Chapter 5: Money and the Economy

Introduction

From now on, we will include money in our model. Although it is so important in economic terms, money has a serious definition problem. It can even be said that one of the reasons of the difference among economic theories is different definitions of money. In this chapter, we will try to find an answer to the question “What is money?”, and we will try to determine the effects of banking system of a country in determining the quantity of money. Supplying money into economy by central bank is called as monetary policy and reviewing the effects of money on economy is called as monetary theory. The primary issue within the scope of monetary theory is that how the quantity of money or change in it effects the general price level and output in the economy.

What is Money?

Economists, rather than making a specific money definition, list the functions of money and include everything fulfilling these functions into money concept. Therefore, instead of defining the money according to its physical properties, setting its content by functions it undertakes is a better approach.

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. The first function of money is to be a medium of exchange. Economic units exchange goods and services on hand with money, and use this money to buy goods and services they want. Money, as a medium of exchange, is a kind of tool simplifying and accelerating exchange process of goods and services. The best way to understand the function of money as a medium of exchange is to consider an environment having no common instrument for exchanging. In such an environment, goods and services would be exchanged with other goods and services. So, in such environments there would be a barter economy and people would exchange the goods they produced with the goods they want to consume. The second function of money is to be a unit of account. Money, as a unit of account, is a common measurement unit in quantifying the value of goods and services. For instance, we express the values of coffee, tea, bread, shirt, shoes, houses or automobiles via Turkish Lira in our country. Without a common measurement unit such that, i.e., if there is a barter system, we would have to express values of goods and services with other goods and services again. In an economy including small amount of goods, this kind of valuation may not be a big problem, but in an economy with hundreds of thousands of goods and services, any valuation in terms of each other would cause a great loss of time. 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.

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. 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.

In a modern economy, money splits into three types; coins, banknotes and demand deposits. Metal money called as coins constitute very small part of total money amount at the present time. The reason for that coins are used in small amount of transactions. For example if you try to collect 1.000 TL as coins of 5 kuruş, you have to create a small hill consisting of 20 thousands of 5 kuruş. Inarguably, the metal value within coins are much less than the value they express. Otherwise everybody would melt these coins and sell them and we cannot find any coins in the market. Banknotes, namely paper moneys such as 5, 10, 20, 50, 100 and 200 TL in Turkey, constitute a bigger amount of total money. The volume of coins and banknotes constitutes the concept called as currency which is used as a synonym for money in everyday usage. As it is not possible to convert money to a precious metal today, coins or banknotes are legal means of payment. So, these metal and paper pieces are money because government wants and you accept. The third type of money is demand deposits which you can withdraw anytime from a commercial bank and they have the largest share in total amount of money. The characteristics of demand deposit accounts are that they can be withdrawn anytime and can be used via checks and credit cards. In daily conversation when people talk about money they generally mean currency. However, we can use checks and credit cards as well as currency (coins and banknotes) in shopping. These three types of money constitute total money in the country. Total amount of money used by a community generally refers to a magnitude increasing year by year.

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. 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.

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 other frequently used money stock definition is the broad definition and is indicated with M2:

M2 = M1 + Time Deposits

In this definition, time deposits include TL and foreign currency time deposit accounts in the banking system. 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

In an economic system, the functions and complying business lines of banks can be in a large variety. Some banks basically serve to corporations and have very few relations with individuals. Some banks are in service to collect deposits from consumers and to lend them. Although it is difficult to generalize banking business due to large working area, it is possible to determine some operating basics and principles.

Banks are generally the corporations making loans to both businesses and individuals with deposits collected from people, and investing to securities (especially to the bills issued by public sector). While performing these operations, banks aim to maximize their profit. Banks make this profit not by selling goods such as steel or automobiles, but by many services such as making loans, investing securities, paying checks and keeping records. While performing these operations, banks try to make profit by getting more interest than they pay to deposit owners. Banks should balance the revenue they will earn from loans and investments they make with the reliability of these loans and investments. The higher the interest rate a bank charges for its loans or the more revenue a bank gets from its investments, the higher the profit it obtains. However loans and investments with higher return than the market average carry also a higher risk. In other terms, the possibility of debtor’s paying back is low. Since banks make loans with the money they borrowed from deposit owners they must control and limit the risk they undertake with their loans and investments.

The best way to understand how a bank operates is to review the balance sheet of a bank. A significant part of bank debits consists of borrowings which have to be paid in case of owner’s request. For example, in the balance sheet given above, if all demand deposit owners want to withdraw their money at the same time, the amount of this money is about one third of bank’s total debts. Inarguably, the possibility of this situation is very low. Contrary, while some deposit owners are withdrawing money, others are depositing money in a day and most part of deposit owners don’t touch their deposits. Therefore bank can afford the withdraw requests on a day with holding little amount of cash and assets easily convertible to cash much less than its total demand deposit debts. The sum of cash in bank’s vault and demand deposits in central bank and other banks are called as reserves. Reserves of a bank is much less in comparison with the bank’s total deposit debts. This may seem very dangerous to you. If you had money in a bank, maybe you would wish to withdraw and deposit it to another bank whose reserves are equal to its debts in form of deposits. Unfortunately this would be not possible. Likewise, all banks hold an amount of cash less than their deposit debts as reserves. This operating method is named as fractional reserve banking.

Bank’s basic business principles and especially the reserves they hold as we try to outline above demonstrate another important function of banks they undertake in the economy: Money creation. In fact banks create money by collecting deposits from people and using them to make loans and investments. This money created in form of demand deposits as a result of banks’ credit transactions is called as deposit money.

Money and Economic Activities

To review the effects of money supply changes on production, we have to understand how the equilibrium in money market is ensured and why it changes.

We previously mentioned that the central bank is the institution being responsible for controlling the amount of money in an economy and specified the contents of money supply. To simplify the analysis here, we will assume that the total quantity of money in the country is solely determined and controlled by central bank. The assumption of central bank be able to determine the level of money supply means that money supply is independent from interest rate. In other words, whether interest rate increases or decreases, money supply will not change if central bank doesnt want it to change.

Money demand can be reviewed within the context of answers to be given to question of why economic units would like to hold money. As there is no possibility of barter in a modern economy, economic units (i.e., households, corporations, government and foreigners) need money to perform their daily operations. Likewise, money, as a medium of exchange, makes it easy for economic units to perform these operations. The amount of money that economic units want to hold to spend for goods and services is called as transaction demand for money. Economic units hold an amount of money to use in emergency situations. This amount of money to be used for unexpected expenses is called precautionary demand for money. Economic units cannot predict when the unexpected expenses occur; in other words, when the actual spending exceeds the planned spending. Finally, it is possible to talk about speculative demand for money. Speculative demand for money is the amount due to the ambiguity about the value of other financial assets. The reason of this kind of demand to occur is the money being the most liquid store of value.

As we just mentioned, economic units desire to hold money for three purposes: For transactions, as a precaution and speculatively. According to our explanations above, there are two factors determining the amount of money demanded: Nominal income and interest rate. The Keynesian approach reviewing the relationship between quantity of money and economic activities via indirect channel, accepts money demand (Md ) as a function of interest rate (i) in an environment having a constant nominal income rate. There is an inverse relation between interest rate and money demand. Amount of money to be held will rise proportional to nominal income increase. This applies to nominal income increase due to price increase as well as real income increase since both of them require more spending. When the price of goods and services produced in the economy increase, more money is necessary to buy the same goods and services. Similarly, as increase in real income refers to more goods and services production, these transactions are only possible by holding more money on hand.

In order to determine equilibrium interest rate and quantity of money in the economy, we can combine the functions of money demand and money supply. Equilibrium is obtained at the intersection point of the functions of money demand and money supply. The point at which demand for money is equalized to supply of money is called as equilibrium point.

After analyzing how money market equilibrium is obtained, we can review how changes in quantity of money affect the level of equilibrium GDP in the economy. According to our explanations, indirect channel between quantity of money and economy works via interest rate. Increase in money supply reduces equilibrium interest rate, reduction in interest rate increases investment expenditures. Increasing investment spending raises both aggregate expenditures and equilibrium level of income. We may summarize this interaction mechanism with symbols like below:

Ms ^› iv›I^›AE^›Y^

It must be considered that the mechanism works inversely if money supply is reduced.

Money and Economic Activities: Direct Channel

The most important property of indirect channel concept suggested by Keynes, is the existence of alternative financial assets instead of holding money. Thus, changes in the quantity of money can affect aggregate expenditures via interest rate. Another approach related to effects of money on the economy insists that changes in the quantity of money affects aggregate expenditures not via interest rate, but directly. According to direct channel approach, money is just one of the assets that would be used as store of value. Beside the financial assets as an alternative to money, there are also real assets like automobiles, durable goods and real estate. An increase in money stock create an excess supply at the beginning level equilibrium interest rate.

There are two sides of transactions which occur in an economy: While sellers deliver goods and services for money, buyers pay the equivalent money for desired goods and services. One way to explain this relation among the basic variables in an economy is to use equation of exchange. Although expressed in various forms according to variable examined, equation of exchange developed by classical economists can basically be written as follows:

M x V = P x Y

In equation above, M refers to the quantity of money, V refers to velocity, (that is, the number indicating how many times a unit of money used in purchase of final goods and services), P refers to general price level and Y refers to the output level (that is, real GDP. The right side of equation, namely the multiplication of prices with real income (P x Y) will provide the nominal GDP value. Hence, equation of exchange shows that the multiplication of the quantity of money in an economy with the velocity of a unit of money will be equal to nominal GDP.

Central Banking and Implementation of Monetary Policy

After understanding the economic effects of money supply, now we have to analyze the institution responsible for controlling money supply in a country; i.e., central bank. There are four basic actors in a country’s financial system: Central bank, financial intermediaries (banks etc.), savers and investors. Among them, the most important one is the central bank with its functions. Despite its importance, it is very difficult to make a short but fully covering definition for exactly clarifying the central bank’s functions. A central bank’s definition can be made according to the functions it undertakes.

Central bank constituting an important part of modern monetary system is an important institution ensuring a healthy economy and performing government’s financial transactions. Although the functions it undertakes differ from country to country, there are three basic functions a modern central bank should perform: To ensure and maintain stability in money markets, to serve as the banker for banks and as the lender of last resort and to perform banking transactions of the government.

Monetary policy is the decisions made by central bank to affect the quantity of money in the country. While making monetary policy decisions, the objective of government is to achieve and maintain full employment without causing inflation. When a slowdown occurs in economic activities and economy signals an upcoming recession, central bank will decide to raise money supply and decrease the interest rates. Specifically, monetary authorities (institutions responsible for implementing the monetary policy, primarily central bank) will facilitate the availability of credits. This kind of monetary policy is named as loose or expansionary monetary policy. On the other hand, 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.

There are three tools named general tools of monetary policy that central banks can use for this purpose: Required reserve ratio, discount rate and open market operations.

Required reserve ratio is the ratio that is determined by central bank and indicates the quantity of reserves that banking system holds against their liabilities. Discount rate is the interest rate that central bank applies to loans to banking system. Open market operations are central bank’s purchasing and selling transactions of government securities in interbank market in order to affect the level of banking system’s reserves and, therefore, supply of money.

When central bank purchases government securities in the market, it transfers reserves to banks and this, as we saw before, is the beginning of deposit money creation process. Thus, when central bank wants to accelerate the raise in money supply, it will directly increase the reserves of banking system by making open market purchasing in the market. When central bank purchases government securities in the market, it transfers reserves to banks and this, as we saw before, is the beginning of deposit money creation process. Thus, when central bank wants to accelerate the raise in money supply, it will directly increase the reserves of banking system by making open market purchasing in the market.