Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 3 What Is Money?

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 3-2 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. 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 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).

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 3-3 Meaning of Money 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.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 3-4 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?)

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 3-5 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;

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 3-6 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.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 3-7 Functions of Money 2. 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= Use this formula: (N(N-1))/2 Where N = number of goods

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 3-8 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.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 3-9 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.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Evolution of the Payments System 2. Fiat Money: paper currency decreed by governments as legal tender but not convertible into coins or precious metal. 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.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2010 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Evolution of the Payments System 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

Copyright © 2010 Pearson Addison-Wesley. All rights reserved 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 cads 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.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Measuring Money 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.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved 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).

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Measuring Money M3 (adds to M2 somewhat less liquid assets) = M2 + deposits in non-bank financial institutions.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Table 1 Measures of the Monetary Aggregates

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Key Terms commodity money, currency, e-cash, electronic money (e-money), fiat money, hyperinflation, income, liquidity, M1, M2, M3, medium of exchange monetary aggregates, payments system, smart card, store of value, unit of account, wealth,