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Chapter 2Chapter 2

Money: Its Nature, Functions, And

Evolution

©Thomson/South-Western 2006

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The Nature And Functions Of Money 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.

Coins, paper bills, etc.

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 MoneyHistorical Money

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Economists’ Definition of Economists’ Definition of MoneyMoney

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, andcredit unions

Practically all 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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Legal TenderLegal Tender

Legal tendercannot lawfully be refused in payment for goods and services and for discharge of debts. no merchant or creditor can demand payment in another form. Only Currency and coins are legal tender.

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

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Why Credit Cards Are Not Why Credit Cards Are Not Money 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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Distinctions Among Money, Wealth, & Distinctions Among Money, Wealth, & IncomeIncome

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

People have ______ if they have large amounts of

currency or big bank accounts at a point in time.

(stock variable)Someone earns ______ from work or

investments over a period of time. (flow

variable)People have ______ if they have assets > debts at a point in time. (stock variable)

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3 Functions of Money 3 Functions of Money

Money serves as a

1. medium of exchange or means of payment

2. standard of value or unit of account

3. store of value

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1. Medium of Exchange1. Medium of Exchange

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

In barter economy, 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.

In a money economy, people use money to sell their goods or services for money and buy what they want with money.

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2. Standard of Value (Unit of 2. Standard of Value (Unit of Account)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).

In a society with N goods, there are:N prices when money works.

N(N-1)/2 prices when barter predominates.

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3. Store of Value 3. 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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LiquidityLiquidity

“ The relative ease with which an asset can be converted into money (i.e., liquidated) without significant

commissions, other charges, inconvenience and risk of principal”

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Liquidity Liquidity (2)(2)

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 & Inseparability of the Store-of-Value & Medium-of-Exchange FunctionsMedium-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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Evolutions of MoneyEvolutions of Money

1. Full-bodied or Commodity Money

2. Representative Full-Bodied Money

3. Fiat or Credit Money

4. Checking Accounts

5. Electronic Money

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1. Full-bodied or Commodity 1. Full-bodied or Commodity Money 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 & demand.

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1. Full-bodied or Commodity 1. Full-bodied or Commodity Money Money (2)(2)

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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2. Representative Full-Bodied 2. Representative Full-Bodied MoneyMoney

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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3. Fiat or Credit Money3. 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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3. Fiat or Credit Money 3. Fiat or Credit Money (2)(2)

“Form of money that derives its value by fiat or government decree rather than through its value as a

commodity”

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Advantages and Disadvantages of Fiat Advantages and Disadvantages of Fiat MoneyMoney

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, Causing inflation.

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4. Checking Accounts 4. Checking Accounts

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 & tax purposes

DisadvantagesCheck clearing costs $5 billion per year.Checks must “clear”—introducing “float” costs.

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5. Electronic Money5. Electronic Money

Innovations in data processing, information retrieval, and communications systems make electronic money systems possible.

Advantages EfficiencyReduced 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

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Newer Electronic MoneyNewer Electronic Money

Debit cards

Stored-value cards

Electronic checks

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Debit cards

A card with which an individual pays for an item by transferring funds

electronically and immediately from his / her bank account to the

merchant’s bank account

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Stored-value cards

Cards loaded with a predetermined amount of money; used to make

payments

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Electronic cash

E-cashForm of money that facilitates payment for items purchased over the InternetAn individual sets up a bank account in which the bank transfers e-cash to the individual’s personal computer via the Internet

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Electronic checks

Similar to regular checks except that the process is electronic, circumventing the costly procedure of physically processing and transporting checks.

Lower cost relative to traditional paper checks

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Factors Slowing the Transition to Electronic Factors Slowing the Transition to Electronic Money Money

High fixed technology costs

No physical receipts and transaction records.

Have to pay immediately (for payer), compare to writing checks.

Legal and security concerns regarding theft and loss of privacy

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Measures of Money Measures of Money Supply 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 M3M1, M2 and M3

M3 = M2 + Large (>$100K) Time Deposits + Repurchase Agreements +

Money Market Mutual Fund Shares (held by institutions)

M2 = M1 + Savings Accounts + Money Market Deposit Accounts (MMDA) +

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

M1 =Currency +

Demand Deposits + Travelers’ Checks+ Other Checkable Accounts