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Understanding Money and Banking Fundamentals

Learn the definition and functions of money, different types of payment systems, and the comparison between M1 and M2 money supplies. Discover how money has evolved in the payments system and the importance of measuring money in the economy.

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Understanding Money and Banking Fundamentals

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  1. Money and Banking Chapter 1 What is money?

  2. Learning Objectives • Describe what money is • List and summarize the functions of money • Identify different types of payment systems • Compare and contrast the M1 and M2 money supplies

  3. Money • Money (or the “money supply”): anything that is generally accepted as payment for goods or services or in the repayment of debts. • Money (a stock concept) is different from: • Wealth: the total collection of pieces of property that serve to store value • Income: flow of earnings per unit of time (a flow concept)

  4. Functions of Money • Medium of Exchange: • Use of asset in a transaction to buy/sell goods and services • Unit of Account: • Used to measure value in the economy • Reduces transaction costs • Store of Value: • Used to save purchasing power over time • Other assets also serve this function. • Money is the most liquid of all assets but loses value during inflation.

  5. Evolution of the Payments System • Commodity Money: valuable, easily standardized and divisible commodities (e.g. precious metals, cigarettes) • Fiat Money: paper money decreed by governments as legal tender • Checks: an instruction to your bank to transfer money from your account • Electronic Payment (e.g. online bill pay) • E-Money (electronic money): • Debit card • Stored-value card (smart card) • E-cash

  6. Group discussion • What was the last thing you bought? How did you pay for it? • How often do you have cash in your wallet? How often do you pay with a debit/credit card? • What other forms of payment have you used? (Apple Pay, Bitcoin, Paypal) • Are we headed towards a cashless society?

  7. Measuring Money in the Economy Monetary Aggregates: • M1 – most liquid form of money • Currency in circulation • Money in checking accounts • Traveler’s checks • M2 – M1+ • Small time deposits • Savings deposits • Money market deposit accounts (Certificates of Deposit)

  8. Finding the data • Go to https://www.federalreserve.gov/data.htm • Find “Money Stock Measures”  H.6 • Go to Table 3 (M1 Components) • What is the largest component of M1? Which is the smallest? • Go to Table 4 (Non-M1 M2 Components) • What is the largest component of M2? Which is the smallest? • M1 is what share of M2? (M1 total / M2 total)

  9. M1 M2 Currency Traveler’s Checks Demand Deposits Other Check. Dep Small Den. Dep. Savings and MM Money Market Mutual Funds Shares M3 Monetary Aggregates

  10. Growth Rates of the M1 and M2, 1960–2014

  11. Key Takeaways • Money is an important part of the economy – but it is different than wealth or income • People consider how much money they want to hold by balancing their preferences for returns vs. liquidity • Money serves three key functions • Money in the economy is categorized in M1 and M2 – also known as the money supply

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