Money

Nature and Functions of Money

• Definition: generally acceptable as payment for goods or services and discharge of debt.
• Today most common definition: currency and coins held by the public + checkable (transaction) accounts of the public (M1).
• US government decreed: currency and coins are legal tender; checkable accounts are not but banks are required to redeem them in legal tender.

Functions of Money
Monetary economy Vs. a barter economy

• 1. Standard of value or unit of account – money is a “numeraire” (common denominator) in measuring value in exchange
• Þ simplifies exchange: in a barter economy each good (service) will have an exchange rate (price) in terms of each of the other goods
• Þ large number of “prices”
• Consider an economy with N goods how many prices will we have in a barter economy?

How many prices will be in a monetary economy?
Example

• Money as common denominator greatly simplifies exchange, reduces information and transaction costs

• 2. Medium of exchange- means for conducting transactions. Allows for the separation of transactions: purchases from sales.
• In a barter economy requirement of “double coincidence of wants “ Þ high cost of search
• Money increases efficiency in the economy: reduces cost of exchange (time and resources).
• Store of value- related to medium of exchange function. Allows for separation over time between flow of income and flow of consumption.
• Money is not unique; other financial assets can serve as store of value. Money however is the most liquid: ease (cost) with which an asset can be converted into a medium of exchange.
• What happens in periods of substantial inflation to the value of money and its functions?
• Value of money inverse of price level
• Types  of Money

Evolution of money (payment system):

• commodity money,
• credit-fiat money and
• electronic money.

1)Commodity Money

•  earliest form of money
• Definition: commodity with intrinsic or non-monetary value close to value in exchange  (monetary) valueÞeffective floor to the value of money, enhances its acceptability.
• Required properties of commodity money:
• scarcity and stability of supply
•  durability
•  divisibility
• Metallic money fulfilled these requirements: iron and copper; silver; gold.

Special case of commodity money :

• The Gold Standard- full bodied money:
• monetary value = non-monetary value
• to maintain the system the government must:

(1)fix the value of gold in terms of the monetary unit ($).
(2) be willing to buy all gold at that price.
(3) legalize melting down of gold coins.

• figure
• Characteristics of the gold standard:
•  government has no control over the money supply
•  production of money is expensive
• Representative Full Bodied Money
• With economic development coins were supplemented with fully backed paper money. The system functioned exactly as a pure commodity money system.
• In the US 1900-1933, later partial backing only, gold standard abolished in 1968.

2)Credit, Fiat Money

• Not convertible into comparable value as commodity
• Value based on faith in government: value in terms of purchasing power stability.
• Definition: money that has a value in exchange greater than its value as a commodity.
• Two types:
• paper currency and coins issued by the government and decreed as legal tender
• banking money, IOU payable on demand in the form of checks. (See later: deposit/ money creation)

Þ Reduces cost of transactions (transportation)
(3) Electronic Money (Paperless)

• Paper money (checks) shuffling is costly and takes time to clear.
• Development of computer and information technology enabled new stage in money:
•  e- money- money stored electronically,

                Several forms:

• debit cards- electronic transfer of funds from bank account to merchant’s account
• Stored-value cards- (electronic wallet), contain fixed amount of funds, the smart card can be reloaded. Modex smart card transfer of funds with wireless device also between individuals. Used in Europe less (trials) in the USA
• Electronic cash- funds used on the Internet to purchase goods and services.
• Electronic Checks used to pay bills on the internet, equivalent of check is sent .
• Advantages of e-money: cost saving, more efficient
• Disadvantages:
• Large initial investment in system
• paper checks provide receipts
• paper checks give the benefit of the “float”
• security and privacy concerns of e-money
• Slow rate of adoption

• Measures of Money
• Need precise definition of what assets to be included: theoretical and empirical approaches.
• Theoretical approach: focus on medium of exchange aspect, not clear-cut.

Empirical approach: objective in defining money (supply) is to control that variable that can be used to stabilize/affect economic activity- monetary aggregate, which can be managed by the government and is closely correlated with economic activity, findings are mixed.

• A number of measures are used by the Federal Reserve, from narrow to broad definition in decreasing order of liquidity:
• M1= currency + demand deposits and other checkable deposits
• M2= M1+ small time deposits + savings and money market deposits + money market mutual funds (non-institutional)
• M3= M2 + large TD, MMMF (institutional) +repurchase agreements+Eurodollars
• L = M3+ highly liquid assets (securities)