CHAPTER 2

Money: Its Nature,

Functions, And Evolution
 The Nature And Functions Of
Money
 Money is anything that is generally acceptable as payment for
goods and services or for the settlement of debt.

 not a legal definition of money--

 a behavioral one.

 Money is anything that we believe others will accept as

payment.

 Acceptance is contingent on confidence that it will retain its

value or purchasing power.

 Confidence in money’s value relies on it being sufficiently scarce

that its value does not diminish over time.
Historical Money
 What Economists Include
in the Definition of Money
 all currency (coins and paper bills) held by the public

 demand deposits and other checking deposits in:

 commercial banks,
 savings and loan associations,
 mutual savings banks, and
 credit unions

 Practically all U.S. payments are made by the

exchange of currency or by the transfer of deposit
balances via checks or electronic (wire) transfer.
 Why Credit Cards Are Not
Money
 Credit cards are essentially a method of postponing
payment for a few days or months.

 The cards themselves do not constitute money.

 Actual money payment is merely deferred until later.

 Credit cards do not influence the supply of money,

but do reduce the demand for money.
 Legal Tender
 Legal tender:
 cannot lawfully be refused in payment for goods and
services and for discharge of debts.
 No merchant or creditor can demand payment in another
form.
 Currency and coin are legal tender.
 Checking accounts are not legal tender.
 Many items have served as money without having
legal tender status.
 Legal tender is a sufficient, but not a necessary,
condition for a substance to be considered money.
 Distinctions Among Money,
Wealth, and Income
 Though money, income and wealth are all measured
in “dollars;” they differ significantly in their meaning.

 People have money if they have large amounts of currency

or big bank accounts at a point in time. (stock variable)

 Someone earns income (not money) from work or

investments over a period of time. (flow variable)

 People have wealth if they have assets that can be

converted into more currency than is necessary to pay their
debts at a point in time. (stock variable)
 Functions of Money
 Money serves as a

 medium of exchange or means of payment

 standard of value or unit of account

 store of value
 Barter Economy
 In a money economy, people use money to sell their
goods or services for money and buy what they want
with money.

 A barter economy is one in which goods and

services are traded directly for one another.

 In barter systems, people must find producers of what they

want who also want what they have to trade.

 This double coincidence of wants is socially inefficient, and

the introduction of money eliminates this problem.
 Money Creates Efficient
Exchange
 Just as the division of labor and
specialization allow for efficient
production, money allows for efficient
exchange.
 Standard of Value or Unit of
Account
 Money serves as a measuring rod or yardstick to assess the relative
value of various goods and services.
 Without money, each item brought to market would bear a certain
value relative to each of the other items--e.g. good A, B, C, and D.
 With money, each good has one price (in dollars).
 Without money,we must establish the:
 A price of B, A price of C, A price of D;

 B price of C, B price of D;

 C price of D, and

 (the reciprocal of the X price of Y is the Y price of X)

 In an N good society there are:

 N prices when money works.

 N(N-1)/2 prices when barter predominates.

 Store of Value
 Money acts as a temporary storage of purchasing power.
 In a barter economy, the purchase of any item implies a
simultaneous sale of another item.
 In a money economy, people can sell something (e.g. their
labor) without buying something simultaneously.
 Money is not the only store of value.
 Money is not a perfect store of value.
 Liquidity
 We store purchasing power as money rather
than as something else because converting it
back into money can be costly.

 An asset is liquid if it can be easily converted

into money and illiquid if it is costly to
convert.
 Cash is perfectly liquid.
 Stocks and bonds are somewhat less liquid.
 Land is illiquid.
 Inseparability of the Store-of-Value
and Medium-of-Exchange Functions
 During hyperinflation, individuals and firms frantically
attempt to rid themselves of money because its value
was deteriorating rapidly—that is, money failed as a
store-of-value.

 Merchants may refuse to accept payment in money,

insisting instead on payment in goods and services—
this reflects money’s failure as a medium-of-
exchange.
 Full-bodied or Commodity
Money
 Early monies were full-bodied, or commodity money.
 Commodity money’s value is approximately the same
whether it is used as money or as a commodity.
 This equality of value was assured by forces of supply and
demand.
 If coins are worth more for their metal than for their
exchange value, then they will be melted down or milled off.
 If metal is worth more as coins than it is as a commodity,
then it will be turned into coins unless regulation prevents
such minting.
 The forces of supply and demand ensure that the value of
the coin will not deviate markedly from its value as a
commodity.
 Representative Full-Bodied
Money
 During the industrial revolution, the
exclusive use of coins as medium of
exchange became increasingly
inconvenient.

 Coins were supplemented with paper

currency that was backed by the
valuable metals.
 Fiat or Credit Money
 Does money need to be backed by a commodity at
all?

 The logical answer to this question is no.

 If the monetary system is stable and functions effectively,

“backing” is expensive, inconvenient, and unnecessary.

 Today, money is only backed by confidence that government

will responsibly limit the quantity of money to ensure that
money in circulation will hold its value.
 Advantages and
Disadvantages of Fiat Money
 Advantages

 Fewer resources are used to produce money.

 The quantity of money in circulation can be determined by

rational human judgment rather than by discovering further
mineral deposits—like gold or diamonds.

 Disadvantage:

 A corrupt or pressured government might issue excessive

amounts of money, thereby unleashing severe inflation.
 Checking Accounts
 Checking accounts first became popular after the Civil War
because the Federal government placed a 10 percent tax on
banknotes issued by state-chartered banks.

 Advantages:
 People are not forced to carry around large amounts of paper
currency.
 You can pay bills without worrying about the cash being stolen in
transit.
 Accounts are insured up to $100,000.
 Checks provide records for accounting and tax purposes.

 Disadvantages
 Check clearing costs $5 billion per year.
 Checks must “clear”—introducing “float” costs. Float costs are in
the process of being eliminated by more rapid check clearing.
 Electronic Money
 Electronic money systems can increase payments
system efficiency.
 Innovations in data processing, information retrieval,
and communications systems make electronic money
systems possible.
 Advantages
 Reduced cost of processing checks
 Reduced costs from billing credit cards
 Employers can reduce their payroll costs by paying with
direct deposit.
 People can reduce their costs by paying bills electronically
(either automatically or manually online.)
 Electronic Money and
Financial Institutions
 Electronic Money and Financial Institutions

 Fedwire and Swift are electronic money

transfers that have been around for 30 years.

 These transfers account for:

 1% of the number of transfers.
 85% of the dollar volume of transactions.
 Newer Electronic Money
 Debit cards

 Stored-value cards

 Electronic checks
Factors Slowing the Transition to
Electronic Money
 High fixed technology costs

 Checks provide physical receipts and transaction

records.

 People often use the “float,” though such advantages

to payers are quickly disappearing because of rapid
(electronic) check clearing.

 Legal and security concerns regarding theft and loss

of privacy
 Measures of Money Supply
 Money supply influences output, income, and prices.

 Accurate measures of money supply must be

tabulated and published regularly.

 Industrial nations employ fairly standard measures of

money.

 The U.S. Federal Reserve currently publishes data on

several “monetary aggregates” (M1, M2, and M3).
 M1, M2 and M3
 M1 = Currency + Demand Deposits + Other Checkable
Accounts + Travelers’ Checks (these are small and will be
ignored later)
 M2 = M1 + Savings Accounts + Money Market Deposit
Accounts + Money Market Mutual Fund Shares (held by
individuals) + Small (<$100K) Time Deposits
 M3 = M2 + Large (>$100K) Time Deposits + Repurchase
Agreements + Money Market Mutual Fund Shares (held by
institutions)
 Deciding What is in Each
Aggregate
 M1 includes highly liquid accounts that are
typically used primarily as a medium of
exchange rather than primarily as a store of
value.

 M2 includes M1 and accounts (MMDA,

MMMFs and small CDs) that are highly liquid.

 M3 includes M2 and all other forms of

deposits.
 Which Measure Is Most
Useful?
 Arguments for narrower measures
 The measure of money should be based on the economic
principles of liquidity and primary use.
 The choice of money to monitor should remain constant.

 Arguments for broader measures

 The purpose of measuring money is to monitor and control
its magnitude in order to stabilize economic activity.
 Which measure is best is an empirical question.

 The measures do not move together--and often move

in different directions.
 Divisia Aggregates :
Weighted Measures of Money
 M1, M2, and M3 give equal weight to each of
the items they include.
 A divisia aggregate is a weighted aggregate
such as:
 M = DDO + Cp + .50 (MMMF) + .25 (SD + TD)
 Economists are researching the best
“weights.”
 No generally accepted set of weights so the
Federal Reserve equally weights all
components.