1 Chapter 2 Money: Its Nature, Functions, And Evolution ©Thomson/South-Western 2006.

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Chapter 2

Money: Its Nature, Functions, And Evolution

©Thomson/South-Western 2006

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The Nature And Functions Of Money

Money is anything that is generally acceptable as payment for goods and services or for the settlement of debt.

not a legal definition of money-- a behavioral one.

Money is anything that we believe others will accept as payment.

Acceptance is contingent on confidence that it will retain its value or purchasing power.

Confidence in money’s value relies on it being sufficiently scarce that its value does not diminish over time.

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Historical Money

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What Economists Include in the Definition of Money

all currency (coins and paper bills) held by the public

demand deposits and other checking deposits in: commercial banks, savings and loan associations, mutual savings banks, and credit unions

Practically all U.S. payments are made by the exchange of currency or by the transfer of deposit balances via checks or electronic (wire) transfer.

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Why Credit Cards Are Not Money

Credit cards are essentially a method of postponing payment for a few days or months.

The cards themselves do not constitute money.

Actual money payment is merely deferred until later.

Credit cards do not influence the supply of money, but do reduce the demand for money.

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Legal Tender Legal tender:

cannot lawfully be refused in payment for goods and services and for discharge of debts.

No merchant or creditor can demand payment in another form.

Currency and coin are legal tender.

Checking accounts are not legal tender. Many items have served as money without having

legal tender status. Legal tender is a sufficient, but not a necessary,

condition for a substance to be considered money.

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Distinctions Among Money, Wealth, and Income

Though money, income and wealth are all measured in “dollars;” they differ significantly in their meaning.

People have money if they have large amounts of currency or big bank accounts at a point in time. (stock variable)

Someone earns income (not money) from work or investments over a period of time. (flow variable)

People have wealth if they have assets that can be converted into more currency than is necessary to pay their debts at a point in time. (stock variable)

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Functions of Money

Money serves as a

medium of exchange or means of payment

standard of value or unit of account

store of value

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Barter Economy In a money economy, people use money to sell their

goods or services for money and buy what they want with money.

A barter economy is one in which goods and services are traded directly for one another.

In barter systems, people must find producers of what they want who also want what they have to trade.

This double coincidence of wants is socially inefficient, and the introduction of money eliminates this problem.

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Money Creates Efficient Exchange

Just as the division of labor and specialization allow for efficient production, money allows for efficient exchange.

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Standard of Value or Unit of Account

Money serves as a measuring rod or yardstick to assess the relative value of various goods and services.

Without money, each item brought to market would bear a certain value relative to each of the other items--e.g. good A, B, C, and D.

With money, each good has one price (in dollars). Without money,we must establish the:

A price of B, A price of C, A price of D; B price of C, B price of D; C price of D, and (the reciprocal of the X price of Y is the Y price of X)

In an N good society there are: N prices when money works. N(N-1)/2 prices when barter predominates.

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Store of Value Money acts as a temporary storage of purchasing power. In a barter economy, the purchase of any item implies a

simultaneous sale of another item. In a money economy, people can sell something (e.g. their

labor) without buying something simultaneously. Money is not the only store of value. Money is not a perfect store of value.

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Liquidity

We store purchasing power as money rather than as something else because converting it back into money can be costly.

An asset is liquid if it can be easily converted into money and illiquid if it is costly to convert. Cash is perfectly liquid. Stocks and bonds are somewhat less liquid. Land is illiquid.

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Inseparability of the Store-of-Value and Medium-of-Exchange Functions

During hyperinflation, individuals and firms frantically attempt to rid themselves of money because its value was deteriorating rapidly—that is, money failed as a store-of-value.

Merchants may refuse to accept payment in money, insisting instead on payment in goods and services—this reflects money’s failure as a medium-of-exchange.

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Full-bodied or Commodity Money

Early monies were full-bodied, or commodity money. Commodity money’s value is approximately the same

whether it is used as money or as a commodity. This equality of value was assured by forces of supply and

demand. If coins are worth more for their metal than for their

exchange value, then they will be melted down or milled off.

If metal is worth more as coins than it is as a commodity, then it will be turned into coins unless regulation prevents such minting.

The forces of supply and demand ensure that the value of the coin will not deviate markedly from its value as a commodity.

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Representative Full-Bodied Money

During the industrial revolution, the exclusive use of coins as medium of exchange became increasingly inconvenient.

Coins were supplemented with paper currency that was backed by the valuable metals.

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Fiat or Credit Money Does money need to be backed by a commodity at

all?

The logical answer to this question is no.

If the monetary system is stable and functions effectively, “backing” is expensive, inconvenient, and unnecessary.

Today, money is only backed by confidence that government will responsibly limit the quantity of money to ensure that money in circulation will hold its value.

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Advantages and Disadvantages of Fiat Money

Advantages

Fewer resources are used to produce money.

The quantity of money in circulation can be determined by rational human judgment rather than by discovering further mineral deposits—like gold or diamonds.

Disadvantage:

A corrupt or pressured government might issue excessive amounts of money, thereby unleashing severe inflation.

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Checking Accounts Checking accounts first became popular after the Civil War

because the Federal government placed a 10 percent tax on banknotes issued by state-chartered banks.

Advantages: People are not forced to carry around large amounts of paper

currency. You can pay bills without worrying about the cash being stolen in

transit. Accounts are insured up to $100,000. Checks provide records for accounting and tax purposes.

Disadvantages Check clearing costs $5 billion per year. Checks must “clear”—introducing “float” costs. Float costs are in the

process of being eliminated by more rapid check clearing.

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Electronic Money Electronic money systems can increase payments

system efficiency. Innovations in data processing, information retrieval,

and communications systems make electronic money systems possible.

Advantages Reduced cost of processing checks Reduced costs from billing credit cards Employers can reduce their payroll costs by paying with

direct deposit. People can reduce their costs by paying bills electronically

(either automatically or manually online.)

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Electronic Money and Financial Institutions

Electronic Money and Financial Institutions

Fedwire and Swift are electronic money transfers that have been around for 30 years.

These transfers account for: 1% of the number of transfers.

85% of the dollar volume of transactions.

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Newer Electronic Money

Debit cards

Stored-value cards

Electronic checks

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Factors Slowing the Transition to Electronic Money

High fixed technology costs Checks provide physical receipts and transaction

records.

People often use the “float,” though such advantages to payers are quickly disappearing because of rapid (electronic) check clearing.

Legal and security concerns regarding theft and loss of privacy

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Measures of Money Supply Money supply influences output, income, and prices.

Accurate measures of money supply must be tabulated and published regularly.

Industrial nations employ fairly standard measures of money.

The U.S. Federal Reserve currently publishes data on several “monetary aggregates” (M1, M2, and M3).

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M1, M2 and M3 M1 = Currency + Demand Deposits + Other Checkable Accounts +

Travelers’ Checks (these are small and will be ignored later) M2 = M1 + Savings Accounts + Money Market Deposit Accounts +

Money Market Mutual Fund Shares (held by individuals) + Small (<$100K) Time Deposits

M3 = M2 + Large (>$100K) Time Deposits + Repurchase Agreements + Money Market Mutual Fund Shares (held by institutions)

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Deciding What is in Each Aggregate

M1 includes highly liquid accounts that are typically used primarily as a medium of exchange rather than primarily as a store of value.

M2 includes M1 and accounts (MMDA, MMMFs and small CDs) that are highly liquid.

M3 includes M2 and all other forms of deposits.

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Which Measure Is Most Useful?

Arguments for narrower measures The measure of money should be based on the economic

principles of liquidity and primary use. The choice of money to monitor should remain constant.

Arguments for broader measures The purpose of measuring money is to monitor and control

its magnitude in order to stabilize economic activity. Which measure is best is an empirical question.

The measures do not move together--and often move in different directions.

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Divisia Aggregates : Weighted Measures of Money

M1, M2, and M3 give equal weight to each of the items they include.

A divisia aggregate is a weighted aggregate such as: M = DDO + Cp + .50 (MMMF) + .25 (SD + TD)

Economists are researching the best “weights.”

No generally accepted set of weights so the Federal Reserve equally weights all components.