Chapter 3
WHAT IS MONEY?
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 represents a certain amount at a given point in time.
Money is distinguished from wealth and income.
— Wealth of a person (or a 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, collectibles, arts and
capital) and financial (money, bonds, etc.)
— Wealth serves as a store value. Wealth is a stock concept that is measured at a
given point in time.
— Income refers to the flow of earnings per unit of time
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.
— Currently, deposits are the largest proportion of money.
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— 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
— 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.
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.
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 the time spent in exchanging goods and services, which is called
transaction cost.
— 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
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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.
— 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.
— 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 and enhances trade among people, which
improves people’s standards of living
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. For example. Ali traded 2 cows for 20
bushels of wheat with Maryam. In this case, 1 cow is worth 10 bushels. If Ali
traded 3 cows for 6 sheep with Yosuf, each cow is worth 2 sheep. What is the price
of sheep if Maryam and Yosuf traded with each other?
— If we have 10 goods in the barter system we would have 45 different prices
N( N − 1 ) 10( 9 )
=
= 45 while using money we need only 10 prices
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— 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
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goods and services easier. For example, the cow is worth 50 units of "money", the
sheep 25 units, and a bushel of wheat 5 units.
— 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.
Store of Value
— The function of money as a store of value refers to the use of money to preserve
purchasing power of money 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.
— 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.
— 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.
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THE EVOLUTION OF MONEY AND 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.
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). Examples
of commodity money could include gold, cows, and pretty shells.
— From ancient times until several hundred years ago commodity money functioned
as the medium of exchange in most of the societies.
— In ancient times, people used rocks, leather, salt and shells as money
— The Roman Byzantine used gold coins (denarius) and the Persians used silver
coins (drachma) as currency
— When the Prophet s.a.w. brought about economic reforms, he continued the use of
the Roman denarius and the Persian drachma, known among the Arabs as dinar
and dirham, respectively
— Gold played the role of money throughout human history
— Gold continued to be part of the international monetary system until the breakdown
of Bretton Woods in 1971
— The problem with a payments system based on precious metals is that
1. such a form of money is very heavy and is hard to transport from one place to
another
2. Another problem is 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.
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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
— Today all national currencies are fiat, that is, neither backed by nor redeemable for
gold. Currencies such as dollars or dinars do not have intrinsic value, because they
are not really useful other than as money. 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.
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.
— The introduction of checks was a major innovation that improved the efficiency of
the payments system.
— The use of Checks has the advantage of:
1. Reducing transaction costs associated with the payments system, and
2. Improve 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.
— The disadvantage of using checks is that
1. It takes time to get checks from one place to another which creates problems
for the needed urgent payments.
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2. In addition it takes several days to clear a check you have deposited before you
can use its funds.
3. The paper work to process checks has its cost too.
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 compared 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).
— E-money refers to money that exists only in electronic form and involves transfer
of money.
— Some forms of e-money include:
o A debit card, which looks like credit cards, enables consumers to purchase
goods and services by electronically transforming funds directly from their
bank accounts to the merchant’s account.
o 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.
o 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.
o A more advanced form of e-money is the stored-value card.
o The simplest form of the stored value card is purchased for a preset amount
that the consumer pays upfront, like a prepaid phone card.
o The more sophisticated stored-value card is known as a smart card
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o A smart card contains a computer chip that allows it to be loaded with
digital cash from the owner’s bank account whenever needed.
— Are electronic payments considered part of the money in the country? 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.
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 should have in order to
perform the three functions of money efficiently
1.
Must be easily standardized, making it simple to ascertain its value.
2.
Must be widely accepted in payments for goods and services and for settling
other business obligations; i.e., must have intrinsic value or made acceptable
by decree of law (assigned legal tender status)
3.
Must be divisible, so that it can be used for exchange of a range of values
4.
Must be stable and durable; i.e., does not deteriorate, perish or erode due to
its own structure and composition
5.
Must be easy to carry around
6.
Must be limited in supply
7.
Must not be easily counterfeited
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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
— Note that the currency component of M1 includes only paper money and coins in
circulation in the hands of the non-bank public 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.
— 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.
M2
— M2 is a broader measure of money than M1. It includes items that are contained in
M1 and a few other items. M2 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 very little cost (savings deposits and
small-denomination time deposits)
— M2 = M1 + savings deposits + small–denomination time deposits + money market
deposit accounts + Money market mutual fund shares.
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— 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.
— 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 shares are retail accounts on which households can
write checks. Money market mutual funds are interest-bearing shares in pools of
funds accumulated by investment companies. The funds are invested in short-term
securities.
— 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).
— There is another measurement of money which is 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.
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