• +T • + • + Central Bank
raveler’s Check Savings Depo Reserve
s sits
• + • +
Demand Depos Small-denomin
its ation Time Dep
• + osits
Other Checkabl • +
e Deposits Retail Money M
arket Mutual Fu
nds

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INDICATOR OF MONEY 2019 2024

M1 Million TL 712,8 5.126.792

M2 Million TL 2.457,5 8.611.724

M3 Million TL 2.575,2 14.588.901

Source: TCMB

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THE CENTRAL BANK SYSTEM
 The Central Bank serves as the central bank of the
Turkey.
 It is designed to oversee the banking system.
 It regulates the quantity of money in the economy.
 This activity is called monetary policy.

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THE CENTRAL BANK SYSTEM
 The helicopter-and-vacuum view of the CB is a bit too simple,
 The CB really can increase or decrease the quantity of money
 But it uses a process called open market operations to do so

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THE CENTRAL BANK SYSTEM
 When the CB wishes to increase the quantity of money in the
economy, it prints money and buys financial assets—such as
government bonds—on the open market
 When the CB wishes to decrease the quantity of money in the
economy, it sells financial assets—such as the government
bonds it may have bought in the past—on the open market, and
burns the money it gets from the sale

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BANKS AND THE MONEY
SUPPLY
 Commercial banks can also increase or decrease the economy’s
quantity of money
 Remember that the quantity of money consists of:
 Currency: the paper bills and coins in the hands of the public
 Demand deposits: balances in bank accounts that depositors can use
as payment by writing a check.
 Banks can control the quantity of money by controlling the
quantity of demand deposits

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BANKS AND THE MONEY
SUPPLY
 When banks make new loans faster than borrowers repay old
loans, the quantity of money in demand deposits increases and,
therefore, the economy’s quantity of money increases
 When banks make new loans slower than borrowers repay old
loans, the quantity of money in demand deposits decreases and,
therefore, the economy’s quantity of money decreases

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BANKS AND THE MONEY SUPPLY: FRACTIONAL-RESERVE
BANKING

 an example:
 The CB prints $10,000 and pays Can a caterer who provided food at a CB
function
 M1 increases by $10,000. (Why?)

 Can deposits the $10,000 in Bank A

 M1 is unchanged. (Why?)

 Bank A’s reserves increase and it decides to make a $9,000 loan out of the
new reserves.

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BANKS AND THE MONEY SUPPLY: FRACTIONAL-RESERVE
BANKING

 The recipient of Bank A’s loan buys a car from Canan.

 Canan deposits $9,000 in her account at Bank B
 M1 increases by $9,000. (Why?)
 M1 = currency with the public + checkable demand deposits
 Currency with the public is unchanged
 Can’s checkable demand deposits are unchanged
 Canan’s checkable demand deposits have increased by $9,000

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BANKS AND THE MONEY SUPPLY: FRACTIONAL-RESERVE
BANKING

 So far, the Can’s printing of $10,000 has already increased M1 by $19,000.

 And further increases in the money supply may follow when Bank B reacts
to Canan’s deposit the way Bank A reacted to Can’s deposit.

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BANKS AND THE MONEY SUPPLY: FRACTIONAL-RESERVE
BANKING

 When one bank loans money, that money generally ends up as a deposit in
a second bank.
 This creates more deposits and more reserves to be lent out by the second
bank.
 When the second bank makes a loan from its reserves, the money supply
increases again.
 And the process continues …

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BANKS AND THE MONEY SUPPLY:
FRACTIONAL-RESERVE BANKING
 Reserves: deposits that banks have received but have not loaned out
 fractional-reserve banking: a banking system in which banks hold only
a fraction of deposits as reserves

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FRACTIONAL-RESERVE BANKING

 Reserve Ratio
 The reserve ratio is the fraction of total deposits that banks hold as reserves.
 The fraction of its total deposits that a bank is required by the CB to keep as
reserves is called the required reserve ratio.
 When banks hold reserves in excess of the required reserves, those reserves are
called excess reserves.
 Reserves = Required Reserves + Excess Reserves

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BANKS AND THE MONEY SUPPLY: THE MONEY
MULTIPLIER

 How much money is eventually created in this economy?

 The money multiplier is the name given to the amount of money the
banking system generates with each dollar of money created by the CB.

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BANKS AND THE MONEY SUPPLY: THE MONEY
MULTIPLIER

 The money multiplier is the reciprocal of the reserve ratio:

M = 1/R
 With a reserve ratio of R = 20% or 1/5,
 The multiplier is 5.
 Example: In this case, if the CB prints a fresh TL , the money supply may
increase by as much as $5.00!

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 THE CB’S TOOLS OF
MONETARY CONTROL
 Influences the quantity of reserves
 Open-market operations
 CB lending to banks
 Influences the reserve ratio
 Reserve requirements

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 CB’S TOOLS OF MONETARY
CONTROL
 Open-market operations
 Purchase and sale of Turkish government bonds by the CB
 To increase the money supply
 The CB buys Turkish government bonds
 To reduce the money supply
 The CB sells Turkish government bonds
 Used more often

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 CB’S TOOLS OF MONETARY
CONTROL
 CB lending to banks
 To increase the money supply
 Discount window
 At the discount rate
 Term Auction Facility
 To the highest bidder

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 CB’S TOOLS OF MONETARY
CONTROL
 The discount rate
 Interest rate on the loans that the CB makes to banks
 Higher discount rate
 Reduce the money supply
 Smaller discount rate
 Increase the money supply

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 CB’S TOOLS OF MONETARY
CONTROL
 Term Auction Facility
 The CB sets a quantity of funds it wants to lend to banks
 Eligible banks bid to borrow those funds
 Loans go to the highest eligible bidders
 Acceptable collateral
 Pay the highest interest rate

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 CB’S TOOLS OF MONETARY
CONTROL
 Reserve requirements
 Regulations on minimum amount of reserves that banks must hold against
deposits
 An increase in reserve requirement
 Decrease the money supply
 A decrease in reserve requirement
 Increase the money supply

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CB’S TOOLS OF MONETARY CONTROL: PROBLEMS IN
CONTROLLING THE MONEY SUPPLY

 The CB’s control of the money supply is not precise.

 The CB must wrestle with two problems that arise due to fractional-reserve
banking.
 The CB does not control the amount of money that households choose to hold as
deposits in banks.
 The CB does not control the amount of money that bankers choose to lend.

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