Money and Money Supply

The money supply is the total amount of money in an economy. In the past, money was in the form of commodities and the money supply relied on the amount of that metal in that country. Nowadays, governments have the exclusive right to issue fiat money and transfer the authority to central banks.

Money has three basic functions. These are; (i) unit of account, (ii) medium of exchange, and (iii) store of value. The unit of account function of money is  as a standard of value. Money facilitates to measure the value of all goods and services, or debts in terms of a single monetary unit. The function of money as a medium of exchange is related to the widespread acceptance of money in transactions involving purchases of goods, services, and debt payments by individuals and institutions alike. This applies to every business, household, or government entity. The agency accepts payments for transactions and debt. Furthermore, most governments only accept domestic currency for tax payments.
Store of value simply means maintaining purchasing power. As a store of value, money transfers today’s purchasing power to the future. People keep money to purchase goods and services in the future.

Commodity money is a physical good that has intrinsic value, is considered valuable by all economic units, and is used as a medium of exchange in transactions. The most common types of commodity money are silver and gold. In the commodity money case, the other goods and services are priced in terms of the commodity. Note that the quantity of this type of money is limited by natural resources.

The perfect or close to perfect liquid assets which are cash and demand deposits are called narrow money supply or M1. When a bit less liquid assets which are time deposits are included, it is called as M2.

The liquidity of assets is a principal factor for the money supply definitions. The perfect or close to perfect liquid assets which are cash and demand deposits are called as narrow money supply or M1. When a bit less liquid assets which are time deposits are included, it is called is M2. When repos, money market mutual funds and short-term government securities (bonds) held by households which are likely less liquid than the time deposits are included, it is called M3. M2 and M3 are called broad money supply definitions.

Time deposits are the bank accounts that the holders (owners of the deposit) deposit their money for a predetermined period, ranging from a few weeks to several years.

High inflation is the main source of dollarization. In countries with very high inflation for a long time, most goods and services may be priced in foreign currencies. In the extreme case, residents may start to use the foreign currency in daily transactions. Therefore, the unit of account and medium of exchange functions of domestic currency may also diminish. The wide use of foreign currency in domestic transactions and as a liquid asset is called “dollarization.”

Türkiye allowed residents to open foreign currency deposits in the banks in 1984. Residents have started to keep some part of their savings in foreign currency deposits instead of Turkish lira deposits since the 1980s. Since the foreign currency deposits can easily be converted into TL, the foreign exchange deposits are also included in money supply in Türkiye.

M3 money supply consists of repo, money market mutual funds and securities in addition to M2.

In practice, central banks do not have full control over the money supply. The money supply and money creation process depend on the behaviors of three actors: (i) central banks, (ii) banks, (iii) non-financial sectors. The central banks affect reserves of banks. Banks decide how to use reserves, such as extending new loans or buying bonds or keeping at free reserves or branch vaults. Meanwhile, non-financial sectors - referred to as households and firms - choose whether to take loans (borrow from banks), hold onto cash, or make new deposits

The ratio that banks must keep some ratio of the deposits they collected in the required reserves account at the central bank is called the “required reserve ratio”. The required reserves ratio is the oldest monetary policy tool of central banks. Its main functions are (i) to provide a liquidity buffer to the banks for unforeseen deposit withdrawals, and (ii) to affect the money supply. 

Liabilities of banks are deposits, open market operations, discount window credits, and owners' equities. Therefore, banks’ main liabilities are the borrowed funds from firms, households, and central banks.

On a balance sheet, assets are listed on the left and liabilities on the right. Assets in the balance sheet of the central bank are as follows; government securities ratio, open market operations and discount windows credits.

The sum of liabilities of the central bank, that is, the sum of currency issued, and banks’ total deposits
(required+free reserves) is called “money base” or “reserve money” or “monetary base”.

There are three critical functions of money. One of them is the store of value which simply means maintaining purchasing power. As a store of value, money transfers today’s purchasing power to the future. People keep money to purchase goods and services in the future.

The liquidity of an asset refers to the ease of converting it into cash quickly and with little or no loss in value. The most liquid asset type is cash money.

The money base is also called “high powered money” because one unit change in the money base causes more than one unit change in the money supply.

Repo is a repurchase agreement for short-term finance. In such agreements, banks can sell government or private sector bonds to households or firms at the market price of bonds for a short period of time with the agreement to buy back the bonds at the maturity date of the agreement at a slightly higher price. The buy-back price is determined according to the market interest rate of the period in the agreement.

The money multiplier is determined by (i) the required reserve ratio, (ii) households’ and firms’ cash preferences, and (ii) banks’ free reserve preferences.

If the required reserve ratio increases, the money multiplier declines. If the required reserve ratio decreases, the money multiplier increases. But  even if the central bank does not change the required reserve ratio, the money multiplier may change as a result of behaviors of households, firms, and banks.

If the multiplier is 6, the £1000 given by the central bank in exchange for the bond will increase the money supply by a factor of 6. Thus, the increase in the money supply will be £6000.