Lecture What Is Money?

1. Lecture What Is Money? Chapters 3

2. Meaning of Money • Money - anything that is generally accepted in payment for goods or services or in the repayment of debts. • A stock concept. It is 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 different from income - flow of earnings per unit of time (a flow concept)

3. Medium of Exchange • The alternative is barter. • For economic exchanges to occur using barter, ____________________ must exist.

4. wants haircut wants furniture needs to eat needs to move wants to read a novel wants corn Coincidence of Wants Farmer Cook Mover Writer Barber Carpenter

5. 3 Functions of Money 1) 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

6. Functions of Money (2) Unit of Account: • used to measure value in the economy (3) 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

7. Inseparability of the Store-of-Value and Medium-of-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.

8. Liquidity • 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.

9. Measuring Money • How do we measure money? Which particular assets can be called “money”? • Monetary aggregates (M1 and M2) are constructed using the concept of liquidity: M1 (most liquid assets) M1 = currency + traveler’s checks + demand deposits + other checkable deposits.

10. Measuring Money • M2 adds to M1 other assets that are not so liquid • M2 = M1 + small denomination time deposits + savings deposits and money market deposit accounts + money market mutual fund shares.

11. http://www.federalreserve.gov/releases/h6/current/h6.htm

12. M1 vs. M2 • Which measure to use? • M1 and M2 can move in different directions in the short run (see figure).

13. Growth Rates of the M1 and M2 Aggregates, 1960–2011 Note change after early 1980s

14. What happened in the 80’s • High and rapid inflation in the 1980’s? Nominal interest rates increased • Checking accounts pay zero interest. New financial products introduced – major innovation was the introduction of the money market mutual funds. • 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.