1. Factsheet No. 20: The Intricate Workings of Money
Financial Services Studies Alive and Well for Advanced
The development of modern and
postmodern economies is based on
money. The supply and demand of this
commodity decides prices and ultimately
affect all financial decisions. But, what
exactly is money? What are its functions
and methods of measurement? How have
payment systems evolved over time?
Hence, from these probing questions it is
clear that the main focus for this factsheet
is money. At the completion of this
factsheet you should be able to:
1. Define the terms money, wealth
and income
2. State and discuss the various
functions served by money in
modern societies paying special
attention to:
a. A medium of exchange
b. Unit of account
c. Store of value
3. Explain how money is measured
by the various authorities in the
Caribbean region and globally
4. Clearly outline and trace the
evolution of money
Money, Currency, Income and
Wealth Defined
a. Money
From a strict economic
perspective money
(money supply) is defined
as any medium which
promotes the exchange of
goods and services between persons. Thus
money is generally viewed as anything that
is accepted for making payments for goods
and services or the repayment of debts. Such
a definition, it has to be admitted is a broad
concept as it can encapsulate a number of
variables. For example, the Mayan
merchants Polmps used cocoa beans to pay
for goods which they purchased to take back
to the Mayan towns for
the rest of the village
folk. By using the
definition provided cocoa
beans in such a context
would function or serve as money as the
cocoa beans facilitate the exchange of
goods.
Throughout human history exchange has
taken other forms. The foremost and most
well-known of them is the barter system
where one commodity was directly
exchanged for
another.
However, the
barter system
had a huge
short coming
that of a
“double
coincidence of
wants”. For
trade to take
place then both parties to the trade had to
want the good that the other party had. If not
then, the system would fail as both needs
could not be satisfactorily met. Thus the
solution to such a problem was to use a
particular commodity that had a value
attached to it that was equivalent to the
activity or good traded and that was not
dependent on a “double coincidence of
wants”.
The use of money helps to
facilitate trade since in its
absence, trade has to proceed
through barter, that is the
direct exchange of one good for
another which was based on a
“double coincidence of wants”.
A Stock
Concept
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b. Currency
It is not uncommon
to hear in everyday
language that when
people speak about money they are referring
to the dollar bills and minted coins they have
in their pockets, purses or wallets. This is
called currency and indeed this is a type of
money. However, for economists defining
money as currency is very limited, as there
exists other acceptable methods of payment
which can also be considered as money.
Cheques and checking account deposits are
just some of the examples. Savings deposits
also function as a form of money as these
can be quickly converted into currency or
checking account deposits. Hence, for an
economist the definition for money has to be
broad enough to take into consideration all
forms that facilitate the payment of goods
and services received.
c. Wealth
Generally, if we believe that
someone has a lot of money
and other valuables we
think that they are rich. In
fact, we often say that that
person has a lot of money
because he or she is able to
purchase assets such as property, car, stock,
bonds a yacht, three (3) town houses and an
island. If
money is
used in this
context,
then it is
being used
simultaneously with that of wealth. From the
examples given above, wealth can be
described as the total of pieces of property
that store value.
d. Income
Another common
statement is to hear: “He/
She earns a lot of money.”
When the term money is
used in such a situation
then it is used in reference to a person’s
income which is the flow of earnings per
unit of time.
Now that we have defined the main concepts
of money, and the various means attached
such as currency, wealth and income, we
will now examine the functions of money.
Functions of Money
Irrespective of whatever form money takes
albeit cocoa beans, paper or coins, it serves
three (3) primary functions in any economy:
a. A medium of exchange
b. Unit of account
c. Store of value
a. Medium of exchange
As a medium of exchange,
money as the ability to be
easily and readily accepted as
payment for goods and
services. In so doing the use
of money as a means of
exchange facilitated the economic efficiency
by promoting specialization and
Wealth includes money,
stock, bonds, land, art
work, vehicles and
houses.
A Flow
Concept
Money is a stock while income is a flow
concept. To illustrate, if someone tells you
they have $500 in your pocket that is all you
have: a stock. However, if this person tells
you they get $500 daily for walking a dog
then that is income as there is a continuous
flow of earnings.
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significantly reducing the time spent on the
exchange of
goods and
services.
Mishkin (2012)
sums it up
g=quite nicely
that money is
the lubricant which allows the economy by
running smoothly by reducing transaction
costs, thereby encouraging specialization
and the division of labour.
b. Unit of Account
In defining money as a unit of account is
stating
simply, that
money is
used as a
measure of
value in an
economy.
Therefore, the value of assets and other
commodities within is given in terms of
money. Money as such provides a reference
point the pricing of commodities ensuring a
more efficient exchange system. In addition,
money provides a yardstick (standard) for
which to measure profitability of business
decisions. This function of money can be
likened to the international scientific system
of measurement: SI units, has like metric
units money is used as a standard to
compare a multitude of things. The
importance of such a money serve by money
can be illustrated by going back to the barter
system. If one hundred commodities were
being traded in this economy, then the
1
The formula for determining the number of prices in
a barter economy is [N(N-1)]/2. N represents the
number of commodities being traded.
consumer has to remember 4950 prices1
.
Such a situation would lead to sure chaos.
However, this problem is rectified under a
monetary
system as each
commodity
being traded
will have its
own unique
price, whereby the number of prices quoted
is equal to the quantity of commodities
traded.
c. Store of Value
Money’s function
has a store of value
is related to its
ability to permit
individuals to save
a part of their present earnings for future
consumption. Money is not the other assets
that has the power. Other commodities such
as property, jewelry, and paintings can also
serve the function of
storing value. These
assets have the
advantage over money
in that their value might
appreciate (increase in
value) while money in the form of currency
(coins and paper) pay no interest and during
inflationary periods (periods of rapid price
increase) will lose value. However, with all
this noted money is still preferred to these
assets as it is considered to be the most
liquid of all the assets. Once again, money
promotes economic efficiency by removing
the cost of converting other assets in a form
Time spent on the
exchange of goods
and services is
known as
transaction cost.
Money also reduces
transaction costs by
reducing the number of
prices to be considered.
Money is a store of
wealth from one-time
period to another.
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that is readily available and acceptable as
payment for goods and services.
Measuring Money
In order to detail the mechanism by which
money is measured one ought to consult the
manual provided by the International
Monetary Fund (IMF). In the document it is
articulated by the IMF that the money
supply of a country is measured as deposit
liabilities within the banking system and
current liabilities of the Central Bank, in the
hands or pockets of households, businesses,
nonprofit organizations and all public
companies outside the ambit of government.
Within the same dossier there are three
money aggregates which are outlined:
M0 (Monetary Base/ Reserve Money):
Currency (paper and coins) held by the
public plus the reserves at the Central Bank
which is held
as a liability
(against the
Central
Bank) on
behalf of the
commercial
banking sector. This monetary aggregate is
controlled by the Central Bank or the
monetary authority in the money.
M1: The most common definition of money,
M1 aggregate describes currency held
outside the banking system plus current
account balances, held for transaction and
may also include foreign currency deposits
which are
held for local/
domestic
transactions.
This monetary
aggregate is
generally the
accepted
means of payment for goods and services
rendered. Some assets according to the IMF
manual may attract a minimal interest.
M2: M2 aggregates include M1 plus short
term time and savings deposits, foreign
currency
transferable
deposits,
certificate of
deposits
(CDs) and
repurchase
agreements. M2 aggregates are close
substitutes to cash and the cost of
conversion to cash is minimal.
For a commodity to function effectively as
money it must have the following features:
a. Widely accepted as a means of
payment (medium of exchange)
b. Divisible: exist in different
denomination, for ease of making
change (unit of account)
c. Easily identified and a standardized
commodity in order to ascertain value
(medium of exchange)
d. Durable: capable of lasting for long
periods and not deteriorate quickly
(store of value)
e. Not easily counterfeited or duplicated
and me of relative scarcity (medium of
exchange)
f. Portable/ Easy to transport/ carriage
from one location to another (medium
of exchange)
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Evolution of the Payment System
A better picture of the function of money
and the various form money has taken on by
an examination of the evolution of the
payment system (the method of conducting
transactions in the economy). The order of
evolution is as follows:
a. Commodity money
b. Fiat Money
c. Cheques
d. Electronic means of payment
(EMOP)
e. E-Money
a. Commodity Money
Commodity money is money made of
precious metal or
another valuable
commodity such as
gold or silver. The face
value of commodity
money is equal to its
intrinsic value. Such form of money was
used in primitive societies where it was
universally accepted as a form of payment.
However, there existed problems with this
payment system as metal used as money was
extremely heavy and not portable.
b. Fiat Money
Fiat money refers to money with no intrinsic
value but is
money; accepted
as a means of
settling debt and
purchasing goods as it is decreed or has
government (legal) backing. This gave birth
to paper currency (pieces of paper that
functions as a medium of exchange like the
$1000 bill you get for lunch money each
day!). this form of money had the advantage
of being lighter than commodity money but
is hampered by the
fact that it can be
counterfeited or
duplicated much
easier than
commodity money.
Hence, for fiat
money to be a
successful medium of exchange then it has
to be difficult to be counterfeited ensuring
that it has the trust of all consumers in the
economy. Another disadvantage of fiat
money is that if government prints too much
this will decrease its value as a result of
inflation causing its non-acceptance by
many. Since the advent of fiat money there
has been the practice of Seigniorage:
revenue earned from the issuing of fiat
money. In today’s modern financial system
this is done by means of charging set rates
of interest on loans given to borrowers.
c. Cheques
A cheque is an instruction to a bank from
the person who wrote the cheque to the
account of the person who deposits it.
Cheques were developed to prevent persons
from carrying around large sums of cash
Fiat Money is
paper currency
decreed by
government as
legal tender.
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which could be easily stolen and was not
easily transported. In this regard cheques
have improved the efficiency of the payment
process. Cheques have certain advantages
and disadvantages Among the advantages of
using cheques as a form of payment are:
a. Payments made back and forth
cancel themselves as cheques allows
for transactions to be facilitated
without the use of cash. If a
transaction need to be stopped then
you can simply cancel the cheque.
b. Cheques can be written for any
amount facilitating transactions
involving large sums of cash.
c. So as to reduce loss and promote
efficiency as if they are lost or stolen
they can be easily cancelled.
d. Cheques serve as receipts.
Cheques also suffer from disadvantages.
Some of these are:
a. The process to clear a cheque is
expensive
b. Cheques can bounce
c. The length of time taken to clear
cheques is considerable. Thus if
money is need instantaneously then
disappointments will be had by the
person who should be paid.
Electronic Means of Payment
(EMOP)
This form of
payment
developed as
the consequence of advanced computer and
telecommunication technologies. All
payments in this method are done via
electronic telecommunications.
Other examples are private EMOPs which
are used to wire funds among banks
internationally. All these electronic payment
systems allow large sums of money in
excess of $ 1 million US dollars to be paid
internationally among financial institutions.
The other is Automatic Clearing House
System (ACHS) allowing smaller amounts
of payments to be made to individuals. All
this allows companies to send their
employees pay straight to their accounts at
the bank. Also, ACHS permits households to
pay bills via the telephone and online.
E-Money
E – Money is money
stored electronically
which has become
increasingly common as
the consequence of cheaper computer
technology. Examples of various E – money
are:
a. Debit Cards
b. Electronic Cash
c. Electronic Cheques
d. Smart Clarts
e. Store Value Cards
Example of telecommunication
technologies used are:
CHIPS: clearing house interbank payment
systems
EFTS: Electronic Funds Transfer System
SWIFT: Society of Worldwide
Intercommunications Financial Transfers
7. Page 7 of 9
a. Debit Cards
Debit cards allow consumers to purchase
goods by electronically transferring funds
directly from the consumers bank account to
that of the seller. Debit cards are used by all
producers or sellers who accept credit cards
and are advantageous as the speed at which
debit cards can be used far exceeds that of
cash.
b. Electronic Cash
Electronic cash or E- cash is a form of e-
money that can be used on the internet to
purchase goods and services rendered. In
order to obtain e-cash to conduct
transactions then an account must be set-up
with a bank that has links to the internet.
Subsequent to this, the e-cash is then
transferred to the consumer’s account which
can then be used to conduct transactions
once the consumer’s PC is available.
Purchasing items on
the internet is quite
simple with e-cash.
All the consumer
needs to do is surf
the internet, pick the
item and by using the buy/purchase option,
the e-cash can then be transferred from the
consumer’s account to the account of the
seller. Upon the receipt of the actual cash by
the seller, the item desired is then shipped to
the consumer.
c. Electronic Cheques
This form of e-money, allows internet users
to pay their bills directly over the internet
without having to send a paper cheque. The
way in which this payment system operates
is that users write an equivalent of the value
of the cheque on their PCs and email the
cheques to the other parties who send it
electronically to their banks for verification
and then transfer money from the user’s
account to the recipients bank account.
E-cash was
developed by
DigiCash a
Dutch company.
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d. Smart Cards
Smart cards are
stored value
cards with an
extra
sophistication.
These cards
contain their
own computer
chip that can be
loaded with digital
cash from the bank
account of the user
whenever it is
needed. Such
technologies cab be
loaded from the PC
of the user, automated transfer machines
(ATMs) and specially equipped telephones
such as smart phones.
e. Stored Value Cards
Stored value cards are like credit and debit
cards, which differ in that they contain a
fixed amount of digital cash, a fixed amount
is purchased and the value is then used
down.
Figure 1 is a diagramtic representation of the evolution of payment methods.
E-Money: Mney stored electronically and includes: debit
cards, electronic cah, electronic cheques, smart cards,
stored-value cards.
EMOY: Developed as a result of computer and
advanced telecommunication technology. Allows for
thre transfer of large sums of money.
Cheques: IOU's payable on demand which have
improved the efficiency of the payment system.
Fiat Money: Money with no instrinic value but is
money decred by government as legal tender.
Commodity Money: Money with instrinsic value such
as precious metals for example gold or silver. Usually
heavy and cumbersome.
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TRY IT ON YOUR
OWN!!!
Summary
1. Money is any commodity that is accepted
as payment for goods and services
rendered or the settlement of debts.
2. Money is different from currency (coins
and papers in the hands of the public)
wealth (the pieces of property owned) and
income (flow of one’s earnings).
3. Money functions as a medium of exchange
for the payment of goods and services; a
unit of account for which direct price
quotes can be made for commodities; and
as a store of value where consumers can
save their income for future consumption.
4. As it relates to the measurement of money
the typical aggregates used are
a. M0: Reserve money/ Monetary Base
b. M1: Currency plus current account
balances
c. M2: M1 plus certificates of deposit,
repurchase agreements and transferable
deposits.
5. Methods of Payments have evolved from
commodity money to fiat money, then
Cheques then Electron Mean of Payment
then final E- Money.
Copyright 2016. This factsheet was
created by Franz Brown.
No part of this factsheet may be
reproduced or copied without prior
permission granted by the author.
1. State the definition of money being
referred to in the following sentences:
a. How much money did you earn last
month?
b. When I go to the supermarket I always
ensure that I have enough money.
c. The love of money is the root of all evil
.
2. Indicate which of the monetary
aggregates would include:
a. Currency
b. Checkable Deposits
c. Small denomination time deposits
3. Three goods are produced within the
market of Waka Waka by the
following individuals:
Bread : Baker
Fish: Fishermen
Orange: Orchard Owner
If the Baker likes only fish, the Orchard
Owner only likes Bread and Fisher man only
likes orange, will there be any trade
conducted between these individuals in a
barter economy? How would the introduction
of money improve the lot of each producer?