topic 03 money mishkinsrdgfh

7/27/2019 Topic 03 MONEY Mishkinsrdgfh

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TOPIC 3

MONEYAND

THE PAYMENT SYSTEM


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CHAPTER PREVIEW

This chapter enables us to understand roles of moneyin the economy. To do so, we start with the exactmeaning money, then the functions of money and explorehow its form evolve over time. More importantly, we are

going to understand the role of money in the economicactivity. Topics include:

1. Meaning of Money

2. Functions of Money

3. Evolutions of Payments System

4. Measuring Money

5. Money and the Economy


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DEFINITION

Anything that is generally accepted in payment forgoods 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, canmake purchases

Wealth is less liquid; total collection of pieces ofproperty that serve to store value.

Wealth include money and other assets (such asstocks and bonds, cars, houses, furniture, land)

Mone vs income


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Copyright 2008 Pearson Addison-Wesley. All rights reserved. 2-4

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


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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 fromother assets

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


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Meeting the Needs of

Exchange

3 methods of exchange to gain theefficiency benefits of specialization include:

barter, government allocation, andmoney

Money can help people benefit from

specializationwithout incurring the hightrading costs of barter or the misallocationsof 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 inunits of money

-Reduce transaction costs by reducing the number ofprices that need to be considered

3. Store of Value:To store purchasing power overtime

-Save purchasing power from time income is receiveduntil it is spent

-Any asset can be used as store of value/wealth: Stock,

bonds, land, houses, cars(?)-


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FUNCTIONS OF MONEY

Is money a good store of value? Depends onPRICE LEVEL

-If price level constant, ok

-If price level increase twice, value of money dropped byhalf

-During high inflation time, people reluctant to hold wealthin money form


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FUNCTIONS OF MONEY

Why hold money?

LIQUIDITY

-Definition: relative ease and speed with which an assetcan be converted into a medium of exchange

-Transaction demand

-Money is most liquid asset of all

-Other assets involve transaction costs to be converted


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EVOLUTION OFPAYMENT SYSTEM


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EVOLUTION OF PAYMENTSYSTEM

Forms that money has taken over time depend on evolution ofpayments system: that is the method of conductingtransactions in economy

1. Commodity money: Money made up of precious metals or

other valuable commodity-Problems: heavy and hard to transport. Making large payments?

1. Fiat money: paper currency accepted by govt as legaltender (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 beconverted to precious metals, then evolved into fiat money

-Can be accepted as medium of exchange only if there is trust inissuing authorities and small possibility of counterfeiting

-Problem: Can be easily stolen and bulky


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EVOLUTION OFPAYMENTS SYSTEM

1. Commodity money2. Fiat money3. Checks: Instruction from you to your bank to

transfer money from your account to someoneelses account when she deposits the check.

-No movement of real currency if transactions are beingcancelled

-Reduce transportation costs and improve economicefficiency

-Up to any amount (based on balance), large transactionseasier

-Loss from theft greatly reduced and receipt of purchase

-Problems: Time: sending checks and floating


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EVOLUTION OF PAYMENTSSYSTEM

1. Commodity money:2. Fiat money

3. Checks4. Electronic payment: Doing financial

transaction electronically via internet andmobile phones

-No more mailing to pay bills; transmit paymentelectronically

-Reduce transaction costs substantially

-Auto debit for recurring bills


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EVOLUTION OFPAYMENTS SYSTEM

1. Commodity money:2. Fiat money3. Checks4. Electronic payment

5. E-money: Money exists in electronic form-Debit card: electronically transferring funds directlyfrom customers bank account to merchant accounts.

-Stored-value card: like pre-paid card

-e-cash: used on internet to purchase goods & services


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MEASURING MONEY


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Measuring Money Supply

To understand moneys role as aneconomic variable, we need to measureit

Definitions of money supply are basedon

the assets included as money and dependon how substitutable different assets are formoney

Liquidity


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Monetary Aggregates

Monetary authority has developed 3

definitions of money that include assets

broader than currency, called monetaryaggregates:

M1 Narrow definition of money

M2

M3 -Broader monetary aggregates


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Measuring Monetary Aggregates,

February 2006


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Selecting Monetary Aggregates

M2currently considered best

Aggregates move broadly together over longtime periods

Some significant differences in monetaryaggregate movements have occurred duringcertain periods

The different monetary aggregates give adifferent picture of movements in the moneysupply over time.


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Figure 2.3 Growth Rates of

M1 and M2, 1960-2006


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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 + FixedDeposits + NIDs +

Repos + Foreign Currency Deposits + other deposits

M3: M2 + deposits placed with other banking institutions


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MONEY AND ECONOMY


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The Quantity Equation

This model allows us to understand effect that thequantity of money has on the economy

To do this we must see how quantity of money isrelated to price and income

Relationship between money and economy can be

explained by the Quantity Equation:MV = PTWhere: M is money supply

V is velocity: average number of times that eachdollar of money supply is used to purchasegood and services

P is price level


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M V P T =

MoneyVelocity = PriceTransactions

On the right hand side, T is totalnumber of transactions during some

period of time, P is price of atypical transaction, and PT is thenumber of dollar (amount of money)

exchanged in a year.

On the left hand side, Mis the quantity of money,

V is the velocity ofmoney, and VM is

essentially a measure ofhow the money is used to

make transactions.

M V P Y =

Economists usually use GDP Yas a proxy for T since data on

the number of transactions isdifficult to obtain.


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MV = PTV can be assumed as constant as the average number oftimes the dollar being spent depend on factors that do notchange much (how often people got paid, frequency of

going to grocery, pay bills, etc)

M=PT/V

M = PY/V

Implications:

(1) IfT (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


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Money, Prices, and Inflation

The quantity theory of money states thatthe central bank, which controls themoney supply, has ultimate control overthe rate of inflation

If the central bank keeps the moneysupply stable, the price level will bestable. If the central bank increases themoney supply rapidly, the price level will

rise rapidly


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Future Money and CurrentPrices

Money, prices, and interestrates are related.

The quantity theory ofmoney explains that moneysupply and money demand

determine price.

By definition changes inprice are inflationary

Inflation affects the nominalinterest rate via the fisher

effect.

And the nominal interestrate affects money demand.

Money

SupplyNominalInterest

Rate

InflationRate

PriceLevel

MoneyD d

topic 03 money mishkinsrdgfh

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