Download Topic_03_MONEY

TOPIC 3
MONEY
AND
THE PAYMENT SYSTEM
CHAPTER PREVIEW
This chapter enables us to understand roles of money in the economy.
To do so, we start with the exact meaning money, then the functions of
money and explore how its form evolve over time. More importantly, we
are going to understand the role of money in the economic activity.
Topics include:
1.
2.
3.
4.
5.
2
Meaning of Money
Functions of Money
Evolutions of Payments System
Measuring Money
Money and the Economy
DEFINITION
• Anything that is generally accepted in payment for goods and
services or in repayment of debts
• Currency as money – too narrow. How about checks, credit cards?
• Money vs wealth
– Money is liquid; currency, demand deposits, can make purchases
– Wealth is less liquid; total collection of pieces of property that
serve to store value.
– Wealth include money and other assets (such as stocks and
bonds, cars, houses, furniture, land)
• Money vs income
3
Criteria for Medium of
Exchange
•
•
•
•
•
Acceptable to most traders
Standardized quality
Durable
Valuable relative to its weight
Divisible
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FUNCTIONS OF MONEY
5
Functions of Money
•
•
•
•
Medium of exchange
Unit of account
Store of value
Standard of deferred payment
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FUNCTIONS OF MONEY
1. Medium of Exchange: Distinguish money from other assets
7
–
Money used to pay for goods & services
–
Promotes economic efficiency:
-Minimizing time spent in bartering - transaction costs, “double
coincidence of wants”
-Allowing specialization & division of labor
Meeting the Needs of
Exchange
• 3 methods of exchange to gain the efficiency benefits
of specialization include barter, government allocation,
and money
• Money can help people benefit from specialization
without incurring the high trading costs of barter or
the misallocations of government allocation
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Methods of Exchange
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FUNCTIONS OF MONEY
2. Unit of Account: Measure value of goods & services in
economy
-Ensuring smooth exchanges of goods & services
-Comparing prices; list of prices of goods & services in units of money
-Reduce transaction costs by reducing the number of prices that need
to be considered
3. Store of Value: To store purchasing power over time
-Save purchasing power from time income is received until it is spent
-Any asset can be used as store of value/wealth: Stock, bonds, land,
houses, cars(?)
-Advantages of other assets as store of value: give higher returns,
appreciation
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FUNCTIONS OF MONEY
• Is money a good store of value? Depends on PRICE LEVEL
-If price level constant, ok
-If price level increase twice, value of money dropped by half
-During high inflation time, people reluctant to hold wealth in money
form
11
Zimbabwe's inflation
rate surges to an
absurd
231,000,000%
October 2008
FUNCTIONS OF MONEY
• Why hold money?
LIQUIDITY
-Definition: relative ease and speed with which an asset can be
converted into a medium of exchange
-Transaction demand
-Money is most liquid asset of all
-Other assets involve transaction costs to be converted
13
EVOLUTION OF
PAYMENT SYSTEM
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EVOLUTION OF PAYMENT SYSTEM
Forms that money has taken over time depend on evolution of payments
system: method of conducting transactions in economy
1.
Commodity money: Money made up of precious metals or other valuable
commodity
-Problems: heavy and hard to transport. Making large payments?
2.
Fiat money: paper currency accepted by govt as legal tender (legally, it
must be accepted as payments for debts) but not convertible into
coins/precious metals
-Initially, paper currency carried a guarantee that it can be converted to precious
metals, then evolved into fiat money
-Can be accepted as medium of exchange only if there is trust in issuing authorities
and small possibility of counterfeiting
-Problem: Can be easily stolen and bulky
15
EVOLUTION OF
PAYMENTS SYSTEM
1. Commodity money
2. Fiat money
3. Checks: Instruction from you to your bank to transfer
money from your account to someone else’s account
when she deposits the check.
-No movement of real currency if transactions are being cancelled
-Reduce transportation costs and improve economic efficiency
-Up to any amount (based on balance), large transactions easier
-Loss from theft greatly reduced and receipt of purchase
-Problems: Time: sending checks and floating
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EVOLUTION OF PAYMENTS SYSTEM
1.
2.
3.
4.
Commodity money:
Fiat money
Checks
Electronic payment: Doing financial transaction
electronically via internet and mobile phones
-No more mailing to pay bills; transmit payment electronically
-Reduce transaction costs substantially
-Auto debit for recurring bills
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EVOLUTION OF
PAYMENTS SYSTEM
1.
2.
3.
4.
5.
Commodity money:
Fiat money
Checks
Electronic payment
E-money: Money exists in electronic form
-Debit card: electronically transferring funds directly from customers’
bank account to merchant accounts.
-Stored-value card: like pre-paid card
-e-cash: used on internet to purchase goods & services
18
MEASURING MONEY
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Measuring Money Supply
• To understand money’s role as an
economic variable, we need to measure
it
• Definitions of money supply are based on
– the assets included as money and depend
on how substitutable different assets are for
money
– Liquidity
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Monetary Aggregates
• Monetary authority has developed 3
definitions of money that include assets
broader than currency, called monetary
aggregates:
M1 – Narrow definition of money
M2
 M3 -Broader monetary aggregates
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Measuring Monetary Aggregates,
February 2006
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MONETARY AGGREGATES
Definition of monetary aggregates in Malaysia
M1 = Currency in Circulation + Demand Deposits
M2 = M1 + Narrow Quasi Money
where Narrow Quasi-Money = Savings Deposits + Fixed Deposits + NIDs +
Repos + Foreign Currency Deposits + other deposits
M3: M2 + deposits placed with other banking institutions
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MONEY AND ECONOMY
The Quantity Equation
• This model allows us to understand effect that the quantity of
money has on the economy
• To do this we must see how quantity of money is related to price
and income
• Relationship between money and economy can be explained by the
Quantity Equation: MV = PT
Where: M is money supply
V is velocity: average number of times that each dollar of money
supply is used to purchase good and services
P is price level
T is total number of transactions
The Quantity Equation
On the left hand side, “M” is the
quantity of money, “V” is the
velocity of money, and “V•M” is
essentially a measure of how the
money is used to make
transactions.
Money•Velocity = Price•Transactions
M V  P  T
On the right hand side, “T” is total number of
transactions during some period of time, “P” is
price of a typical transaction, and “P•T” is the
number of dollar (amount of money) exchanged
in a year.
Economists usually use GDP “Y” as a proxy
for “T” since data on the number of
transactions is difficult to obtain.
M V  P  Y
The Quantity Equation
• MV = PT
V can be assumed as constant as the average number of times the dollar
being spent depend on factors that do not change much (how often
people got paid, frequency of going to grocery, pay bills, etc)
• M=PT/V
Implications:
(1) If T (total number of transactions) does not change: Increase in money
supply leads to increase in price level
(2) T change to Y: Increase in M must result in increase in Y, or else, price
level increase – demand-pull inflation
Money, Prices, and Inflation
• The quantity theory of money states that the central
bank, which controls the money supply, has ultimate
control over the rate of inflation
• If the central bank keeps the money supply stable,
the price level will be stable. If the central bank
increases the money supply rapidly, the price level
will rise rapidly
Future Money and Current Prices
• Money, prices, and interest rates
are related.
• The quantity theory of money
explains that money supply and
money demand determine price.
• By definition changes in price are
inflation
• Inflation affects the nominal
interest rate via the fisher effect.
• And the nominal interest rate
affects money demand.
Money
Supply
Price
Level
Money
Demand
Inflation
Rate
Nominal
Interest
Rate