Definition and
Measurement of Money
Objectives:

What is money and what are the functions of it?

What are the various roles that money plays in
the economy?

How is the amount of money measured in the
economy?
What is Money?

What is money?

What is wealth?

What distinguishes money from other forms
of wealth?
What is Money?

Money is any asset that can easily be used to
purchase goods and services.

An asset is liquid if it can easily be converted
into cash

Money consists of cash itself, as well as other
assets that are highly liquid.
What is Money?

Currency in circulation is cash held by the public.

Checkable bank deposits are bank accounts on which
people can write checks.

The money supply is the total value of financial assets
in the economy that are considered money.

Narrower definition considers only the most liquid
assets to be money



Currency in circulation
Traveler’s checks
Checkable bank deposits
What is Money?

Narrower definition considers only the most liquid
assets to be money




Broader definition includes all three above plus
other “assets” that are “almost” checkable


Currency in circulation
Traveler’s checks
Checkable bank deposits
Savings account deposits that can be transferred into a
checking account online
Money plays a crucial role in generating gains
from trade because it makes indirect exchange
possible
Roles of Money

Money plays three roles in any modern
economy:
1.
Medium of Exchange
2.
Store of Value
3.
Unit of Account
1. Medium of Exchange

A medium of exchange is an asset that individuals
acquire for the purpose of trading rather than for
their own consumption.

Examples:

Normal Times – official money of any given country is
the medium of exchange

Troubled Economic Times – other goods or assets are
often used instead
2. Store of Value

A store of value is a means of holding
purchasing power over time.

Money is not the only store of value, any asset
that holds its purchasing power over time is a
store of value
3. Unit of Account

A unit of account is a measure used to set prices
and make economic calculations.

A commonly accepted measure is necessary in
terms of transaction would be harder to
determine if there wasn’t one.

If transactions are harder to determine, then it would
be difficult to achieve gains from trade
Types of Money

Commodity money is a good used as a medium of
exchange that has other uses.

Normally gold or silver

A commodity-backed money is a medium of
exchange with no intrinsic value whose ultimate
value is guaranteed by a promise that it can be
converted into valuable goods.

Advantage over commodity-backed money over
simply commodity money like gold and silver, is
that it ties up fewer valuable resources
Types of Money
Fiat money is a medium of exchange whose
value derives entirely from its official status as
a means of payment.
 Fiat has two advantages:
1. It doesn't’t tie up any real resources
2. The money supply can be managed based on
the needs of the economy instead of being
determined by the amount of gold and silver
prospects happen to discover
 Risks:


counterfeiting
Measuring the Money Supply

The Federal Reserve calculate the size of the
monetary aggregate


A monetary aggregate is an overall measure of the
money supply.
Near-moneys are financial assets that can’t be
directly used as a medium of exchange but can
readily be converted into cash or checkable bank
deposits.
The Time Value of Money
Objectives:

Why is a dollar today worth more than a dollar a
year from now?

How can the concept of present value help make
decisions when costs or benefits come in the
future?
The Concept of Present Value

Everyone is faced with financial decisions that will
have consequences long into the future

Time places a role in all economic decisionmaking

Paying for College, better salary

Going on a cruise, paying off the cruise after you return
Borrowing, Lending, and Interest




Having a dollar today is worth more than having a
dollar a year from now.
True?
False?
True!



If you get a new job that comes with a $1,000 bonus,
which will be paid at the end of the first year, can you
spend the extra money now?
Yes, borrow now and repay the debt later
You wouldn’t borrow the full $1,000 today though,
because a year from now, you have to repay the full
amount plus interest
Borrowing, Lending, and Interest

All it means is that $1,000 today is worth more
than having a $1,000 a year from now.

Borrower and Lenders know that this allows a
lender to charge a borrower interest on loan

Borrowers are willing to pay interest in order to have
money today rather than waiting until they acquire
that money later on
Defining Present Value

The key to concept of present value is to
understand that you can use the interest rates to
compare the value of a dollar realized today with
the value of a dollar realized later

Why the interest rate?

Interest rate correctly measures the cost to you of
delaying the receipt of a dollar of benefit and,
correspondingly, the benefit to you of delaying the
payment of a dollar of cost
Defining Present Value




Example:
You are deciding on whether or not to take a job
in which your employer promised to pay you a
bonus at the end of the first year
What is the value to you today of $1 of bonus
money to be paid one year in the future?
First, you need less than $1 today in order to be
assured of having $1 one year from now


Any money that you have today can be lent out at
interest
This turns any amount you have today into a greater
sum at the end of the year
Defining Present Value





r = interest rate (in decimal terms)
Amount received one year from now as a result of
lending $X today =
$X + $X x r = $X x (1 + r)
Condition satisfied when $1 is received one year from
now as a result of lending $X today:
$X x (1 + r) = $1
Amount lent today in order to receive $1 one year
from now =
$X = $1/(1 + r)
This means you will be willing to accept today the
amount $X defined by the above equation for every $1
to be paid to you one year from today
Defining Present Value

Solving the equation

r = 0.10 (10%)

Value of $X when r = 1.10:
$X = $1/(1-0.10) = $1/1.10 = $0.91

You would accept $0.91 today in exchange for
every $1 to be paid to you one year from now

$X is called the present value of $1
Defining Present Value

The present value of $1 realized one year from
now is equal to $1/(1 + r): the amount of money
you must lend out today in order to have $1 in one
year

It is the value to you today of $1 realized one year
from now
Using Present Value

Problems with choosing between items is that you
have to weight costs and benefits for each but
costs and benefits are realized for items at
different times

Present value is able to convert any dollars
realized in the future using the net present value

Net present value of a project is the present value
of current and future benefits minus the present
value of current and future costs