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

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).


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.


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?)


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;


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.


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=499500• Use this formula:

(N(N-1))/2Where N = number of goods


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.


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.


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.


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.



• 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.



• 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



• 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.



• 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



• 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.



• 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.


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.


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).


Measuring Money

• M3 (adds to M2 somewhat less liquid assets) = M2 + deposits in non-bank financial institutions.


Table 1 Measures of the Monetary Aggregates

Central bank of Kuwait Monetary Aggregates

Period 2003 2004 2005 2006 2007 2008 2009 2010 Q1

Currency Issued -1 585.5 606.3 684.6 804.9 756.7 869.1 943.8 943

Cash with Local Banks -2 91.3 75.3 105.9 148.6 115.2 161.4 168.1 140.4

Currency in Circulation (3)=(1)-(2) 494.1 531 578.7 656.3 641.5 707.8 775.7 802.6

Sight Deposits in KD -4 2117.4 2643.3 3148.7 2893.9 3505.2 3662.5 3938.3 4445.7

Money (M1) (5)=(3)+(4) 2611.5 3174.2 3727.4 3550.3 4146.7 4370.3 4714 5248.3

Quasi-Money -6 7789.7 8481 9358.8 12370.3 14813.2 17579.9 20181.8 20389.6

Money Supply (M2) (7)=(5)+(6) 10401.2 11655.2 13086.2 15920.6 18959.9 21950.2 24895.8 25637.9

Deposits with Financial Institutions* -8 8.9 23.2 14.2 26.1 26.1 56.8 23.7 24.7

Money Supply (M3) (9)=(7)+(8) 10410.2 11678.4 13100.4 15946.7 18986 22007 24919.4 25662.6


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,

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

Documents