02 what is money

7/30/2019 02 What is Money

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Banking & Finance

What is Money?



1.1. Clarifying a misunderstanding

In our everyday lives we often refer to “money” as one of threethings:

1. Coins and paper money (currency):

(“Hand over your money or I’ll shoot you”)

2. A person’s wealth

(“Bill Gates has a lot of money”)

3. A person’s income

(“Working in finance is a fantastic job and you earn a lotof money”)




– When economists refer to money, they have adifferent connotation in mind:

“Money [is] anything that is generally accepted in payments for goods or services or in therepayment of debts.”

Mishkin, F. “The Economics of Money, Banking andFinancial Markets”, p. 44




• This definition deviates from the above mentioned colloquialdefinitions of money:

Ad 1.: Currency fits the economic definition of money, but it isonly part of it. There are other forms of media of exchange,such as e.g. checks. Even “money” holdings in savingsaccounts affect the money stock of an economy. Currency,therefore, is too narrow for a good definition

Ad 2.: A person’s wealth, on the contrary, consists of manyitems which do not fit the definition of money provided above,such as stocks, bonds, houses, etc, which cannot betransferred into media of exchange easily. Wealth therefore istoo broad for a good definition

Ad 3.: Income often is transferred in form of money. However,money is defined as a stock, while income is a flow.Moreover, part of a person’s income can be non-monetary, such as health benefits, etc.



2. Functions of Money

• Commonly, individuals hold money for three reasons.

1. Money acts as a medium of exchange

2. Money is used as unit of account

3. Money is a store of value

– What mainly distinguishes money from other assetssuch as bonds or stock is its use as a medium of

exchange



Money as a medium of exchange 1.

• Imagine an economy without money – a bartereconomy.

• In such an economy all goods and services have tobe exchanged directly for each other.

• Exchange in such an economy requires what is known asthe “dual coincidence of wants”:

• Both trading partners have to mutually offer agood or service that their counterpart demands.Otherwise no trade occurs.

• This method of exchange complicates tradeimmensely and creates high transaction costs.




Individual A

Offers

bread

Demandssoda

Individual B

Offerssoda

Demands

bananas

Individual C

Offers

bananas

Demandsbread

Individual D

Offersbananas

Demands

education

An example of a barter economy:

Trade in this barter economy only

takes place, if individual A decides to

trade its bread against individual C’s bananas, which in turn A can

exchange against B’s bananas.

Individual D cannot trade in this

economy since within this group

nobody is offering anything D wants.D, however, potentially has bananas

to offer, which remain unused.




• In most of the transactions in modern economies money,therefore, is used as a medium of exchange reducing

transaction costs involved with barter (mainly in formof time).

• Any commodity used as a medium of exchange must

show certain features:

1. It must be easily standardized

2. It must be widely accepted

3. It must be divisible4. It must be portable

5. It must not deteriorate in value quickly



Money as a unit of account

Money is the most common measure of economic value inan economy:

• Prices of goods and services are typically notindicated relative to all other goods and services,but are usually referenced to a single numeraire

good, namely money.

• Again this creates a huge informational and – therefore – cost advantage over a barter economy,since we do not have to worry whether 5 eggs atthe supermarket are worth 0.05 economicslectures, 6 bananas, 2 ounces of titanium, 0.01gallon of gas, etc.



Money as a store of value 2.

• The third function of money reflects its capacity tomaintain part of its value over time

– Individuals use part of their income for consumptionand part of their income for saving.

– There are numerous assets that can be used for saving.Bonds, stock, houses, even consumption goods areoften mainly held for purposes of postponing

consumption. Money is merely one of them.




• Many of these assets have clear advantages over money.Bonds for example pay coupons or gain in price, houses

produce housing services, etc.

• The only rent money provides is inflation, which is(usually) negative.

• So why do people hold money for saving purposes inthe first place?

• The answer to that question is liquidity.




• Liquidity indicates how easily and quickly an asset can betransformed into a means of payment. Since the world

we live in is uncertain, liquidity is desirable:

• Money, apparently, is the most liquid asset. It doesnot need to be transformed into anything else for

purposes of transaction, being the medium ofexchange itself.

• Other assets such as checking, saving or time

deposits also have a high degree of liquidity and are,therefore, often considered part of the money stock




• Is money a good store of value?

• The answer to this question depends – as alreadyindicated – on inflation, since the value of money isfixed in the price level.

• During “normal” phases of inflation, money is arelatively good store of value

• During phases of high inflation or hyperinflation (inflation rates above 50%), however, money canloose its value very quickly.



A history of the payment system 1.

The payment system is the method of conducting

transactions in an economy.

Historical forms of means of payment are the following:

• Commodity money• Fiat money

• Checks

• Electronic payment

• E-Money



Commodity money 1.

• Commodity money is a means of payment made out of

precious metals such as gold or silver or other valuablecommodities.

• It has been the prevailing medium of exchange in most

societies since classical times up to around two hundredyears ago.

Roman circus coin (Hadrianus) 1878 Brasher doubloon



Commodity money 2.

• Commodity money fulfills the criterion of general acceptance,because it consists of materials which are already high indemand.

• It comes with a number of problems, however:

1. It’s value is not necessarily easily to prove for everyone.

Problems of forgery or debasing have been common inhistory.

2. Commodity money is generally heavy and hard totransport.

3. The value of commodity money varies with the value of the underlying commodity and, therefore, is subject tofluctuations of supply and demands for these goods.



3.2. Fiat Money 1.

• The development of bank notes – originally backed by aconvertibility guarantee – succeeded commodity money.

• Paper money quickly converted into fiat money – money issued by governments as legal tender, butwithout any right of convertibility

US Dollar 10.000 Milpengő (during the Hungarian

hyperinflation 9,000,000%/month!! )

i 2



Fiat Money 2.

• Fiat money is easier to transport and it is not subject to demand and

supply fluctuations like commodity money

• However, it can only be used as a medium of exchange as long as it is

generally accepted, which is not always a safe bet:

• Individuals’ expectations on the value of paper money andthe integrity of the monetary authority build the main pillaron which a fiat money system is based upon. Once people stopbelieving in the value of fiat money, the system falls apart.

• Fiat money, moreover, has similar problems as commoditymoney. It is easily stolen and often subject to counterfeit



Checks 1.

• Checks are an instruction to a bank to transfer moneyfrom on person’s account to the bank account of the

recipient once he or she deposits the check.

Ch k 2

http://upload.wikimedia.org/wikipedia/commons/3/37/BritishCheque.png



Checks 2.

• Checks, thus, solve the problem of transport for largeamounts of money and facilitate transactions in a number

of other ways.

• However, two problems are connected to the use ofchecks:

• Moving checks from one point to another takes time

• The processing of checks does not come for freeand imposes a transaction cost by itself to society

El i



Electronic payment

• Increasingly common forms of means of transaction areelectronic payment services offered online by banks.

• Instead of mailing out a check for every single

payment, you simply log on to the bank’s web site orhave your money automatically deducted on a regularbasis

• Electronic payment is a very common means oftransaction in Europe and increasingly popular in theU.S.

E M



E-Money

• Not only checks get increasingly substituted by electronic forms ofpayment, cash has also been partly replaced by other instruments

• Common forms of E-money include– Debit and credit cards

– Money cards or “smart” cards

– E-cash

Credit cards

Debit card: Visa Electron

A smart card: the 3 by 5 mm securitychip embedded in the card is shownenlarged in the inset. The goldcontact pads on the card enableelectronic access to the chip.

D bit d dit d

http://en.wikipedia.org/wiki/Smart_card

http://en.wikipedia.org/wiki/Smart_card

http://en.wikipedia.org/wiki/Image:Smartcard.JPG

http://en.wikipedia.org/wiki/Image:Visa_Electron_card.jpg

http://en.wikipedia.org/wiki/Image:Credit-cards.jpg



Debit and credit cards

1. Issuing bank logo2. EMV chip

3. Hologram 4. Card number 5. Card brand logo6. Expiry date7. Cardholder's name

Reverse side of a typical debit card:

1. Magnetic stripe

2. Signature strip3. Card Security Code

M i

http://en.wikipedia.org/wiki/EMV

http://en.wikipedia.org/wiki/Hologram

http://en.wikipedia.org/wiki/Credit_card_number

http://en.wikipedia.org/wiki/Magnetic_stripe

http://en.wikipedia.org/wiki/Signature

http://en.wikipedia.org/wiki/Card_Security_Code

http://en.wikipedia.org/wiki/Card_Security_Code

http://en.wikipedia.org/wiki/Signature

http://en.wikipedia.org/wiki/Magnetic_stripe

http://en.wikipedia.org/wiki/Image:CCardBack.svg

http://en.wikipedia.org/wiki/Credit_card_number

http://en.wikipedia.org/wiki/Hologram

http://en.wikipedia.org/wiki/EMV

http://upload.wikimedia.org/wikipedia/commons/7/76/CCardFront.svg



Measuring money

• We defined money as anything generally

accepted in payment for goods and services• Since many commodities have had this function in

history, we need a closer definition of money tomeasure the actual stock of money in an

economy at a specific point in time

How do we measure money? Which particular assetscan be called “money”?

– Construct monetary aggregates using theconcept of liquidity

M i US 1



Measuring money – US 1.

• The common measures of the money stock are given in thedefinition of the monetary aggregates issued by the Fed.

• Due to the large number of financial innovations of thelast decades the definition of these aggregates have beenfrequently revised.

• There are three common aggregates of money – veryimaginatively – labeled M1, M2 and M3 in the US

– (M3 has been discontinued in 2006).

M i US 2

http://www.federalreserve.gov/releases/h6/discm3.htm

http://www.federalreserve.gov/releases/h6/discm3.htm




• M1 consists of(1) currency outside the U.S. Treasury, Federal Reserve

Banks, and the vaults of depository institutions;(2) traveler's checks of nonbank issuers;(3) demand deposits at commercial banks (excluding

those amounts held by depository institutions, the U.S.government, and foreign banks and official institutions)

less cash items in the process of collection and FederalReserve float; and(4) other checkable deposits (OCDs), consisting of

negotiable order of withdrawal (NOW) and automatictransfer service (ATS) accounts at depository

institutions, credit union share draft accounts, anddemand deposits at thrift institutions. Seasonallyadjusted M1 is constructed by summing currency,traveler's checks, demand deposits, and OCDs, eachseasonally adjusted separately.

M i g US 3




• M2 consists of M1 plus(1) savings deposits (including money market deposit

accounts);(2) small-denomination time deposits (time deposits in

amounts of less than $100,000), less individualretirement account (IRA) and Keogh balances atdepository institutions; and

(3) balances in retail money market mutual funds, lessIRA and Keogh balances at money market mutual funds.Seasonally adjusted M2 is constructed by summingsavings deposits, small-denomination time deposits,and retail money funds, each seasonally adjustedseparately, and adding this result to seasonallyadjusted M1.

US MONEY STOCK MEASURES

M1 s M2

http://www.federalreserve.gov/releases/h6/hist/







M1 vs. M2

Does it matter which measure of money is

considered?• M1 and M2 can move in different directions in the

short run (see figure next slide)

Conclusion:

• the choice of monetary aggregate is important forpolicymakers.

Gro th Rates of the M1 and M2 Aggregates 1960 2008



Growth Rates of the M1 and M2 Aggregates, 1960–2008

Sources: Federal Reserve Bulletin, p. A4, Table 1.10, various issues;Citibase databank; www.federalreserve.gov/releases/h6/hist/h6hist1.txt.

How Reliable are the Money Data?



How Reliable are the Money Data?

• Revisions are issued because:

– Small depository institutions report infrequently– Adjustments must be made for seasonal

variation

• We probably should not pay much attention toshort-run movements in the money supplynumbers, but should be concerned only withlonger-run movements

Measuring money ECB



Measuring money - ECB

The ECB's definition of euro area monetary aggregates is based on thefollowing:

• A harmonised definition of the money-issuing sector.

– It consists of those entities which issue liabilities with a high degreeof moneyness to non-MFIs located in the euro area (excludingcentral government). This sector comprises MFIs resident in theeuro area.

• A harmonised definition of the money-holding sector, which comprisesall non-MFIs resident in the euro area (except central government).

– In addition to households, non-financial corporations and financialinstitutions which are not MFIs are included, as well as state andlocal governments and social security funds. Central governmentsare considered to constitute a "money-neutral" sector, with oneexception: central government liabilities with a monetary character(Post Office accounts, national savings accounts and Treasuryaccounts) are included as a special item in the definition of

monetary aggregates.• The harmonised definitions of MFI liabilities categories.

– These make it possible to distinguish between MFI liabilitiesaccording to their degree of moneyness, while also taking intoaccount the features of different financial systems.

C 2



Measuring money – ECB 2.

Liabilities

M1 M2 M3

Currency in circulation X X X

Overnight deposits X X X

Deposits with an agreed maturity up to 2 years X X

Deposits redeemable at a period of notice up to 3months

X X

Repurchase agreements X

Money market fund (MMF) shares/units X

Debt securities up to 2 years X

Liabilities of the money-issuing sector and central government liabilitieswith a monetary character held by the money-holding sector.

ECB Monetary Aggregates



ECB Monetary Aggregates

(annual growth rates)

ECB Components of Monetary Aggregates



ECB Components of Monetary Aggregates

(annual growth rates)

Measuring money ECB 3



Measuring money – ECB 3.

• Narrow money (M1)– includes currency, i.e. banknotes and coins, as well as balances which

can immediately be converted into currency or used for cashlesspayments, i.e. overnight deposits.

• "Intermediate" money (M2)– comprises narrow money (M1) and, in addition, deposits with a maturity

of up to two years and deposits redeemable at a period of notice of upto three months. Depending on their degree of moneyness, suchdeposits can be converted into components of narrow money, but insome cases there may be restrictions involved, such as the need foradvance notification, delays, penalties or fees. The definition of M2

reflects the particular interest in analysing and monitoring a monetaryaggregate that, in addition to currency, consists of deposits which areliquid.

• Broad money (M3)– comprises M2 and marketable instruments issued by the MFI sector.

Certain money market instruments, in particular money market fund(MMF) shares/units and repurchase agreements are included in thisaggregate. A high degree of liquidity and price certainty make these

instruments close substitutes for deposits. As a result of their inclusion,M3 is less affected by substitution between various liquid assetcategories than narrower definitions of money, and is therefore morestable.

MONETARY AGGREGATES IN THE EURO AREA

http://www.ecb.int/stats/money/aggregates/aggr/html/index.en.html





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