Unit 2 What Is Money?

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

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

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 Barter suffers from three problems that are solved by the introduction of money. 4

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 The use of money eliminates the need for a double coincidence of wants that is required for barter exchange. 5

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 Under barter there are many different sets of prices, and the unit of account function of money solves this problem. 6

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 Money serves as a store of value, solving the barter problem that saving may be costly or impossible and that future prices of individual commodities are uncertain. 7

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 Credit cards are not money because they are not a means of final payment. 8

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 The payments system consists of the methods of transferring funds to sellers. This system is evolving with increasing use of electronic payments. 9

Evolution of the Payments System Barter Commodity Money Commodity-based Money Fiat Money Checks Electronic Payment E-Money

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 Precious metal commodity money can be coined or represented by paper redeemable for the commodity. 11

The Travels of Your Rent Check This figure shows how checks travel through the payments system. If you and Julia, your landlady, have different banks, paying your rent triggers a series of transactions. You give your rent check to Julia (step 1), and she deposits it in her bank (step 2). Julia’s bank deposits the check in its account at the Federal Reserve (step 3), and the Fed debits your bank’s account. Finally, the Fed sends the check to your bank (step 4), and your bank debits your account. 12

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 Stored-value cards are an alternative way to transfer funds. Like traveler’s checks, these cards are prepaid for a specific amount which can be used to make purchases. Many stored-value cards can be used for only a single purpose, like phone, fare, and gift cards. 13

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 E-money is used for Internet payments. It is currently a minor method of making payments. For an update on Money, please visit the Ball Book Companion website. 14

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 Liquidity is a highly desirable characteristic of an asset. 16

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 Assets have differing degrees of liquidity, and an asset’s return generally varies inversely with liquidity. This is why people hold a variety of different assets. 17

Degrees of Liquidity This figure illustrates the spectrum of liquidity from liquid to illiquid assets. 18

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 Monetary aggregates measure the amount of money in an economy. 19

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 Cash can be used only one way to make payments. Payments from checking accounts can be made several ways. 20

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 The M1 monetary aggregate measures the amount of the medium of exchange in an economy. The components of M1 include currency (including coins) in circulation, all types of checkable deposits, and nonbank traveler’s checks. Bank-issued traveler’s checks are included in checkable deposits. 21

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 M2 contains M1 plus highly liquid bank deposits and similar assets. 22

The Monetary Aggregates The table presents the values of the aggregates as of March 2008. 23

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 Savings deposits are the largest component of M2. 24

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 Certificates of deposit worth less than $100,000 are also included in M2. CDs worth $100,000 or more are negotiable. 25

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 Money-market mutual fund deposits are included in M2 even though they are not bank deposits. These assets are highly liquid, and individuals generally view these funds as alternatives to bank savings accounts. 26

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 Retail sweep accounts beginning in 1994 have distorted the M1 aggregate. Banks shift funds from checking to MMDA accounts. This shifts deposits from accounts subject to 10% reserve requirements to deposits with zero reserve requirements. May economists would like the Fed to measure and report a “sweep-adjusted” M1 aggregate. 27

Sweep Programs and M1 The figure displays the impact of the retail sweeps programs on the M1 measure of money. Measured M1 actually fell for several years following the inception of the sweeps programs. As shown by the “sweep-adjusted” measure of M1, this monetary aggregate was growing along with economic output. Since 1994, banks’ sweep programs have moved funds from checking accounts, which are part of M1, to money-market deposit accounts, which are not. Consequently, M1 fell from 1994 to 1997 and its subsequent growth has been slow. Data on M1 would show faster growth if the aggregate were redefined to include swept funds. Source: sweepmeasures.com (maintained by Barry E. Jones of the State University of New York at Binghamton) 28

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

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” This case study traces the development of the United States currency from fiat money to a commodity money and back to fiat money. 32

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 Case study continued. 33

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 Case study concluded. The case traces the evolution of the dollar between fiat currency and commodity money through the nation’s history. 34

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 Dollarization is the adoption of another currency, not necessarily dollars. Lichtenstein uses the Swiss franc and Vatican City uses the Euro. Currency boards tie the domestic currency to a country’s holdings of a foreign currency. Dollarization and currency boards are typically responses to inflation problems. The Euro is a currency union. Other currency unions exist in West Africa and the Caribbean. 35