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Chapter 3
What Is Money?
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Meaning of Money
• money (also referred to as the money supply) as
anything that is generally accepted in payment for
goods or services or in the repayment of debts.
• When most people talk about money, they’re talking
about currency (paper money and coins). To define
money merely as currency is too narrow definition of
money. Other means are also accepted as payment
for purchases.
• money in the form of currency, demand deposits, and
other items that are used to make purchases and
wealth (the total collection of pieces of property that
serve to store value).
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Meaning of Money
• People also use the word money to describe what
economists call income. Income is a flow of
earnings per unit of time. Money, by contrast, is a
stock.
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Functions of Money
1. Medium of Exchange: i.e., it is used to pay for
goods and services. Using money as medium of
exchange promotes economic efficiency
• Look at a barter economy, one without money, in
which goods and services are exchanged directly for
other goods and services.
• In a barter economy, transaction costs are high
because people have to satisfy a “double
coincidence of wants”. Money
- reduces transaction costs,
- Promotes specialization (why specialization is a problem in a
barter economy?)
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Functions of Money
• As a medium of exchange money promotes
economic efficiency by:
- eliminating much of the time spent exchanging
goods and services.
- allowing people to specialize in what they do best
• For a commodity to function effectively as money, it
has to meet several criteria:
(1) It must be easily standardized, making it simple to
ascertain its value;
(2) it must be widely accepted;
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Functions of Money
(3) it must be divisible, so that it is easy to “make
change”;
(4) it must be easy to carry;
(5) it must not deteriorate quickly
• Most of these criteria are met by gold.
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Functions of Money
2. Unit of Account: used to measure value in the
economy.
• To see how this function is important, let us consider
a barter economy:
• If the number of goods=3, No. of prices=3
• If the number of goods=10, No. of prices=45
• If the number of goods=100, No. of prices=4950
• If the number of goods=1000, No. of prices=499500
• Use this formula:
(N(N-1))/2
Where N = number of goods
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Functions of Money
• The solution to the problem is to introduce money
into the economy and have all prices quoted in terms
of units of that money. This substantially reduces the
number of prices, e.g., if the No. of goods = 10, No.
of prices=10 and so on.
• using money as a unit of account reduces transaction
costs in an economy by reducing the number of
prices that need to be considered.
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Functions of Money
• 3. Store of Value: is used to save purchasing power
from the time income is received until the time it is
spent.
• Money is not unique as a store of value, other assets
have advantages over money as a store of value:
- They often pay the owner a higher interest rate than money,
- experience price appreciation
- deliver services
• Why do people hold money at all?
• Money is the most liquid asset. Liquidity is the
relative ease and speed with which an asset can be
converted into a medium of exchange.
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Functions of Money
• Other assets involve transaction costs when they are
converted into money.
• How good a store of value money is depends on the
price level. when the price level is increasing
(inflation), money loses value.
• extreme inflation, known as hyperinflation, in which
the inflation rate exceeds 50% per month.
• Zimbabwe is an example of recent hyperinflations.
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Evolution of the Payments System
• The payments system is the method of conducting
transactions in the economy.
• 1. Commodity Money: Money made up of precious
metals or another valuable commodity.
• Problems:
- very heavy
- hard to transport from one place to another, especially for
large purchases.
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Evolution of the Payments System
• 2. Fiat Money: paper currency decreed by
governments as legal tender but not convertible into
coins or precious metal.
• Advantages:
- being much lighter than coins or precious metals
• Problems:
- accepted only if there is some trust in the authorities who
issue it.
- easily stolen
- expensive to transport in large amounts because of their bulk.
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Evolution of the Payments System
• 3. Checks: an instruction from you to your bank to
transfer money from your account to someone else.
• Advantages:
- Minimize the movement of money, payments that cancel each
other can be settled by canceling the checks.
- reduce the transportation costs associated with the payments
system and improve economic efficiency.
– can be written for any amount up to the balance in the
account, making transactions for large amounts much easier
– loss from theft is greatly reduced,
– provide convenient receipts for purchases
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Evolution of the Payments System
• Problems:
– It takes time to get checks from one place to another.
– the paper shuffling required to process checks is costly,
estimated to be $10 billion a year in USA.
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Evolution of the Payments System
• 4. Electronic Payment: make payments
electronically over the internet.
• Advantages:
– save the cost
– Require little effort
– recurring bills can be automatically deducted from the bank
account
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Evolution of the Payments System
• E-Money: money that exists only in electronic form.
– 1. Debit cards, enable consumers to purchase goods and
services by electronically transferring funds directly from
their bank accounts to a merchant’s account, e.g., K-Net card
in Kuwait.
– 2. Credit cards are now often becoming faster to use than
cash, e.g., Visa and MasterCard.
– stored-value card, like a prepaid phone card, sophisticated
cads are now known as Smart cards, allows cards to be
loaded with digital cash from the owner’s bank account
whenever needed. Smart cards can be loaded from ATM
machines, personal computers with a smart card reader, or
specially equipped telephones.
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Evolution of the Payments System
• 3. e-cash: accounts with a bank that has links to the
internet and then has the e-cash transferred to your
PC, you then can be using the cash to pay for your
purchases.
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Measuring Money
• What makes an asset money is that people believe it
will be accepted by others when making payment.
• this behavioral definition does not tell us exactly what
assets in our economy should be considered
• money.
• To measure money, we need a precise definition that
tells us exactly what assets should be included.
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Measuring Money
• The Central Bank of Kuwait’s Monetary
• Aggregates.
• M1 (most liquid assets) = currency in circulation with
the public + sight deposits (private deposits in KWDs)
+ other checkable deposits.
• M2 (adds to M1 other assets that are not so liquid) =
M1 + Quasi money (saving deposits in KWDs + time
deposits in KWDs).
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Measuring Money
• M3 (adds to M2 somewhat less liquid assets) = M2 +
deposits in non-bank financial institutions.
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Table 1 Measures of the Monetary
Aggregates
Central bank of Kuwait Monetary Aggregates
Period
2003
2004
2005
2006
2007
2008
2009
2010 Q1
Currency Issued
-1
585.5
606.3
684.6
804.9
756.7
869.1
943.8
943
Cash with Local Banks
-2
91.3
75.3
105.9
148.6
115.2
161.4
168.1
140.4
Currency in Circulation
(3)=(1)-(2)
494.1
531
578.7
656.3
641.5
707.8
775.7
802.6
Sight Deposits in KD
-4
2117.4
2643.3
3148.7
2893.9
3505.2
3662.5
3938.3
4445.7
(5)=(3)+(4) 2611.5
3174.2
3727.4
3550.3
4146.7
4370.3
4714
5248.3
8481
9358.8 12370.3 14813.2 17579.9 20181.8 20389.6
Money (M1)
Quasi-Money
Money Supply (M2)
Deposits with Financial Institutions*
Money Supply (M3)
-6
7789.7
(7)=(5)+(6) 10401.2 11655.2 13086.2 15920.6 18959.9 21950.2 24895.8 25637.9
-8
8.9
23.2
14.2
26.1
26.1
(9)=(7)+(8) 10410.2 11678.4 13100.4 15946.7 18986
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56.8
23.7
24.7
22007 24919.4 25662.6
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Key Terms
commodity money,
e-cash,
fiat money,
income,
M1,
M3,
monetary aggregates,
smart card,
unit of account,
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currency,
electronic money (e-money),
hyperinflation,
liquidity,
M2,
medium of exchange
payments system,
store of value,
wealth,
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