the concept of money. what they say about money? research shows that the more money people have,...
TRANSCRIPT
The Concept of Money
What they say about money?
Research shows that the more money people have, the more likely they are to report being satisfied with their lives.
Money buys you things that make life easier and more satisfying; the easier your life, the happier you tend to be.
That relationship isn't entirely linear, since there's a limit to how much wealth can please you; the happiness benefit of an increasing income is especially powerful among people who don't have much money to start with, and diminishes as wealth increases.
What is Money?
• Money is that which is universally acceptable in an economy and used as a medium of exchange (i.e., accepted as payment for purchases of goods and services or for a debt).
What is Money?• It is any object that is
commonly accepted, spendable and authorized by the state as a means of exchanging products and services in a certain place and time.
• It is also defined as anything which has a fixed and unvarying price in terms of the unit of account (ex. dollar, peso, etc.).
Money as an Asset
• Money can be considered an asset, or something of value. As such it is part of your wealth (Net worth = Assets – Debt).– Although not the only form of wealth
exchangeable for goods and services, money is the one most widely accepted (liquidity).
• An asset is liquid when it can be easily exchanged for goods and services.
– Money is the most liquid of all assets.
The Relationship of Money and Economic Activity
• One of the most common measures of economic activity is GNP.– GNP – is defined as the value of all
final goods and services produced in one year in the economy.
Note: Some studies in the past reveal the relationship between the growth of money supply and the level of (non-inflation adjusted) national income.
Money and Prices (Inflation)
• Another key economic variable is the price level and how it changes.– Inflation – is defined as the rise in
the (weighted) average of all prices. • One theory attributes inflation to
changes in the amount of money in circulation. – Studies show that increases in the
growth of the money supply leads to an increase in the inflation rate.
The Gresham’s Law
• Sir Thomas Gresham (1519-1579) an English financier during the Tudor Dynasty states that any circulating currency consisting of both "good" and "bad" money (both forms required to be accepted at equal value under legal tender law) quickly becomes dominated by the "bad" money.
• This is because people spending money will hand over the "bad" coins rather than the "good" ones, keeping the "good" ones for themselves.
• Legal tender laws act as a form of price control. In such a case, the artificially overvalued money is preferred in exchange, because people prefer to save rather than exchange the artificially demoted one (which they actually value higher).
• In short, the coins that circulate in the economy will tend to be of the most “debased” sort available.
“Bad money drives out good.”
How was money invented?
• Money was invented because of the failure of the barter system. (Barter – is the trade of goods and services for another without the use money.)– A barter system typically would involve
an exchange of commodities (ex. exchanging 3 chickens for 1 goat, a pair of shoes for a blouse, so on and so forth) between 2 or more people.
– The major problem facing a barter economy is that a double coincidence of wants is required for exchange.
Shortcomings of a Barter System
• Shortcomings of a Barter System– Absence of a method of storing
generalized purchasing power.– Absence of a designated unit to use
in writing contracts requiring future payments.
– Absence of a common unit of measure and value.
Disadvantages of the Barter System
• Barter System– Disadvantages:
•The limited shelf–life of goods, bad roads, and the difficulty of transporting goods due to bulk.
•The near impossibility of matching the goods the seller has with the needs of the buyers he/she meets (double coincidence of wants).
•The problem of determining whether the value of one product or service is equal to the value of the product or service being exchanged.
Purchasing Power, Explained
Purchasing power – is the number of goods/services that can be purchased with a unit of currency.
• Explanation: If you had taken P10,000 to a store in the 1990s, you would have been able to buy a greater number of items than you would today, indicating that you would have had a greater purchasing power in the 1990s.
As Adam Smith noted, having money gives one the ability to "command" others‘ labor, so purchasing power to some extent is power over other people, to the extent that they are willing to trade their labor or goods for money.
Purchasing Power, Explained
Formula:tt i)(1
CC
Where: Ct = Value of currency in time t
C = Value of currency t = time
Ex: What could be the value of P100 in 5 year’s time if inflation is projected to be 4%. Answer: P82.19 Illustration:
P82.19
)04.01(
1005
tC
Common Unit of Measure and Value, Explained
Formula:
Where: E/R (Prices) = Exchange rate or prices
N= the number of goods and services produced and exchanged.
Ex. In a barter economy, if N=100, how many E/R (Prices) exist in that economy? The answer is 4,950.
2
)1()Prices(/
NNRE
Evolution of Money
• At first, personal ornaments such as rare seashells and stones were exchanged for food and other commodities.
• As early as 3000 B.C., people discovered the convenience of using precious metals – such as gold and silver – as money.
Objects Used as Money
Object Place Date
Knives, rice spades
China Around 3,000 BC
Cattle and clay tablets
Babylonia Around 2,500 BC
Wampum (beads) and beaver fur
American Indians of the Northeast
Around AD 1,500
Tobacco Early American colonists
Around 1,650
Whales teeth Pacific peoples on the Island of Fiji
Until early 1900s
Bank Notes and Greenbacks
• A Bank Note – is a piece of paper that represents a liability on the part of the issuing bank to the holder – and not to a specific payee.
• A Greenback – is a fiduciary nonredeemable paper money issued by the US during the Civil War.
Functions of Money
• As Medium of ExchangeMoney's most important function is as
a medium of exchange to facilitate transactions. Whatever people usually give in exchange for the things that they buy is the medium of exchange (such as a coin, or the paper money). When money is used to intermediate the exchange of goods and services, it is performing a function as a medium of exchange.
Ex. A professor cannot arrange barter, i.e., exchange his teachings in exchange for a haircut (from a barber). Money is necessary to carry on exchange.
Function of Money• As a Unit of Account
A unit of account – is defined as a standard numerical unit of measurement of the market value of goods, services, and other transactions; the unit of account is the unit in which values are stated, recorded and settled.
Money also functions as a unit of account, providing a common measure of the value of goods and services being exchanged.
Note: As a medium of exchange – money functions as something real , ex. a coin, a piece of currency, a credit in a bank account. But as a unit of account – money functions as an abstract measure of value, ex. the dollar, the pound sterling, etc.
Function of Money• The Liquidity Function
Liquidity – is defined as the degree to which an asset can be sold for cash without a loss in nominal value; it also means that the price of money is fixed and that money can be readily exchanged for desired goods and services.
To be liquid the asset must be: (1) readily marketable or transferable, and (2) stable in price.
Note: The essence of liquidity is the ability of an asset to be converted into spendable form, immediate marketability (or transferable) at a price certain.
Function of Money• As a Store of Value
Store of value – is defined as the ability of an item to hold value over time. To act as a store of value, it must be able to be reliably saved, stored, and be retrieved.
This is something that people keep in order to maintain the value of their wealth. Money is "set aside" for the future. Goods cannot be stored because they are perishable. People receive their incomes in money form and keep their savings in money form in banks. In this way, money is used to store value of commodities.
Note: The price of money is fixed (ex. $1, $5, $10, $50, and $100) but its value may change over time, since economic activity takes place under conditions of change and uncertainty.
Kinds of Money and their Characteristics
• Commodity moneyAn exchange medium representing
value; a material established as a standard of value and used legally in settling debts because of its intrinsic value.
• Credit moneyAny claim against a person, used for
the purchase of goods and services, and is not immediately repayable.
Kinds of Money and their Characteristics
• Fiat moneyMoney declared by the
government as legal tender. Fiat money is paper money that is backed only by the issuing government's decree that it is acceptable as “legal tender” currency.
Note:In a fiat money system, money is not backed by a physical commodity (e.g., gold). Instead, the only thing that gives the money value is its relative scarcity and the faith placed in it by the people that use it.
Kinds of Money and their Characteristics
Cont'd. (Fiat money)
Today, money typically consists of coins, paper, currency and checking account balances.
In the past, societies have most often chosen a precious metal or coin as money, ex. gold and silver.
Seignorage vs. Brassage
Two definitions of seignorage:
1. Seignorage – the fee or price governments charge when they certify for the weights of silver and gold coins.
2. Seignorage – the process whereby governments gain “profit” by placing a face value on a coin that exceeds is inherent market value; it is the charge levied to individuals for converting metal to money.
Ex. If the market value of the base metal in the coin is less than the face value of the coin, seignorage exists (ex. the base metal in a ¢5 is only worth ¢1).
When the charge levied for conversion simply covers the cost of conversion the process is called “brassage”.
E-Money and its Forms
Since money is what is accepted as money, in practice money assumes different forms.
Technological changes in the banking industry lead to changes in the form of money.
For these reasons money is difficult to define and measure.
Forms of Electronic Money• Debit Cards
A bank card used to make an electronic withdrawal from funds on deposit in a bank, as in purchasing goods or obtaining cash advances.
• Stored Value CardsA credit card with a built-in
microprocessor and memory that is loaded with cash.
• Electronic ChecksA form of payment made via the
internet that is designed to perform the same function as a conventional paper check.
Other Forms of Money• Coins and currencies (called
paper money or notes) – are the most common form of money which one can hold and touch; physical objects.
• Bank checks or drafts: Money can also be any other object that represents value such as a manager's check or a gift certificate.Notes: Bank checks or drafts are different with money in a sense that coins and currencies are anonymous (if one will tell who owns it or where it came from). Ownership of a bank check/draft can be traced.
Desirable Properties of Money
1. DurabilityMoney that does not have the
quality of physical durability will lose its value as money.
Ex. Popcorn could be money but it would be difficult to keep it in its current form. It would become state, soggy, wear out, flake apart, and so on.
Money has not always been characterized by durability. Roman soldiers were paid in salt (hence the origin of the word “salary”) which certainly is not durable in a humid or wet climate.
2. PortabilityMoney must be easy to carry
around and easy to transfer in order to make purchases in different locations.
If money is not portable, it cannot be widely used.
Desirable Properties of Money
3. Homogeneity (or Standardizability)A commodity from which it is made
must be of the same quality wherever it can be found.
Only if money is standardized can individuals be certain of what they are receiving when they make economic exchanges.
Note: The American colonists used tobacco as money, but tobacco could never be standardized. It could never represent equal value because of the different qualities of tobacco; humidity could also cause problems on occasion.
Desirable Properties of Money
4. DivisibilityMoney must be easily divided into
equal parts to allows for purchases of smaller units.
Note: Some monies have been indivisible. In African countries, cows have been used as money in spite of the fact that a fraction of a cow is quite a different entity than a whole cow.
Desirable Properties of Money
5. RecognizabilityMoney must be easily recognized.
If it is not easily recognized, individuals will find it difficult to determine whether they are dealing with money or some inferior asset.
Desirable Properties of Money
Monetary Standard – is the set of monetary arrangements and institutions governing the supply of money.
The Monetary Standard
2 Aspects of Monetary Standards:1. Domestic aspect - refers to the
institutional arrangements and policy actions of monetary authorities.
2. International aspect - refers to monetary arrangements between nations.
• Representative Money – refers to money that consists of a claim on items of value held elsewhere.
Representative signifies that a certain amount of bullion was stored in a Treasury while the equivalent paper in circulation represented the bullion.
Examples of representative money:1. Gold certificates2. Silver certificates
What is Representative Money?
Gold Certificates, Example
SSS Eyes Sale of P1-B Gold Certificates
The SSS is planning to issue gold certificates to local retail investors backed by P1 billion worth of gold that the pension fund is offering to buy from the BSP.
SSS said the plan was meant to provide a new investment opportunity that would serve as a hedge against currency fluctuations and help expand the country’s capital market.
With other major players in the capital markets, SSS hopes to establish a trading mechanism for the certificates in the PSE.
SSS explained that the plan would also enable SSS to hedge part of its assets in gold reserves, widely considered a safe and stable investment and a haven for investors during times of currency uncertainties.
SSS said it is expected gold trading to bring in additional income for the SSS aside from helping the BSP absorb excess liquidity in the open market.
The Evolution of The Philippine Currency
Pre-Hispanic Era• Trade among the early
Filipinos and with traders from the neighboring islands was conducted through barter.
• The inconvenience of barter later led to the use of some objects as medium of exchange.
• Gold: piloncitos (small bead-like gold bits considered as the earliest coin of the ancient Filipinos)
• Gold barter rings
Spanish Era (1521-1897)• Philippine money was a
multiplicity of currencies that included Mexican pesos, Alfonsino pesos and copper coins of other currencies.
• The cobs or macuquinas of colonial mints were the earliest coins brought in by the galleons from Mexico and other Spanish colonies.
Spanish Era (1521-1897)
• The barilla, a crude bronze or copper coin worth about one centavo, was the first coin struck in the country.
• The pesos fuertes, issued by the country’s first bank, the El Banco Espanol Filipino de Isabel II, were the first paper money circulated in the country.
The Development of Phil. CurrencyPre-Spanish Period to the 1800s
Currency Used Period
Barter system, no currency Pre-Spanish period, 1st phase
Sea shells Pre-Spanish period, 2nd phase
Gold, wax, cotton, small shells, dye-wood, carabao horns, metal bells, and silver wires
Pre-Spanish period, 3rd phase
Piloncito
Penniform Gold Barter Ring
European Silver Coins
Silver coins from the mints of Mexico and other Latin American Countries
Spanish Barilla (first coin minted in the Phil.)
Spain’s eight-real coins circulated throughout the world including the Phil.
Currencies of Mexico, Peru, Bolivia, Chile, Argentina and other Latin American countries
Revolutionary Period (1898-1899)
• Asserting its independence, the Philippine Republic of 1898 under General Emilio Aguinaldo issued its own coins and paper currency backed by the country’s natural resources.
Revolutionary Period (1898-1899)
• One peso and five peso notes printed as Republika Filipina Papel Moneda de Un Peso and Cinco Pesos were freely circulated.
• 2 centimos de peso copper were also issued in 1899.
The American Period (1900-1941)
• The Americans instituted a monetary system for the Philippine based on gold and pegged the Philippine peso to the American dollar at the ratio of 2:1.
• The renaming of El Banco Espanol Filipino to Bank of the Philippine Islands in 1912 paved the way for the use of English from Spanish in all notes and coins issued up to 1933.
The Japanese Occupation (1942-1945)
• Several notes were circulated in the country during this period.
• The Japanese Occupation Forces issued war notes in big denominations.
The Japanese Occupation (1942-1945)
• Provinces and municipalities, on the other hand, issued their own guerrilla notes or resistance currencies, most of which were sanctioned by the Philippine government in-exile, and partially redeemed after the war.
The Philippine Republic
• Having gained independence from the United States following the end of World War II, the country used as currency old treasury certificates overprinted with the word “Victory”.
The Philippine Republic
• With the establishment of the Central Bank of the Philippines in 1949, the first currencies issued were the English series notes printed by the Thomas de la Rue & Co., Ltd. in England and the coins minted at the US Bureau of Mint.
• The Filipinazation of the Republic coins and paper money began in the late 60’s and is carried through to the present.
The Philippine Republic
• In the 70’s, the Ang Bagong Lipunan (ABL) series notes were circulated, which were printed at the Security Printing Plant starting 1978.
• The new design series of banknotes issued in 1985 replaced the ABL series.
• Ten years later, a new set of coins and notes were issued carrying the logo of the Bangko Sentral ng Pilipinas.
The Money Supply and
Measures of Money
The Money SupplyMoney Supply – is defined as the
amount of money circulating in the economy.
While a number of factors determine how fast or how slowly prices move up, a key driver of inflation is the money supply. When there is too much money going around chasing too few goods, the inevitable result is for prices to move up.
Whoever manages the money supply (ex. the US Federal Reserve, the BSP, etc.) must make sure that the money supply keeps pace with the actual growth in production of goods and services in the economy.
Money Supply(An Example)
Demand deposits* $159,800
Currency and coinFederal reserve notes 44,450Treasury currency 620Coins 5,690
210,760Less currency and coin held by banks
7,060Total public money supply
$203,700
*Demand deposits other than interbank and US government, less cash items in process of collection
Factors that Change the Money Supply
Changes in the Money Supply, 1980-2006
Explains long run movements
Explains short run fluctuations
Changes in the Money Supply, 1980-2006
Effects of Changes in Money Supply
Money Supply
Increase
Decrease
Fewer funds
available for
lending
Increase in the supply of loanable
funds
Rise in security prices
Fall in security prices
Real interest
rates will rise
Market interest
rates rise
Real interest rates fall
Market interest
rates will fall
Investments will
fall
Investments will rise
Two Approaches in Measuring Money
The Transaction Approach• Emphasizes money’s function as a medium
of exchange. Note: GS and savings deposits are excluded
because they must first be converted before spending.
• A CB controls the supply of money used to make transactions.
• Money shows a reliable and predictable relationship to national economic goals.
The Liquidity ApproachStresses that very liquid assets should be easily
converted into money without loss of nominal value.
Empirical Measures of Money
• The different functions of money are associated with different empirical measures of the money supply.
• The supply of money is broken down into types of money based on how much of an effect monetary policy can have on each.
• Narrow measures include those more directly affected by monetary policy, whereas broader measures are less closely related to monetary-policy actions.
• The different types of money are typically classified as Ms. The number of Ms usually range from M0 (narrowest) to M3 (broadest) but which Ms are actually used depends on the system.
M1, M2 and the Monetary Base
• M0 – includes bank reserves; M0 is referred to as the monetary base, or narrow money.
• MB (Monetary Base or Total Currency) – currency in circulation plus reserves.
Note: This is the base from which other forms of money (like checking deposits) are created and is traditionally the most liquid measure of the money supply.
• M1 – currency in circulation plus demand deposits (in a bank) and traveler’s checks (issued by nonbanks). (Note: bank reserves are not included in M1.)
M1, M2 and the Monetary Base
• M2 – represents money and "close substitutes" for money.
The M2 formula:M2 = M1+overnight REPOs+overnight
Eurodollars+Money Market Mutual Funds+Savings Deposits+ small-denominated Time Deposits,
• M2 is a broader classification of money than M1. Economists use M2 in quantifying the amount of money in circulation and explaining different economic monetary conditions. M2 is a key economic indicator when forecasting inflation.
M1, M2 and the Monetary Base
• M3 – Since 2006, M3 is no longer published or revealed to the public by the US central bank. However, there are still estimates produced by various private institutions.
• MZM – Money with zero maturity. It measures the supply of financial assets redeemable at par on demand.
Note: The ratio of a pair of these measures, most often M2/M0, is called an actual or empirical money multiplier.
M1, M2 and the Monetary Base
• The CB has greater control over the MB than it does over M1– Checkable deposits are influenced by a
number of factors that the CB does not have direct control over.
• We link MB and M1 together through the money multiplier– M1 = m*MB– For every $1 increase in the MB, the
money supply (M1) increases by m*$1– m is almost always greater than 1.
The Money Multiplier (also called the credit multiplier or the deposit multiplier) – is a measure of the extent to which the creation of money in the banking system causes the growth in the money supply to exceed growth in the monetary base.
The money multiplier is usually restricted to deposits in banks, this implies that we are talking about M1 (most commonly) or M2. Multipliers can also be calculated for broad money measures such as M3 and M4.
The Money Multiplier
Factors that Determine the Money Multiplier
• Changes in the required reserve ratio (r)– The money multiplier and the money
supply are negatively related to r
• Changes in the currency ratio (cr)– The money multiplier and the money
supply are negatively related to cr
• Changes in the excess reserves ratio (e)– The money multiplier and the money
supply are negatively related to the excess reserves ratio e
Deriving the Money Multiplier
Derivation of m1
C = currency in circulationcr = currency ratioD= demand deposit (checking account)rr = required reserve ratee = excess reserves = r–rrm1 = M1 Money multiplier = M1/MB
M1 = Money supply = C+DMB = Monetary base = C+RR = Total actual reserves
• MB = (rr + e + cr)*D
• Rearranging gives:
• Recall M1 = C + D = (cr*D) + D = (1+cr)*D
• Plugging in our definition of D:
• Since M1 = m1*MB:
MBcrerr
D
1
MBcrerr
cr
1
M1
crerr
cr
1
1m
Deriving the Money Multiplier
Example 1• Suppose the desired currency ratio is 40%, the
reserve requirement is 10% and the excess reserve ratio is 0.5%
• The money multiplier is
– A one dollar increase in the monetary base will lead to a $2.77 ($1 x 2.77) increase in the money supply
• Accounting for currency and excess reserves is clearly important.
77.240.0005.010.0
40.01
crerr
cr
1
1m
Example 2• Let cr=25% , e = 0.10%, and rr = 10%.
Compute the money multiplier
• The CB decides to increase rr to 20%. What happens to the money multiplier (and the money supply as a result)
– A smaller multiplier means that banks create less money through lending and therefore the money supply will fall.
56.325.0001.010.0
25.011m
77.225.0001.020.0
25.011m
Example 3• What happens to the money multiplier when
the desired currency ratio rises?
• Let cr = 20%, rr = 25%, and e = 5%
• Now suppose cr rises to 30%, while all other variables remain constant
• Increasing the fraction of deposits held as currency causes the money supply to fall– Money is being taken out of the banking
system where it could have been used to make loans.
40.220.005.025.0
20.011m
17.230.005.025.0
30.011m
Derivation of m2
The M2 money supply is defined as M1 money supply plus Overnight Repos plus Overnight eurodollars plus money market mutual funds plus savings deposits plus small-denominated time deposits
• To keep matters simple all of the above items (except for large-denominated time deposits) will be grouped together as MMF. Thus, M2 = M1 + T + MMF.
Note: M2 is used by economists to forecast inflation.
Deriving the Money Multiplier
How CB manages money supply?
To understand how a CB manages money supply—we need to understand how the banking system “creates” money.
Banks are in the business of taking our deposits and making them grow by much more than what they pay us (in interest).
They do this by lending our money to various borrowers: Businesses who need money to invest in an enterprise, consumers wishing to buy a house or car, or even government (when banks invests in interest-earning government securities).
How CB manages money supply?
Ex. A reserve requirement of 20% means that for every $1,000 deposit banks take in, they should hold $200 ($1,000 x 20%) in reserve and lend out $800 [i.e., $1,000 x (1– 0.20)].
When they loan out $800, that money eventually ends up being deposited in banks again, leading to a new round of $640 [$800 x (1 – 0.20)] in loans, which in turn end up being deposited somewhere, thereby leading to new loans of $512 [$640 x (1 – 0.20)], so on and so forth.
Bank Each Single Bank
Cumulative Increase for
System
Increase in Reserves of Each Single
Bank
A $1,000 $1,000 $200
B 800 1,800 160
C 640 2,440 128
D 512 2,952 102
…Totals
…$5,000
… …$1,000 = increase in reserves for system
Formula and Illustration
$5,000 = $1,000 ÷ 0.20
The formula may be written as d = d (1÷rr) which is the maximum rise in deposit, while the money multiplier is 1÷ rr.
• Computing for the maximum rise in deposit (d).
Formula: d = d * (1÷rr)
Ex. In a 5% reserve requirement, if a bank receives $1 million deposit, the maximum rise in total deposit is $20,000,000 [$1,000,000 * (1÷0.05)]
• Computing for the increase in lending (L).
Formula: L = d * (1 - rr)
Ex. Continuing from the above example, lending can increase by $19,000,000 [20,000,000 * (1 - 0.05)]
Max. rise in deposit/ Increase in lending
• Computing for money multiplier (m) taking into consideration the required reserve ratio (rr).
Formula: m = 1÷ rr
Ex. In a 5% required reserve ratio the money multiplier is 20 (1÷ 0.05).
The money multiplier and RR ratio