Chapter three

What is Money?

Chapter three

• Meaning of Money

• Functions of Money

• Evolution of payments system

• Measuring Money

Meaning of Money• Money is defined as : anything that is generally accepted in

payment for goods or services or in the repayment of debts.

• Historically, many different items such as: leather, stones and different types of metallic coins have served as money because people had confidence in their value & were willing to accept them as payment

• Money defined as all currency & coins together with demand deposits and other checkable deposits in commercial banks & saving institutions.

• The use of credit cards is essentially a method of postponing payment, and therefore credit cards do not constitute money.

Money , currency , wealth & Income

• To define money merely as currency is much narrow for economists. Because money is not only currency , it is also checks, which are also accepted as payment for purchases,

checking account deposits are considered money as well.

• Wealth, the total collection of pieces of property that serve to store value. Wealth includes not only money but also other assets such as bonds, common stock, land, furniture, cars, and houses.

Money , currency , wealth & Income

• Income is a flow of earnings per unit of time. Money, by contrast , is a stock : it is a certain amount at a given point in time.

Functions of Money

1- Medium of exchange

2- Measure of value and a Unit of Account

3-store of value

- Standard of deferred payments.

1- Medium of Exchange• Money in the form of currency or checks is a medium of

exchange. It is used to pay for goods and services.

• If there were no money, goods would have to be exchanged by barter.

• If I have a commodity (X) to trade, I must search not only for a person who wants (X), but also for one who has something that I would like to acquire. Furthermore , if I find someone who wants my commodity, we must agree on swap rate.

• Transaction costs : It is time spent trying to exchange goods or services

• The use of money as a medium of exchange remove these problems, as long as money is readily accepted by every one.

• For a commodity to function effectively as money, it as to meet several criteria:

1- it must be widely accepted2- it must be divisible3- it must be easy to carry4- it must not deteriorate quickly.

2- Measure of value or Unit of Account• The second role of money is to provide a unit of account,

that is , It is used to measure value in the economy. We measure the value of goods and services in terms of money.

• Using money as a unit of account reduces transaction costs in an economy by reducing the number of prices that need to be considered.

• In both households and businesses, it is necessary to look a head and calculate future income and expenditure. Money, acting as a unit of account, can serve these purposes.

3- store of value

• People usually save in the form of money. However, this function of money depends on its stability of value. If money loses its stability of value, people tend to save in the form of buying assets.

• Money is not, of course, the only store of value. This function can be served by any valuable asset. One can store value for the future by holding: bonds, houses, land or any other kind of valuable goods.

• The principle advantages of these other assets as a store of value are that, unlike money, they yield an income in the form of interest, profits, rent and they sometimes rise in value in terms of money.

• On the other hand, these assets have certain disadvantages as a store of value

1- they sometimes involve storage costs2- they may depreciate in terms of money3- they are illiquid in varying degrees.

4- Standard of deferred paymentsMoney can be used to obtain goods and services on credit

Evolution of payments System

1- the commodity Money:• There was a wide range of commodities used as money in

the earlier times• For any object to function as money, it must be universally

acceptable, everyone must be willing to take it in payment for goods and services.

• The problem with a payments system based exclusively on precious metals is that: such a form of money is very heavy, and is hard to transport from one place to another.

• For a commodity to function effectively as money, it as to meet several criteria:

1- it must be widely accepted2- it must be divisible3- it must be easy to carry4- it must not deteriorate quickly.

2- Fiat Money(Paper currency): • Initially, paper currency carried a guarantee that

it was convertible into coins or into a quantity of precious metal.

• However ,currency has evolved into fiat money. Fiat money: Paper currency decreed by governments as legal tender (meaning that legally it must be accepted as payment for debts) but not convertible into coins or precious metal.

• Paper currency has the advantage of being much lighter than coins or precious metal, but it can be accepted as a medium of exchange only if there is some trust in the authorities who issue it.

• Major drawbacks of paper currency and coins are that they are easily stolen and can be expensive to transport in large amounts because of their bulk.

• To combat this problem, another step in the payment system occurred which is the checks.

3- Checks: A check is an instruction from you to your bank to transfer

money from your account to someone else’s account when he deposits the checks.

Advantages:1- checks allow transactions to take place without the

need to carry around large amounts of currency2- it avoids the transportation costs of moving currency.3- loss from theft is greatly reduced.

Disadvantages:1- it take time for a check to be sent from one

place to another2- the checking system is expensive.

4- Electronic payment: In the past, you had to pay your bills by mailing a

check, but now banks provide a web site in which you just log on, make a few clicks, and thereby transmit your payment electronically.

5- E-Money:E- money : is money that is stored electronically, or that exists only in

electronic form.

a) Debit cards: Debit cards (which look like credit cards), enable consumers to purchase goods by

electronically transferring funds directly from their bank accounts to a merchant’s account.

b) Stored value card: It differ from debit cards that they contain a fixed amount of digital cash. Like a

prepaid phone cardc)Electronic cash: is a form of electronic money that can be used on the internet to purchase goods

or services

Measuring Money

• The Narrowest definition of money (M1) M1 includes only currency , demand deposits

and other checkable deposits.• Broader Measures of Money (M2) M2 = M1 + small time deposits+ savings deposits

+ money market deposits

• When the world wide depression occurred in the beginning of 1930’s, various countries had to give up the gold standard.

• The gold reserves in the Bank of England diminished during the 1920’s so much that England had to give up the gold standard at 1931. This devalued the pound sterling, which affected the whole world’s payment system. The international banking and

• payment system is highly integrated in the way that a bank panic in one major banking center affects the payment system of the whole world.

• Due to the problems in England, various other European countries, including all Scandinavian countries, had to give up their gold standard.

• Bank of Finland stopped redeeming its bank notes with gold at 1931. It was believed at that time that giving up of the gold standard is a temporary phenomena, but it has turned permanent .