Unit 2

1. Unit 2 What Is Money?

2. Meaning of Money • Money (money supply)—anything that is generally accepted in payment for goods or services or in the repayment of debts; a stock concept • Wealth—the total collection of pieces of property that serve to store value (a person’s assets less liabilities) • Income—flow of earnings per unit of time

3. Functions of Money • Medium of Exchange—promotes economic efficiency by minimizing the time spent in exchanging goods and services • Must be easily standardized • Must be widely accepted • Must be divisible • Must be easy to carry • Must not deteriorate quickly • Unit of Account—used to measure value in the economy • Store of Value—used to save purchasing power; most liquid of all assets but loses value during inflation

4. Money versus Barter Barteris the direct exchange of goods and services, which is how exchange occurs when there is no money Barter exchange has several problems: Barter requires a double coincidence of wants With barter there are multiple prices for each good It may be difficult to store wealth with barter

5. Double Coincidence of Wants Barter requires that two parties have something to trade, that each party wants what the other person is offering, and that each feels the values of the traded goods or services are equal A medium of exchangesolves this problem since the purchase and sale are separated, with each transaction being conducted using money

6. Barter Prices With barter, prices are quoted in terms of other goods, such as shoes or bread, resulting in many sets of prices that make comparisons difficult With money serving as theunit of account, all prices are quoted in terms of the money, making comparisons of prices quoted by different sellers very easy

7. A Store of Value Storing wealth under barter can be difficult as many goods and services cannot be easily saved Money is a store of value that is easily saved to make future payments In developed economies there are many assets that are more attractive stores of value than money In countries suffering high inflation, foreign currency is often the most popular store of value

8. What About Credit Cards? Credit cards are not money Use of a credit card is an act of borrowing money Final payment for the use of credit cards is made by check or electronically

9. The Payments System The payments systemis the way funds are transferred to sellers of goods and services Transferring checking payments between banks occurs through other banks and/or through the Federal Reserve System With digital imaging of checks, transferring paper checks between banks is disappearing Electronic payments also ensure the funds are available

10. Evolution of the Payments System • Barter • Commodity Money • Commodity-based Money • Fiat Money • Checks • Electronic Payment • E-Money

11. Commodity Money Coins Made from precious metals with standard weights and purities First appeared in China in 1000 BC and in Greece in 700 BC Paper money Originally backed or redeemable for commodities Appeared in China in the year 1000 AD and in Europe between 1500 AD and 1700 AD

12. The Travels of Your Rent Check

13. New Kinds of Money Stored-value cardscan be used for a prepaid amount of money; some can be reloaded Since they are prepaid, these cards are electronic traveler’s checks Examples include phone cards, gift cards, and fare cards for public transportation Currently more popular in Asia

14. Electronic Money E-moneyis funds in an electronic account used for Internet purchases PayPal accepts transfers from checking or credit cards to an account designated for Internet purchases Internet payment can also be made with debit and credit cards, so e-money is not necessary

16. Liquidity Liquidityis how easily and costly an asset can be converted for money The most liquid assets are converted to money easily and inexpensively Liquid assets generally offer higher returns than money Liquid assets are easily traded for money

17. Degrees of Liquidity Money is the most liquid asset Savings account deposits are easily withdrawn or transferred to a checking account and are considered near money Securities are less liquid than savings deposits Physical assets are less liquid than financial assets There is a trade-off between yield and liquidity

18. Degrees of Liquidity

19. Money Today The money supplyis the total amount of money in the economy Monetary aggregatesare measures of the money supply The two monetary aggregates or money supply measures in the United States are M1 andM2

20. Making Payments Currency is exchanged directly for goods Checks Payments can be made by writing checks Debit cards access funds in checking accounts Electronic payments transfer funds between checking accounts Electronic payments reduce costs

21. M1 M1 is the primary measure of the money supply M1 is the measure of the medium of exchange M1 consists of currency in circulation, checkable deposits, and nonbank traveler’s checks

22. Measuring Broad Money: M2 M2includes all of M1 plus other liquid assets In addition to M1, M2 includes savings deposits, small time deposits, and retail money-market mutual funds

23. The Monetary Aggregates

24. Measuring Broad Money: M2 Savings deposits include all savings accounts, including money-market deposits accounts (MMDA) MMDAs have a limited check-writing privilege, but are more like savings accounts than checking accounts

25. Measuring Broad Money: M2 Small time deposits consist of certificates of deposit (CD) worth less than $100,000 Larger CDs are held by firms and financial institutions CDs have withdrawal restrictions, making them less liquid than savings deposits

26. Measuring Broad Money: M2 Retail money-market mutual funds are shares in funds that buy short-term bonds These funds are highly liquid and often allow limited check writing to withdraw “deposits” or shares Shares purchased for less than $50,000 are considered retail. These shares are more likely held by individuals

27. Sweep Programs Sweep programsare banks’ practice of shifting checking deposits to MMDAs to avoid reserve requirements The Fed allowed sweep programs beginning in 1994 Sweep programs transfer funds out of the M1 measure of money and have distorted this aggregate

28. Sweep Programs and M1

29. How Reliable are the Money Data? • Revisions are issued because: • Small depository institutions report infrequently • Adjustments must be made for seasonal variation • We probably should not pay much attention to short-run movements in the money supply numbers, but should be concerned only with longer-run movements

32. Case Study: The History of the U.S. Dollar The Continental dollar was a fiat currency After the revolution the new country minted gold and silver coins The First and Second Banks of the United States, our first central banks, issued paper money redeemable for gold or silver To pay for the Civil War the government issued fiat currency called “Greenbacks”

33. Case Study: The History of the U.S. Dollar The return to commodity money occurred in 1879 when the gold standard was reestablished, with an ounce of gold worth $20.67 In 1914 the Federal Reserve began operations and its notes had only 40% gold backing In 1933 President Roosevelt suspended the gold standard

34. Case Study: The History of the U.S. Dollar In 1934 Roosevelt restored the gold standard with a devalued dollar. Foreign governments could exchange dollars for gold at $35 per ounce. Private ownership of monetary gold was prohibited In 1945 the Fed’s gold reserve requirement was reduced to 25%, and it was ended in 1965 In 1971 President Nixon broke all ties to gold. The dollar once again became a fiat currency

35. Alternatives to a National Currency Dollarization is the use of another country’s currency to replace the domestic currency Ecuador and El Salvador have adopted the U.S. dollar Under a currency boardthe national currency is backed by an equal amount of foreign currency Bulgaria and Hong Kong have currency boards A currency union exists when a group of countries adopt a common currency The Euro is a currency union