chapter 3: What is Money ? Flashcards
Meaning of Money
- economists define the word “Money” (+examples)
(or the “money supply”): anything that is generally accepted as payment for goods or services or in the repayment of debts.
- Currency (paper money and coins): only one type of money
- Checks, saving deposits, … whenever it can easily be converted into currency
• Wealth:
the total collection of pieces of property that serve to store value (not just money, also bonds, common stocks, land, houses, cars, furniture, art,…)
• Income:
flow of earnings per unit of time (a flow concept)
a rather broad definition of what is money
- anything that is generally accepted as payment for goods and services or in the repayment of debts
- a certain amount at a certain point in time (a stock concept)
Functions of money
- Medium of Exchange
- Unit of Account
- Store of Value
Medium of Exchange
Used to pay for goods and services
The use of money as a medium of exchange promotes economic efficiency by minimizing the time spent in exchanging goods and services:
- Eliminates the trouble of finding a double coincidence of needs (reduces transaction costs – time spent to try to exchange goods or services)
- Promotes efficiency by allowing specialization in what people do best
Medium of Exchange
• Criteria that need to be met:
- be easily standardized (to ascertain value)
- be widely accepted
- be divisible (to make change)
- be easy to carry
- not deteriorate quickly
Unit of Account
•Used to measure value in the economy
- Compare with barter – introduction of money allows you to quote prices in terms of units of that money
• Reduces transaction costs
- Reducing the number of prices that need to be considere
Liquidity
- Relative ease and speed with which an asset can beconverted into a medium of exchange
- Highly desirable
- Money is the most liquid asset because it is the medium of exchange – no conversion is necessary, therefore no transaction costs
Store of Value
Remarks:
- liquidity
- Quality of the store of value depends on the price level
Why quality of the store of value depends on the price level
- Inflation versus Hyperinflation (period of extreme inflation)
- When price level increases rapidly, money loses value fast and people become reluctant to hold wealth in this form
Payment system:
the method of conducting transactions in the
economy
Evolution of the Payments System
- Commodity Money
- Fiat Money
- Checks
- Electronic Payment
- E-Money
Commodity Money
• Money needs to be universally acceptable – object that has value to everyone is a clear candidate
• Valuable, easily standardized and divisible
commodities (e.g. precious metals, cigarettes)
•Heavy… (gold coins)
Fiat Money
- Paper money (pieces of paper that function as a medium of exchange) decreed by governments as legal tender, not convertible in coins or precious metal
- Lighter but need for trust, and counterfeiting needs to be difficult
- Still: easily stolen, expensive to transport
Checks
• An instruction to your bank to transfer money from your account
pro:
- No need to carry around large amounts of currency
- Improved the efficiency of the payments system
- Payments can be cancelled out and reduces transportation costs, improves the economic efficiency
- Easier for larger transaction
- Loss from theft greatly reduced
Electronic Payment
e.g. online bill pay
• Webbanking
• Recurring bills can automatically be deducted from your account.
• Important cost savings
Electronic Money – E-Money
Money that exists only in electronic form
• Debit card:
• Stored-value card
• E-cash:
Debit card:
enable consumers to buy goods and services by
electronically transferring funds directly form their bank account to a merchant’s account.
• E-cash:
setting up an account that has links to the internet and transfers the e-cash to the computer
Stored-value card
Examples:
- Bought for a present amount that the consumer pays up front (example: Proton – comparable to a prepaid phone card)
- Card containing a chip that can be loaded with digital cash from the owner’s bank account when needed (smart card) – eg pay by phone
currency
- commodity money
- > INTRINSIC VALUE of the product (gold)
- fiat money= fiduciary money
- > TRUST !
- > is decreed by the government
- local money/ alternative money
- > not based on intrinsic value (IV)
- > not decreed by the government
- > accepted on a voluntary basis
what is the demand to be the most liquid form of Money, the Motives:
• Number of transactions - positive
• Precautionary: against uncertain future
• Speculative:
- The real rate of money holdings (positive)
- The opportunity cost (return of substitutes: negative)
- The risk to lose value (positive)
The Fed
The Federal Reserve’s Monetary
Aggregates : central banking authority responsible for the monetary policy in the US)
Construct monetary aggregates using the concept of liquidity:
- M1 (most liquid assets)
- M2 (intermediate money )
- M3 (broad money )
Quantity theory of money
• Direct relation between the quantity of money in an economy and the level of prices of goods and services sold.
• Money is like any other commodity: increases in its supply decrease marginal value (the buying capacity of one unit of currency). This implies that an increase in money supply causes prices to rise( inflation) as they compensate for the decrease in money’s marginal
value.
• Inflation is a monetary phenomenon (because…)
- When money loses its value, you need more money to pay for the same thing
- Link between the money growth rate and the inflation
Hyperinflation
• Inflation that is very high and out of control – prices increase so fast and by enormous amounts
Monetary policy
- To control for inflation but also pay attention to stabilizing output and keeping the economy near full employment
- Twin objective: balance price and output objectives
