Chapter 3. What Is Money?

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Myles Freeman
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1 Chapter 3 What Is Money?

2 Meaning of Money Economists definition: Money (money supply) anything that is generally accepted in payment for goods or services or in the repayment of debts; a stock concept How does the above definition compare to currency? How about wealth or income Wealth the total collection of pieces of property that serve to store value Income flow of earnings per unit of time 3-2

3 Functions of Money Medium of Exchange promotes economic efficiency by minimizing the time spent in exchanging goods and services By avoiding double coincidence of wants people can specialize in what they do best. For a commodity to function as a medium of exchange: Must be easily standardized (no doubts about its value) Must be widely accepted Must be divisible (easy to make change) Must be easy to carry Must not deteriorate quickly 3-3

4 Unit of Account used to measure value in the economy Store of Value saves the purchasing power from the time income is received until the time income is spent (but loses value during inflation) What are some other assets which have store of value? What are the advantages of these other assets over money? Why do people hold money and not those other assets? most liquid of all assets 3-4

5 Evolution of the Payments System Commodity Money Precious metals like gold and silver What are the problems with commodity money? Fiat Money Initially paper currency was convertible into coins or a quantity of precious metal. It was then decreed by the governments as the legal tender fiat money What are the problems with fiat money? Checks What are the problems with checks? Why did it never pick up in Turkey? Electronic Payment E-Money Debit cards, Stored-value cards, Smart cards 3-5

6 How do we measure the Money in the economy? Given the rapid evolution of money, defining the proper measure of money is not a straightforward task (remember the definition of money ). Example: In a world with fiat money only, money would simply be equal to currency in circulation With the introduction of checks, one needs to include checking accounts into the definition of money With the introduction of alternative deposit accounts, more assets become liquid forms of money There are several measures of money: M1, M2, M3 (dropped) 3-6

7 3-7

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

9 Why is it so crucial to come up with the proper measure of money? Do different measures tell us different stories about the money supply? 3-9

10 Figure 1 Growth Rates of the M1 and M2 Aggregates, Sources: Federal Reserve Economic Database (FRED); Federal Reserve Bank of Saint Louis;

11 Assigned Questions Chapter 3: 2, 5, 6, 9, 11, 12, 13, 15, 16, Lecture notes are posted on KUAIS courseware on the day before the lecture. Answer Key for End of Chapter problems are posted on KUAIS 3-11

12 Selected end of chapter questions for class discussion 5) For each of the following situations, identify which function of money is emphasized: a) Brooke accepts money in exchange for performing her daily tasks in the office, since she knows she can use that money to buy goods and services 3-12

13 b) Tim wants to calculate the relative value of oranges and apples and therefore checks the price per kg of each of these goods quoted in currency units c) Maria is currently pregnant. She expects her expenditures to increase in the future and decides to increase the balance in her savings account. 3-13

14 11) If you use an online payment system such as Paypal to purchase goods or services on the internet, does this affect the M1 money supply, M2 money supply, both, or neither? Explain. 3-14

15 12) Rank the following assets from the most liquid to least liquid: A) Checking account deposits B) Houses C) Currency D) Automobie E) Savings deposits F) Common stock 3-15

16 15) For each of the following assets, indicate which of the monetary aggregates (M1 and M2) includes them: A) Currency B) MMMF C) Small denomination time deposits D) Checkable deposits 3-16

17 16) Assume you are interested in earning some return on idle balances you usually keep in your checking account and decide to buy some MMMF shares by writing a check. Comment on the effect of your action on M1 and M

18 17) In September 2008, the growth rate of the M1 money supply was zero, while the growth rate of the M2 money supply was about 5 %. In July 2009, the growth rate of M1 was about 17 %, an the growth rate of M2 was about 8 %. How should Federal Reserve policy makers interpret these changes in the growth rates of M1 and M2? 3-18

3. Any medium of exchange (including commodity money) must: a. be easily standardized. b. be widely accepted. c. be divisible. d. be easy to carry.

3. Any medium of exchange (including commodity money) must: a. be easily standardized. b. be widely accepted. c. be divisible. d. be easy to carry. What is Money? This lecture examines the functions of money, the evolution of the payments system, and how money is measured. Functions of Money A. Medium of Exchange 1. Money is any item that is generally