Chapter 2
Money: Its Nature,
Functions, And Evolution
©Thomson/South-Western 2006
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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.
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Historical Money
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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:
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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.
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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.
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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.
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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)
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Functions of Money
 Money serves as a
 medium of exchange or means of payment
 standard of value or unit of account
 store of value
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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.
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Money Creates Efficient
Exchange
 Just as the division of labor and specialization
allow for efficient production, money allows for
efficient exchange.
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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:
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.)
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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.
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Newer Electronic Money
 Debit cards
 Stored-value cards
 Electronic checks
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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
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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).
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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)
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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.
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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.
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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.
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