Lecture 3 Chapter 3

What Is Money?
Chapters 3
Learning Objectives
• Describe what money is
• List and summarize the functions of
• Identify different types of payment systems
• Compare and contrast the M1 and M2
money supplies
Meaning of Money
• Money – anything that is generally accepted in payment
for goods or services, taxes or in the repayment of debts.
• Its an asset that can be used to make transactions.
• Money is different from wealth - the total collection
of pieces of property that serve to store value.
– Money is a component of wealth.
• Money is a “stock” concept. It is different from
income which is a flow concept measured per unit
of time.
Medium of Exchange
• The alternative to money is barter.
– For economic exchanges to occur using barter,
____________________ must exist.
Coincidence of Wants
to eat
needs to
wants to
read a
Three Functions of Money
Medium of Exchange:
– Eliminates the trouble of finding a double coincidence of
needs (reduces transaction costs)
– Promotes specialization
– A medium of exchange must
be easily standardized
be widely accepted
be divisible
be easy to carry
not deteriorate quickly
Three Functions of Money
(2) Store of Value:
– used to transfer purchasing power over time.
• other assets also serve this function.
• Money is the most liquid of all assets but loses value
during inflation
(3) Unit of Account:
– used to measure value in the economy
Inseparability of the Store-of-Value and Mediumof-Exchange Functions – Hyperinflation Example
• During hyperinflation, individuals and firms frantically
attempt to get rid of money because its value
deteriorates rapidly
- money fails as a store-of-value!
• Merchants refuse to accept payment in money,
insisting instead on payment in goods and services
- money fails as a medium-of-exchange!
• For money to function as a means of payment it must
durable and capable of transferring purchasing power
from one day to the next.
• Measure of the ease an asset can be turned into
a means of payment (money)
• 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.
Evolution of the Payments System
• Commodity Money: valuable, easily
standardized and divisible commodities (e.g.
precious metals, cigarettes)
• Fiat Money: paper money decreed by
governments as legal tender
Measuring Money
• Which particular assets can be called “money”?
• Monetary aggregates (M1 and M2) are
constructed using the concept of liquidity:
M1 (the most liquid assets)
M1 = currency + demand deposits
+ other checkable deposits + traveler’s checks .
Measuring Money
• M2 money adds to M1 other assets that are not
so liquid, but easily converted to M1.
• M2 = M1 + small denomination time deposits +
savings deposits and money market deposit
accounts + retail money market mutual fund
Government Money
Private Money
M1 vs. M2
• Which measure to use?
• M1 and M2 can move in different
directions in the short run (see figure).
Growth Rates of the M1 and M2 Aggregates, 1960–2011
Note change after early 1980s
What happened in the 80’s
• High and rapid inflation in the1980’s and high nominal
interest rates
• Checking accounts pay zero interest. New financial
products introduced
– Major innovation was the introduction of the money market mutual
– Funds shift from checking accounts (the M1 component of M2) to
money market accounts (non-M1 component of M2).
– The new money market accounts made M2 more liquid, so M2
looked at by analysts.
Where Are All the U.S. Dollars?
• Currency = $1.3 trillion.
• Population is 321 million
• $4,050 of U.S. currency held per person in
the United States.
• Where are all these dollars and who is
holding them?