Transcript Chapter No. 1

Chapter 3
What Is Money?
Meaning of Money
• money (also referred to as the money supply) as anything
that is generally accepted in payment for goods or services
or in the repayment of debts.
• Money and Currency: when most people talk about
money, they’re talking about currency (paper money and
coins). To define money merely as currency is too narrow
definition of money. Other means are also accepted as
payment for purchases.
• Money and Wealth: money in the form of currency,
demand deposits, and other items that are used to make
purchases and wealth (the total collection of pieces of
property that serve to store value).
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Meaning of Money
• Money and Income: people also use the word money to
describe what economists call income. Income is a flow of
earnings per unit of time. Money, by contrast, is a stock.
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Functions of Money
1. Medium of Exchange: i.e., it is used to pay for goods and
services. Using money as medium of exchange promotes
economic efficiency
• Look at a barter economy, one without money, in which
goods and services are exchanged directly for other goods
and services.
• In a barter economy, transaction costs are high because
people have to satisfy a “double coincidence of wants”.
Money
- reduces transaction costs,
- Promotes specialization (why specialization is a
problem in a barter economy?)
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Functions of Money
• As a medium of exchange money promotes economic
efficiency by:
- eliminating much of the time spent exchanging goods and
services.
- allowing people to specialize in what they do best
• For a commodity to function effectively as money, it has
to meet several criteria:
(1) It must be easily standardized, making it simple to
ascertain its value;
(2) It must be widely accepted;
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Functions of Money
(3) It must be divisible, so that it is easy to “make change”;
(4) It must be easy to carry;
(5) It must not deteriorate quickly
• Most of these criteria are met by gold.
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Functions of Money
2.
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Unit of Account: used to measure value in the economy.
To see how this function is important, let us consider a
barter economy:
If the number of goods=3, No. of prices=3
If the number of goods=10, No. of prices=45
If the number of goods=100, No. of prices=4950
If the number of goods=1000, No. of prices=499500
Use this formula:
(N(N-1))/2
Where N = number of goods
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Functions of Money
• The solution to the problem is to introduce money into the
economy and have all prices quoted in terms of units of
that money. This substantially reduces the number of
prices, e.g., if the No. of goods = 10, No. of prices=10 and
so on.
• using money as a unit of account reduces transaction
costs in an economy by reducing the number of prices
that need to be considered.
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Functions of Money
• 3. Store of Value: is used to save purchasing power from
the time income is received until the time it is spent.
• Money is not unique as a store of value, other assets have
advantages over money as a store of value:
- They often pay the owner a higher interest rate than
money,
- experience price appreciation
- deliver services
• Why do people hold money at all?
• Money is the most liquid asset. Liquidity is the relative ease
and speed with which an asset can be converted into a
medium of exchange.
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Functions of Money
• Other assets involve transaction costs when they are
converted into money.
• How good a store of value money is depends on the price
level. when the price level is increasing (inflation), money
loses value.
• extreme inflation, known as hyperinflation, in which the
inflation rate exceeds 50% per month.
• Zimbabwe is an example of recent hyperinflations.
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Evolution of the Payments System
• The payments system is the method of conducting
transactions in the economy.
• 1. Commodity Money: Money made up of precious metals
or another valuable commodity.
• Problems:
- very heavy
- hard to transport from one place to another, especially
for large purchases.
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Evolution of the Payments System
• 2. Fiat Money: paper currency decreed by governments as
legal tender but not convertible into coins or precious
metals.
• Advantages:
- being much lighter than coins or precious metals
• Problems:
- accepted only if there is some trust in the authorities who
issue it.
- easily stolen
- expensive to transport in large amounts because of their
bulk.
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Evolution of the Payments System
• 3. Checks: an instruction from you to your bank to transfer
money from your account to someone else.
• Advantages:
- Minimize the movement of money, payments that cancel
each other can be settled by canceling the checks.
- reduce the transportation costs associated with the
payments system and improve economic efficiency.
– can be written for any amount up to the balance in the
account, making transactions for large amounts much
easier
– loss from theft is greatly reduced,
– provide convenient receipts for purchases
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Evolution of the Payments System
• Problems:
– It takes time to get checks from one place to another.
– the paper shuffling required to process checks is costly,
estimated to be $10 billion a year in USA.
• 4. Electronic Payment: make payments electronically
over the internet.
• Advantages:
– save the cost
– Require little effort
– recurring bills can be automatically deducted from the
bank account
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Evolution of the Payments System
• E-Money: money that exists only in electronic form.
– 1. Debit cards, enable consumers to purchase goods
and services by electronically transferring funds directly
from their bank accounts to a merchant’s account, e.g.,
K-Net card in Kuwait.
– 2. Credit cards are now often becoming faster to use
than cash, e.g., Visa and MasterCard.
– stored-value card, like a prepaid phone card,
sophisticated cards are now known as Smart cards,
allows cards to be loaded with digital cash from the
owner’s bank account whenever needed. Smart cards
can be loaded from ATM machines, personal computers
with a smart card reader, or specially equipped
telephones.
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Evolution of the Payments System
• 3. e-cash: accounts with a bank that has links to the
internet and then has the e-cash transferred to your PC,
you then can be using the cash to pay for your purchases.
• What makes an asset money is that people believe it will be
accepted by others when making payment.
• this behavioral definition does not tell us exactly what
assets in our economy should be considered money.
• To measure money, we need a precise definition that tells
us exactly what assets should be included.
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Are We Headed for a Cashless Society?
• Predictions of a cashless society have been around for
decades, but they have not come to fruition
• Although e-money might be more convenient and
efficient than a payments system based on paper,
several factors work against the disappearance of the
paper system
• Still, the use of e-money will likely still increase in the
future
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Measuring Money
• The Central Bank of Kuwait’s Monetary
• Aggregates.
• M1 (most liquid assets) = currency in circulation with the
public + sight deposits (private deposits in KWDs) + other
checkable deposits.
• M2 (adds to M1 other assets that are not so liquid) = M1 +
Quasi money (saving deposits in KWDs + time deposits in
KWDs).
• M3 (adds to M2 somewhat less liquid assets) = M2 +
deposits in non-bank financial institutions.
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Monetary Aggregates (USA)
M1 (4)
M2 (4+3)
Currency
Traveler’s Checks
Demand Deposits
Other Check. Dep
Small Den. Dep.
Savings and MM
Money Market Mutual
Funds Shares
M3 (4+3+4)
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Measuring Money(USA)
• How do we measure money? Which
particular assets can be called “money”?
• Construct monetary aggregates using the
concept of liquidity:
• M1 (most liquid assets) = currency +
traveler’s checks + demand deposits +
other checkable deposits.
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Measuring Money (USA)
• M2 (adds to M1 other assets that are not so liquid) = M1
+ small denomination time deposits + savings deposits
and money market deposit accounts + money market
mutual fund shares.
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Table 1 Measures of the Monetary Aggregates
(USA)
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M1 vs. M2(USA)
• Does it matter which measure of money is
considered?
• M1 and M2 can move in different directions
in the short run (see figure).
• Conclusion: the choice of monetary
aggregate is important for policymakers.
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Figure 1 Growth Rates of the M1 and M2
Aggregates, 1960–2011(USA)
Sources: Federal Reserve Economic Database (FRED); Federal Reserve Bank of Saint Louis;
http://research.stlouisfed.org/fred2/categories/25
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FYI Where Are All the U.S. Dollars?
• The more than $2,000 of U.S. currency held
per person in the United States is a
surprisingly large number
• Where are all these dollars and who is
holding them?
– Criminals
– Foreigners
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commodity money,
e-cash,
fiat money,
income,
M1,
M3,
monetary aggregates,
smart card,
unit of account,
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currency,
electronic money (e-money),
hyperinflation,
liquidity,
M2,
medium of exchange
payments system,
store of value,
wealth,
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