Chapter 3 - What Is Money

Prior to the War for Independence, your money might have consisted of Spanish doubloons (silver pieces of eight).

Before the U.S. Civil War, principal forms of money were gold and silver coins, and banknotes issued by private banks.

Today, coins, dollar bills issued by the U.S. Federal government, as well as checks written on accounts held at banks.

 What is money?

 How is it measured?

 How does it promote economic efficiency?

Meaning of Money, Wealth and Income

money (or money supply) - anything that is generally accepted in payment for goods or services, or in the repayment of debts

 Includes currency…like dollar bills and coinage, but economic definition is more

 Checking account deposits also considered money (but not the actually checks)

wealth- total collection of assets and property that serve as a store of value

 includes not only money but bonds, common stock, art, land, cars, houses, etc.

income - flow of earnings

 money is a stock, not a flow

Functions of Money - Three Functions

  1. Money as a Medium of Exchange

 Money used to pay for goods and services

 Promotes economic efficiency…no barter system needed

 With barter systems, transaction costs (time spent exchanging G/S) are high since individuals have to satisfy a "double coincidence of wants"

Someone has to want what I have,

and they have to have what I want.

 Money eliminates time spent exchanging G/S, and promotes economic efficiency by allowing individuals to specialize in what they do best (division of labor)

Commodity Money and Fiat Money

commodity money - money that is based on a specific commodity (gold, silver) and does have intrinsic value

e.g. cigarettes in WWII prisoner of war camps, strings of beads, tobacco, whiskey

Criteria of commodity money:

  1. It must be easily standardized, so as to ascertain value easily
  2. It must be widely accepted
  3. It must be divisible ("make change")
  4. It must be easy to carry
  5. It must not deteriorate quickly

fiat money - money with no intrinsic value

 fiat - Latin for "let it be done"

  1. Money as a Unit of Account

 Money is an agreed measure for stating the prices of goods & services…a numéraire

 To get the most out of your budget, ask…is the G/S price worth its opportunity cost?

…the former easy to calculate, the latter is difficult…

 Suppose an economy has only three goods: peaches, economic lectures & movies…

Need to know three prices…peaches in terms of lectures, lectures in terms of movies, and movies in terms of peaches

 For ten goods, we need to know 45 prices in order for exchange to occur…with 100 goods, we need to know 4950 prices

  1. Money as a Store of Value

 If something stores value, it holds purchasing power over time

 Any commodity that can be held & later exchanged for goods and services

 How good a store of value money is depends on the price level…if prices double, purchasing power falls,…and so does the value of money (value of money halved)

 If inflation high (prices increasing rapidly), individuals reluctant to hold wealth in the form of money…opt for assets & property (stocks, bonds, land, houses, art, jewelry) …post WWI Germany Hyperinflation

 Assets also often appreciate in price or pays owner a higher return than what money does

Liquidity

Question: if assets can serve as a store of value, and provide a higher return than money does,…why hold money?

Answer: Liquidity, or the relative ease and speed with which assets can be converted to a medium of exchange

 Liquidity highly desirable

 Money is most liquid asset of all because it is the medium of exchange…no conversion is necessary to make purchases of G/S

cash ------CDs ------real estate

(very liquid) (less liquid) (even less liquid)

Evolution of the Payments System

payments system- method of conducting transactions in the economy

commodity money - problem is that such a form of money is heavy (precious metals) and difficult to transport

fiat money - paper currency solves transportation problem (lighter), but requires trust in the issuing authority, and can be easily stolen

checks- type of IOU payable on demand… allows transactions without money

Pros:

 Reduction in transportation costs

 Improves economic efficiency

 Can be written for any amount up to the balance of the account

 Loss from theft is greatly reduced

Cons:

 It takes time to get checks from one place to another…bank exchange of funds may take several business days

 Check "shuffling" is costly…over $5 bil. per year to process all checks written in U.S.

Solution to drawbacks of a modern checking system is the advent of an electronic means of payment (EMOP),… where all payments are made using electronic telecommunications

 EMOP has existed for sometime

 Federal Reserve's Fedwire… allows financial institutions (that maintain accounts with Fed) to wire/transfer funds to each other without having to send checks

 Wire transfers using similar systems are typically for amounts greater than $1 million …even though less than 1% of transactions use EMOP method, over 80% of dollar value transactions conducted electronically

 Employee direct deposit programs utilize automatic clearing houses (ACHs)…HHs also utilize ACHs to pay bills

Electronic Money (e-money)

debit cards - enable consumers to purchase goods electronically transferring funds directly from their bank accounts to the merchant's account

 Accepted in many places that credit cards are accepted (issuing companies like VISA)

stored-value card - contain a fixed amount of digital cash

 Simplest form is a "spend-down" card (CMU copy cards same type of card)

 More sophisticated cards are "smart cards" that contain computer chips loaded with digital cash from owner's bank account whenever needed…loaded from ATM machines, personal computers, cell phones

electronic cash (e-cash)–รูปแบบของเงินอิเล์คโทรนิคส์ทั้ใช้สำหรับการซื้อสินค้าและบริการต่างๆทางอินเตอร์เน็ต

ผู้บริโภคสามารถที่จะได้เงินที่เรียกกันว่าe-cashโดยการเชื่อมโยงเว็บไซด์ของธนาคารทำให้สามารถทำรายการผ่านทางจอคอมพิวเตอ์และสามารถซื้อสินค้าและบริการทางอินเตอร์เน็ตได้ต่อไป

โดยการใช้e-cash นั้นเป็นการใช้เพื่อใช้จ่ายทางอินเตอร์เน็ตได้อย่างเดียวเท่านั้น

electronic checks- allow Internet users to pay bills directly online without having to send a paper check

 since the transaction is processed electronically, its cheaper and more convenient than paper checks

Cashless Society?

Business Week predicted (1975) that electronic means of payment would soon "revolutionize the very concept of money"

Several factors work against the disappearance of a paper money system…

 Expensive to set up computers, card readers, & telecom. networks necessary for electronic money to become the dominant form of money

 Paper checks provide receipts

 Paper checks give consumers several days of "float" before check is cashed

 Security and privacy concerns

Measuring Money

Recall the definition of money…anything generally accepted in payment for G/S

This suggests that money is defined by people's behavior

Many different assets performed the role of payment,…from gold to paper currency to checking accounts…to measure money, need to be more precise in definition

…use Fed Reserve's Monetary Aggregates

Measuring Money - M1, M2, M3

M1: currency, checking account deposits, and traveler's checks

 Narrowest money measure the Fed reports

 M1 assets clearly money since they can be used directly as a medium of exchange

M2: M1 plus other assets that have check-writing features and that are extremely liquid assets

 MM deposits, MM mutual fund shares, time deposits like CDs, repos, overnight Eurodollars

M3: M2 plus less liquid assets

 Large-denomination time deposits, term repurchase agreements, term Eurodollars and institutional MM mutual fund shares

 Table 1 - Measures of Money Aggregates

Movements of Money Aggregates Matter?

Do the monetary aggregate movements closely parallel one another?

If so, then we can use one measure to base monetary policy on, with little cost to our decision…

If not, and aggregates do not move together, differing movements might yield information as to what is happening in the economy

 Figure 1 - Growth Rates of 3 Money Aggs.

Movements in Monetary Aggregates

 Growth rates of M1, M2 and M3 do tend to move together

 Similar rise/fall in 1990s, higher averages in 1970s compared to 1960s

 However, according to M1, growth of money did not accelerate in 1968 when it was in the 6-7 percent range

…M2 and M3 show marked increase from the 8-10 percent range to 12-15 percent range

 1989-1992, growth rate of M1 increased, but growth rates of M2 and M3 showed a downward trend

 1992-1999, M1 growth falls sharply, while M2 and M3 growth increases

Is the Money Data Reliable?

Difficulties of measuring money arise not only due to definitions of money, but also because the Fed frequently revises estimates of money aggregates, often by large amounts.

 Small depository institutions need report deposit amounts only infrequently,… so Fed has to estimate these amounts until actual numbers provided at a future date

 Adjustment of data for season variation is revised substantially as more data becomes available

 Table 2 - M2 1999 Growth Rate,

Initial & Revised Series

Is the Money Data Reliable?

 Initial data on monetary aggregates reported by Fed are not a reliable guide to what is happening to short-run movements in the money supply (e.g. one-month growth)

 Initial money data reasonably reliable for longer periods, such as a year

Conclusion: do not give much notice to short-run movements in the money supply numbers,…

…but should pay attention to longer-run movements

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Copyright © 2001, 2004 J. Reynolds - Addison Wesley