Chapter Three Money and Payments

Copyright © Houghton Mifflin Company. All rights reserved.3 | 2 Medium of Exchange –lowers transactions costs in exchanges of goods and services Unit of Account –item in which prices are denoted; useful in making comparisons among goods Store of Value –money maintains its value, except for inflation Standard of Deferred Payment –loan repayments are stated in money terms How We Use Money

Copyright © Houghton Mifflin Company. All rights reserved.3 | 3 Payments System = Set of mechanisms for making transactions Money enables people to make exchanges within the system The Payments System

Copyright © Houghton Mifflin Company. All rights reserved.3 | 4 Created by the government (currency) or by nature (gold) Commodity money = money with some intrinsic value (also known as full-bodied money) –Gold, silver, etc. –Paper money fully backed by and redeemable for metal Fiat money = money whose value is decreed by the government –No longer backed by metal –Low cost of production Outside Money

Copyright © Houghton Mifflin Company. All rights reserved.3 | 5 Money created in private sector Checking accounts are an example Reduces costs of large transactions, provides a paper trail for receipts and/or tracking fraud More complicated than cash because it requires a clearing mechanism…banks and the Federal Reserve Moving to more electronic money and electronic clearing of checks Inside Money

Copyright © Houghton Mifflin Company. All rights reserved.3 | 6 Costs include long float times (time it takes a check to travel between banks) More checks are now cleared electronically Automated clearing house (ACH) systems use only electronic communication Fedwire connects banks to the Federal Reserve for large electronic transfers Inside Money Transfers

Copyright © Houghton Mifflin Company. All rights reserved.3 | 7 The Federal Reserve monitors amount of money in circulation, which affects the inflation rate and overall level of economic activity Federal Reserve monetary aggregates (categorized based on degree of liquidity) –M1: coins, currency, travelers checks, checking accounts –M2: M1 + savings accounts, individual MMMFs, small time deposits (under $100,000) –M3: M2 + large time deposits, institutional MMMFs, repurchase agreements issued by banks, eurodollar deposits Counting Money

Copyright © Houghton Mifflin Company. All rights reserved.3 | 8 The Fed's Money Measures, December 2004 Figure 3.1

Copyright © Houghton Mifflin Company. All rights reserved.3 | 9 The Fed's Money Measures, December 2004

Copyright © Houghton Mifflin Company. All rights reserved.3 | 10 Growth Rates of the Monetary Aggregates Figure 3.2 Growth Rates of the Monetary Aggregates Jan to April 2005, 12-Month Moving Average

Copyright © Houghton Mifflin Company. All rights reserved.3 | 11 Over $2,000 in currency per person in U.S. Where is it all? –Some money is used in illegal activities –Almost 80% of U.S. money is held abroad (places with weak local currency hold U.S. dollars as a store of value) The Case of the Missing Currency

Copyright © Houghton Mifflin Company. All rights reserved.3 | 12 Divisia monetary aggregate –Scientific approach to weighting components of M1, M2, and M3 by their interest rates MZM (Money with zero maturity) –M2 – Small time deposits + institutional MMMFs –Idea: Money that can be spent immediately M2 + bond funds + equity funds Alternative Money Measures

Copyright © Houghton Mifflin Company. All rights reserved.3 | 13 The payments system relies on steady supply of coins to make change In 1999 and 2000, the U.S. experienced a shortage The state quarter program more popular than expected. Demand for dimes and nickels greatly increased as well But government makes large profit on coins (seignorage revenue) Banks no longer take loose coin, but companies such as Coinstar do What Do You Do with Your Change?

Copyright © Houghton Mifflin Company. All rights reserved.3 | 14 Demand for coin peaked with the introduction of the state quarter program Annual Demand for New Coins Figure 3.3