3rd Chapter of The Economics of Money , Banking and Financial Markets

1. Chapter 3
WHAT IS MONEY?

2. MEANING OF MONEY
 In ordinary conversation, we commonly
use the word money to mean income ("he
makes a lot of money") or wealth ("she
has a lot of money").
 Money ( or money supply) refers to
anything that is generally accepted in
payment for goods or services or in the
repayment of debts.
 Money is a stock concept. It is a certain
amount at a given point in time.
 Money is distinct from wealth or income.

3.  Wealth of a person (or nation) is the value
of assets owned minus the value of
liabilities owed (to foreigners in the case
of a nation) at a point in time. The assets
include those that are tangible (land,
houses, furniture, cars, arts and capital)
and financial (money, stocks, bonds, etc.)
 Wealth serves as a store value. It is a
stock concept that is measured at a given
point in time.
 Income refers to the flow of earnings per
unit of time

4. TYPES OF MONEY:
 Money consists of
 Currency: The paper notes and coins that
people use in a country. They are money
because government declares them so.
(legal tender)
 Deposits at banks and other depository
institutions are also money. Deposits are
money because they can be converted
into currency and because they are used
to settle debts.

5.  Currently, deposits are the largest
proportion of money.
 Exercise:
Are Checks money?
The answer is no. The check is only a way
to instruct your bank to transfer money
from your account to another person’s
account. However, deposit accounts are
money

6.  Exercise:
Is credit card considered money?
The answer is No. It is not legal tender. What
a credit-card purchases really represents is
just an extremely convenient, pre-approved
loan. It's only part of the transaction, since
the merchant then goes to the bank that
issued the credit card to get money, and the
bank sends you a bill which must be paid
with money. Credit card is just an ID card
that lets you take out a loan at the moment
you buy something.

7. FUNCTIONS OF MONEY
 Money has three primary functions in any
economy: as a medium of exchange, as a
unit of account, and as a store of value.
 Of these three functions, its function as a
medium of exchange is what
distinguishes money from other assets
such as stocks, bonds, and houses.

8. Medium of Exchange
 Money is used as a medium of exchange
in the form of currency or checks. It is
used to pay for goods and services.
 The use of money as a medium of
exchange promotes economic efficiency
by minimizing transaction cost, which is
the time spent in exchanging goods and
services.

9.  In a barter economy, transaction costs are
high because people have to satisfy a
“double coincidence of wants”; i.e., they
have to find someone who not only has a
good or service they want but also wants
the good or service they have to offer.
 It is very difficult to find another individual
who has what you want, and wants what
you have.

10.  With the invention of money, you no
longer need to find another individual who
has what you want, and wants what you
have.
 All you need to do is to find someone who
has what you want, and you buy it from
him/her with "money".
 The problem of double coincidence of
wants is avoided. Money reduces the high
search costs that are characteristic of
barter exchanges.

11.  Divisibility of money makes the exchange
of different quantities of items possible
and simple
 The use of money as a medium of
exchange also promotes economic
efficiency by allowing people to specialize
in what they do best.
 Specialization increases productivity.

12. Unit of Account
 Unit of Account refers to the use of money
to measure value in the economy; i.e., you
can use it to price goods and services.
 Quoting prices in terms of dollars or
dinars is a lot easier than quoting prices
in terms of other goods.
 Before the invention of money (i.e., in the
stage of bartering), prices were expressed
in relation to the goods traded.

13.  If we have 10 goods in the barter system
we would have 45 different prices while
using money we need only 10 prices
 With the invention of money, a unit of
account has been chosen to measure the
prices of goods and services. This makes
the comparison of the prices among
goods and services easier.
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14.  Using money as a unit of account reduces
transaction costs (information and
exchange costs) in an economy by
reducing the number of prices that need
to be considered.

15. Store of Value
 The function of money as a store of value
refers to the use of money to save
purchasing power from the time income
received until the time it is spent.
 This function facilitates the exchange of
goods and services over time.
 Money is not unique as a store of value.
There are many other assets can be used
as a store of value such as stocks, bonds,
real estate, collectibles, arts, etc.

16.  In fact many such assets have advantages
over money as a store of value. They earn
a return while money (as cash) does not
earn a return.
 However, money is the most liquid of all
assets because it is the medium of
exchange; it does not need to be
converted into anything else to make
purchase. Other assets involve
transaction costs when they are
converted into money.

17.  Liquidity refers to the relative ease and
speed with which an asset can be
converted into a medium of exchange.
 Money also has no default risk. Money in
bank accounts earns some interest and is
guaranteed against default by Central
Bank’s deposit insurance.
 The problem of money as a store of
values is that it loses value during
inflation.

18. EVOLUTION OF THE PAYMENTS SYSTEM
 The payments system refers to the
method of conducting transactions in the
economy.
 The payment system and money have
been evolving over centuries from
commodity money at one point in history
to e-money in the recent days, and
innovations will not stop here.

19. Commodity Money
 Commodity Money is money that is made
up of precious metals or other valuable
commodities that have intrinsic value (are
valuable in their own right).
 From ancient times until several hundred
years ago commodity money functioned
as the medium of exchange in most of the
societies.

20.  The problems with a payments system
based on precious metals are
1. such a form of money is very heavy and
is hard to transport from one place to
another
2. When the value of the precious metal
increased more than its value as money,
people used to melt the coins to use
them as precious metal rather than as
money.

21. Paper Currency
 Paper currency refers to pieces of paper
that function as a medium of exchange.
 Originally, paper currency carried a
guarantee that it was convertible into a
fixed quantity of precious metal.
Fiat Money
 Fiat money refers to paper currency
decreed by governments as legal tender.
 Legal tender means that money must be
legally accepted as payment for debts

22.  Fiat money is not convertible to
precious metals. Without legal tender
they are nothing but pieces of paper
 Fiat money is lighter but it has the
problem of counterfeiting and it is hard
to transport large amounts because of
their bulk.

23. Checks
 A check is an instruction from you to your
bank to transfer money from your account
to someone else’s account when he
deposits the check.
 Checks allow transactions to take place
without the need to carry around large
amount of currency.
 The introduction of checks was a major
innovation that improved the efficiency of
the payments system.

24.  The use of checks has the advantage of
1. reducing transaction costs associated
with the payments system, and
2. improving economic efficiency
3. Another advantage of checks is that they
can be written for any amount up to the
balance in the account, making
transactions for large amount much
easier.

25.  The disadvantage of using checks is that
4. it takes time to get checks from one
place to another which creates problems
for the needed urgent payments.
5. In addition, it takes several days to clear
a check you have deposited before you
can use its funds.
6. The paper work to process checks has
its cost

26. Electronic Payment
 The development of inexpensive
computers and the spread of the internet
now make it cheap to pay bills
electronically.
 Electronic payments result in cost saving
compare to payments by checks.
 Electronic payments technology can
substitute not only for checks, but also for
cash in the form of electronic money (or e-
money).

27.  E-money refers to money that exists only
in electronic form
 Some forms of e-money include:
1. Debit cards, which looks like credit
cards, enable consumers to purchase
goods and services by electronically
transforming funds directly from their
bank accounts to the merchant’s
account.

28. 2. Automatic bill-paying: whereby money is
transferred straight from your bank
account to the phone company, the
power company, the local tax collector,
according to prior arrangements you
have made. Pay-by-phone works
similarly.

29. 3. E-cash, which is used on the internet to
purchase goods or services. A consumer
get e-cash by setting up an account with
a bank that has links to the internet and
then has the e-cash transferred to his
PC. Then he can buy goods and services
by transferring money directly from his
PC to the seller.

30. 4. A more advanced form of e-money is the
stored-value card.
 The simplest form of the stored value
card is purchased for a preset amount
that the consumer pays upfront, like a
prepaid phone card.

31.  The more sophisticated stored-value card
is known as a smart card
 A smart card contains a computer chip
that allows it to be loaded with digital
cash from the owner’s bank account
whenever needed.

32.  Are electronic payments considered part
of the money in the country?
 The answer is actually no. They provide
access to bank accounts, which are
already in the money supply. These are
really just more efficient and convenient
ways of making payments than the old
ones.

33. CHARACTERISTICS OF MONEY
 The forms that money has taken on
depend heavily on how well it performs
the three functions we have discussed
earlier.
 The following are some of the
characteristics that an item needs to
have in order to perform the three
functions of money efficiently
1. Must be easily standardized, making it
simple to ascertain its value.

34. 2. Must be widely accepted in payments for
goods and services and for settling other
business obligations.
3. Must be divisible, so that it is easy to
make change.
4. Must not deteriorate quickly.
5. Must be easy to carry.
6. Must be limited in supply.
7. Must not be easily counterfeited.

35. MEASURING MONEY SUPPLY (MONETARY
AGGREGATES)
 Economists and governments have a
broader measure of what money is than
cash.
M1
 The narrowest measure of money is M1,
which includes assets that can be used
directly as a medium of exchange.
 M1 = Currency +Traveler’s Checks +
Demand deposits + Other checkable
deposits

36.  Note that the currency component of M1
includes only paper money and coins in
the hands of the non-bank public (in
circulation) and does not include cash
that is held in ATMs or banks vaults.
 The traveler’s checks component of M1
includes only traveler’s checks not issued
by banks.
 The demand deposits component
includes business checking accounts that
do not pay interest as well as traveler’s
checks issued by banks.

37.  The other checkable deposits item
includes all other checkable deposits,
particularly checking accounts held by
households that pay interest, such as
NOW (negotiated order of withdrawal) and
ATS (automatic transfer from savings).
 M1 is considered by the central bank
perfectly liquid assets, i.e. pure medium of
exchange.

38. M2
 M2 is a broader measure of money than
M1.
 M2 includes items that are contained in
M1, and adds to M1 other assets that have
check-writing features (money market
deposit accounts and money market
mutual fund shares) and other assets that
are highly liquid at a little cost (savings
deposits and small-denomination time
deposits)

39.  M2 = M1 + savings deposits
+ small–denomination time deposits +
money market deposit accounts + Money
market mutual fund shares.
 Saving deposits are non-transactions
deposits that can be added to or taken out
at any time.
 Small–denomination time deposits are
certificates of deposit (CDs) with a
denomination of less than $100,000 that
can only be redeemed at a fixed maturity
date without a penalty.

40.  Money market deposit accounts (i.e.
interest bearing accounts) are short term
accounts that pay interest and allow
limited withdrawals. They are similar to
money market mutual funds, but are
issued by banks.
 Money market mutual fund are interest-
bearing shares in pools of funds
accumulated by investment companies.
The funds are invested in short-term
securities and households can write
checks..

41.  The components of M2 (other than M1) are
considered as the assets that emphasize
the function of money as a store of value.
However, they can also be used as
medium of exchange (with some delay).

42. M3
 M3 is the broadest measure for money,
includes some of the “longer-term”
money market instruments. The
components of M3 (other than M2) are
assets of mostly large businesses and
institutions. They are very non-liquid
assets, and hence not used as medium of
exchange.