Lecture 1
Basic theories about
MONEY
Content
The nature and functions of money
The evolution of the payments system
Measuring money – The money aggregates
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The nature and functions of money
• What is money?
Anything that is generally accepted in payment
for goods or services or in the repayment of
debts. (Frederic S. Mishkin)
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Meaning of Money
Money is different from:
• Wealth: the total collection of pieces of
property that serve to store value
• Income: flow of earnings per unit of time
(a flow concept)
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In barter economy
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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
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Functions of Money (cont’d)
• Unit of Account:
– used to measure value in the economy
– reduces transaction costs
• Store of Value:
– used to save purchasing power over time.
– other assets also serve this function
– Money is the most liquid of all assets but loses
value during inflation
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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.
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Evolution of the Payments
System (cont’d)
• Checks: an instruction to your bank to
transfer money from your account
• E-Money (electronic money):
– Debit card
– Credit card
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Evolution of the Payments
System (cont’d)
Coins, bank notes, checks…
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FYI Are We Headed for a Cashless
Society?
• Predictions of a cashless society have been
around for decades, but they have not come
to fruition
• Although e-money might be more
convenient and efficient than a payments
system based on paper, several factors work
against the disappearance of the paper
system
• Still, the use of e-money will likely still
increase in the future
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Measuring Money
• How do we measure money? Which
particular assets can be called “money”?
• Construct monetary aggregates using the
concept of liquidity:
• M1 (most liquid assets) = currency +
traveler’s checks + demand deposits +
other checkable deposits.
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Measuring Money (cont’d)
• M2 (adds to M1 other assets that are not so
liquid) = M1 + small denomination time
deposits + savings deposits and money
market deposit accounts (MMDA) + money
market mutual fund shares.
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Table 1 Measures of the
Monetary Aggregates
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Monetary Aggregates
M1 (4)
M2 (4+3)
Currency
Small Den. Dep.
Traveler’s
Savings and MM
Checks
Money Market
Demand
Mutual Funds
Deposits
Shares
Other Check.
Dep
M3
(4+3+4)
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Figure 1 Growth Rates of the M1 and
M2 Aggregates, 1960–2011
Sources: Federal Reserve Economic Database (FRED); Federal Reserve Bank of Saint Louis;
http://research.stlouisfed.org/fred2/categories/25
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Revision
• What is money?
• What is the most important function of
money?
• What is the payment system?
• Cashless society: the future prospects?
• Money aggregates and money supply
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