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Unit 2

What Is Money?

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Meaning of Money Money (money supply)—anything that is

generally accepted in payment for goods or services or in the repayment of debts; a stock concept

Wealth—the total collection of pieces of property that serve to store value (a person’s assets less liabilities)

Income—flow of earnings per unit of time

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Functions of Money

Medium of Exchange—promotes economic efficiency by minimizing the time spent in exchanging goods and services Must be easily standardized Must be widely accepted Must be divisible Must be easy to carry Must not deteriorate quickly

Unit of Account—used to measure value in the economy

Store of Value—used to save purchasing power; most liquid of all assets but loses value during inflation

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Money versus Barter Barter is the direct exchange of goods and services,

which is how exchange occurs when there is no money

Barter exchange has several problems: Barter requires a double coincidence of wants With barter there are multiple prices for each

good It may be difficult to store wealth with barter

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Double Coincidence of Wants

Barter requires that two parties have something to trade, that each party wants what the other person is offering, and that each feels the values of the traded goods or services are equal

A medium of exchange solves this problem since the purchase and sale are separated, with each transaction being conducted using money

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Barter Prices

With barter, prices are quoted in terms of other goods, such as shoes or bread, resulting in many sets of prices that make comparisons difficult

With money serving as the unit of account, all prices are quoted in terms of the money, making comparisons of prices quoted by different sellers very easy

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A Store of Value Storing wealth under barter can be difficult as many

goods and services cannot be easily saved Money is a store of value that is easily saved to

make future payments In developed economies there are many assets

that are more attractive stores of value than money

In countries suffering high inflation, foreign currency is often the most popular store of value

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What About Credit Cards?

Credit cards are not money Use of a credit card is an act of borrowing

money Final payment for the use of credit cards is

made by check or electronically

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The Payments System The payments system is the way funds are

transferred to sellers of goods and services Transferring checking payments between banks

occurs through other banks and/or through the Federal Reserve System

With digital imaging of checks, transferring paper checks between banks is disappearing

Electronic payments also ensure the funds are available

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Evolution of the Payments System

Barter Commodity Money Commodity-based Money Fiat Money Checks Electronic Payment E-Money

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Commodity Money

Coins Made from precious metals with standard weights

and purities First appeared in China in 1000 BC and in Greece

in 700 BC Paper money

Originally backed or redeemable for commodities Appeared in China in the year 1000 AD and in

Europe between 1500 AD and 1700 AD

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The Travels of Your Rent Check

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New Kinds of Money

Stored-value cards can be used for a prepaid amount of money; some can be reloaded Since they are prepaid, these cards are electronic

traveler’s checks Examples include phone cards, gift cards, and

fare cards for public transportation Currently more popular in Asia

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Electronic Money

E-money is funds in an electronic account used for Internet purchases

PayPal accepts transfers from checking or credit cards to an account designated for Internet purchases

Internet payment can also be made with debit and credit cards, so e-money is not necessary

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Liquidity

Liquidity is how easily and costly an asset can be converted for money

The most liquid assets are converted to money easily and inexpensively

Liquid assets generally offer higher returns than money

Liquid assets are easily traded for money

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Degrees of Liquidity

Money is the most liquid asset Savings account deposits are easily withdrawn or

transferred to a checking account and are considered near money

Securities are less liquid than savings deposits Physical assets are less liquid than financial assets There is a trade-off between yield and liquidity

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Degrees of Liquidity

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Money Today

The money supply is the total amount of money in the economy

Monetary aggregates are measures of the money supply

The two monetary aggregates or money supply measures in the United States are M1 and M2

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Making Payments

Currency is exchanged directly for goods Checks

Payments can be made by writing checks Debit cards access funds in checking accounts Electronic payments transfer funds between

checking accounts Electronic payments reduce costs

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M1

M1 is the primary measure of the money supply

M1 is the measure of the medium of exchange

M1 consists of currency in circulation, checkable deposits, and nonbank traveler’s checks

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Measuring Broad Money: M2

M2 includes all of M1 plus other liquid assets In addition to M1, M2 includes savings

deposits, small time deposits, and retail money-market mutual funds

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The Monetary Aggregates

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Measuring Broad Money: M2

Savings deposits include all savings accounts, including money-market deposits accounts (MMDA)

MMDAs have a limited check-writing privilege, but are more like savings accounts than checking accounts

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Measuring Broad Money: M2

Small time deposits consist of certificates of deposit (CD) worth less than $100,000 Larger CDs are held by firms and financial

institutions CDs have withdrawal restrictions, making them

less liquid than savings deposits

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Measuring Broad Money: M2

Retail money-market mutual funds are shares in funds that buy short-term bonds These funds are highly liquid and often allow

limited check writing to withdraw “deposits” or shares

Shares purchased for less than $50,000 are considered retail. These shares are more likely held by individuals

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Sweep Programs

Sweep programs are banks’ practice of shifting checking deposits to MMDAs to avoid reserve requirements

The Fed allowed sweep programs beginning in 1994

Sweep programs transfer funds out of the M1 measure of money and have distorted this aggregate

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Sweep Programs and M1

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How Reliable are the Money Data?

Revisions are issued because: Small depository institutions report infrequently Adjustments must be made for seasonal variation

We probably should not pay much attention to short-run movements in the money supply numbers, but should be concerned only with longer-run movements

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Case Study: The History of the U.S. Dollar

The Continental dollar was a fiat currency After the revolution the new country minted

gold and silver coins The First and Second Banks of the United States,

our first central banks, issued paper money redeemable for gold or silver

To pay for the Civil War the government issued fiat currency called “Greenbacks”

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Case Study: The History of the U.S. Dollar

The return to commodity money occurred in 1879 when the gold standard was reestablished, with an ounce of gold worth $20.67

In 1914 the Federal Reserve began operations and its notes had only 40% gold backing

In 1933 President Roosevelt suspended the gold standard

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Case Study: The History of the U.S. Dollar

In 1934 Roosevelt restored the gold standard with a devalued dollar. Foreign governments could exchange dollars for gold at $35 per ounce. Private ownership of monetary gold was prohibited

In 1945 the Fed’s gold reserve requirement was reduced to 25%, and it was ended in 1965

In 1971 President Nixon broke all ties to gold. The dollar once again became a fiat currency

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Alternatives to a National Currency

Dollarization is the use of another country’s currency to replace the domestic currency Ecuador and El Salvador have adopted the U.S.

dollar

Under a currency board the national currency is backed by an equal amount of foreign currency Bulgaria and Hong Kong have currency boards

A currency union exists when a group of countries adopt a common currency The Euro is a currency union