İKTİSADA GİRİŞ II - Deneme Sınavı - 17

Unit of account function of money means that it is the common measurement unit in quantifying the value of goods and services.

Deposit money multiplier is equal to the reciprocal of required reserve ratio. In our example, as required reserve ratio is 15 percent, then the reciprocal of it will be:

1/(0.15)=15

The best example of commodity money is gold.

If we denote the amount of deposit money which banking system can create, that is, change in in demand deposits, as ΔD, change in reserves of banking system as ΔR
and required reserve ratio as r, we can calculate the deposit money amount that can be created with the formula:

Then, change in demand deposits = 1/10*(5000)= 500

Money market funds are included in the M3.

Precautionary demand for money is the quantity of money that economic agents
want to hold with the intent of defraying unforeseen expenses.

As long as money supply does not change, excess money demand will cause a pressure on interest rate to rise. In an environment where money supply does not change, economic units will try to have the additional amount of money they need by converting some of their financial assets to cash. One of these assets is bills they hold. When economic units start
selling bills, the price of these asset decreases and therefore their interest rate increases.

100/12.5=8

A bond with an annual interest payment of 270 TL has been sold for a price of 900 TL in bond market. The interest rate of this bond can be determined as:

i=annual interest payment/bond price

=270/ 900=0.3

If economy recovers more than required and there are signs of inflationary threats,
monetary authorities would decide to slowdown the money supply and to increase interest rates. This kind of monetary policy is named as tight or contractionary monetary policy.

Functions of Money

Money has three basic functions in an economic structure: It serves as a medium of exchange, a unit of account and a store of value.

Serving as a Store of Value

The third function of money is to be a store of value. Money, as a store of value, ensures to keep purchasing power on hand. For example, you hold an amount of purchasing power equal to the amount of money in your pocket right now. If you have 20 TL in your pocket, you can imagine your purchasing power by thinking about the goods and services you may purchase with this amount of money and understand this function of money easily. This function of money is closely related with the prices of goods and services in the country. For instance, if all prices double right now, the amount of goods and services you can purchase with the money in your pocket cut in half. In other words, your purchasing power with the money in your pocket halves. Contrary, if all prices of goods and services are lowered, then you can purchase more goods and services with the money in your pocket, meaning that your purchasing power increases. Store of value function of money means that it ensures to keep purchasing power on hand.

EVOLUTION OF MONEY

Within the framework of basic functions of it, money took various shapes in time. It is known that many different objects have been used as medium of exchange in various cultures. For example, American natives used whale teeth; tobacco and cow were used in colonial USA, cigarettes were used in German prisoner of war camps during World War II, and gold was used in many countries as mean of payment. It is possible to find more examples of objects used as money in history. In fact, evolution of money from whale teeth to current banknotes can be reviewed basically in two categories: Commodity money and fiat money. Commodity money is the object which has a value when used as goods and which can also be used as medium of exchange. The best example of commodity money is gold. Gold has been used as means of payment to purchase goods and services for centuries; gold also has a value in other usage areas as a good. For instance, gold is being used as jewelry or ornaments for centuries, as well as a means of payment.

In an economy with commodity money, for instance, if both gold and silver coins are in use (in circulation) at the same time, an interesting situation emerges. Since gold as a commodity has a greater value than silver, nobody wants to spend coins in his/her pouch and everyone tries to spend silver coins first. If everybody behaves like that, the money passing from hand to hand will be silver coins and gold coins will stay in people’s pouch. If we call silver coins as bad money and gold coins as good money, we can easily say that bad money drives out good money in the market. This phenomenon is known as Gresham’s Law (Sir Thomas Gresham was sixteenth century financial agent in Britain Kingdom).

The objects having no value as goods but referring to a value in purchasing goods and services are called as fiat money. The paper pieces we use as medium of exchange today has no value as goods. But these papers in your pocket refer to an amount of value equal to the numbers printed on it in purchasing goods and services. The main question to be answered here: “When there are objects having values as a good, why do we accept worthless paper pieces as money?” If the answer is “Because paper money has a value in terms of gold or silver”, let us say that you are wrong. For instance, you cannot exchange paper Turkish Liras with gold. This paper pieces are accepted as money because the government declared them as legal payment tools and you (and other members of community) accepted this declaration. Today, fiat money forms the basis of monetary system in many countries. Fiat money can be in different forms in each country. In section below, we will review kinds of fiat money in economies today.

EVOLUTION OF MONEY

In an economy with commodity money, for instance, if both gold and silver coins are in use (in circulation) at the same time, an interesting situation emerges. Since gold as a commodity has a greater value than silver, nobody wants to spend coins in his/her pouch and everyone tries to spend silver coins first. If everybody behaves like that, the money passing from hand to hand will be silver coins and gold coins will stay in people’s pouch. If we call silver coins as bad money and gold coins as good money, we can easily say that bad money drives out good money in the market. This phenomenon is known as Gresham’s Law (Sir Thomas Gresham was sixteenth century financial agent in Britain Kingdom).

EVOLUTION OF MONEY

The objects having no value as goods but referring to a value in purchasing goods and services are called as fiat money. The paper pieces we use as medium of exchange today has no value as goods. But these papers in your pocket refer to an amount of value equal to the numbers printed on it in purchasing goods and services. The main question to be answered here: “When there are objects having values as a good, why do we accept worthless paper pieces as money?” If the answer is “Because paper money has a value in terms of gold or silver”, let us say that you are wrong. For instance, you cannot exchange paper Turkish Liras with gold. This paper pieces are accepted as money because the government declared them as legal payment tools and you (and other members of community) accepted this declaration. Today, fiat money forms the basis of monetary system in many countries. Fiat money can be in different forms in each country. In section below, we will review kinds of fiat money in economies today.

Types of Money

Near (Quasi) Money: We included demand deposits into money concept by referring that they are accepted as money by economists in the explanations above. But we know that there are also time deposits in banks as well as demand deposits. This kind of deposits can be withdrawn from bank only after a certain time. Therefore, you can not use your time deposits to make any payment. If you have a time deposit in a bank, you cannot make a payment by writing a check like in demand deposits. Therefore, time deposits are excluded from the money types listed above. In practice, banks generally allow time deposits to be withdrawn before its due date (maturity) like demand deposits. Since banks allow time deposits to be withdrawn before its due date, the difference between time and demand deposits becomes narrower. Although it is not possible to write a check on time deposits, the possibility to convert them to cash or demand deposits anytime causes to think that they have same characteristics. Many financial assets in many countries can easily be exchanged with cash, even not as much as time deposits. For example, in countries experiencing high inflation, the foreign currencies (such as US Dollar or Euro) are generally used to protect purchasing power and easily be exchanged with domestic currency. In fact, most of the time foreign currencies can be used for payments instead of domestic currency. Similarly, treasury bills can easily be exchanged with cash, as well. The possibility and speed of conversion for these type of assets to currency or demand deposit is called as liquidity. Considering the full liquidity of money, many financial assets may have this property more or less, even not exactly. When considering the liquidity property, it is not easy to distinguish monetary things and non-monetary things. This kind of assets having a high liquidity but not used in payments directly are called as near (or quasi) monies.

Official Money Stock Definitions

For the reasons we try to outline above, in each country, central bank makes official money supply definitions. Some of these definitions are more or less standardized and have some common components and names. These definitions are generally called as money supply or money stock, but both refer to the same concept. In our country, CBRT makes various definitions for money stock. One of the most commonly used definitions is known as narrowly defined money stock and indicated with M1. CBRT’s definition of M1 is as follows:

M1 = Currency in Circulation + Demand Deposits

The demand deposits in this definition include TL and foreign currency deposits in commercial banks, participation banks, investment and development banks operating in Turkey.

Official Money Stock Definitions

Along with traditional definitions above, CBRT also makes a third money stock definition in which total liquid assets in the economy are measured and is called as M3:

M3 = M2 + Repo + Money Market Funds + Debt Securities Issued

In this definition, repo (repurchasing agreements) accounts include funds used as a very short-term financial tool, money market funds include B type liquid investment funds and debt securities issued include bonds and bills issued domestically in TL by banks with maturity up to 2 years.

BANKING SYSTEM AND BANKS’ MONEY CREATION

Fractional reserve banking is the banking practice in which banks hold less reserves than their total liabilities.

Banks’ Money Creation

There is another question we have to answer here: In that case, what is the total amount of deposit money that can be created until the end of this process? In the consecutive deposit creation process started by an increase in reserves of the banking system, the demand deposit amount that banking system can create is

calculated with simple deposit money multiplier. Within the framework of simplifying assumptions above, simple deposit money multiplier is equal to the reciprocal of required reserve ratio. In our example, as required reserve ratio is 10 percent, then the reciprocal of it will be

Thus, in our example, the deposit money amount which banking system can create with an increase of 1000 TL in reserve is 10 x 1000 TL = 10.000 TL. If we denote the amount of deposit money which banking system can create, that is, change in in demand deposits, as ΔD, change in reserves of banking system as ΔR and required reserve ratio as r, we can calculate the deposit money amount that can be created with the formula:

The term in parenthesis in this equation above is called as simple deposit money multiplier.