What Is Money?

Chapter 3

Economist’s Meaning of Money Definition: Anything that is generally accepted in

payment for goods and services or in the repayment of debt.

Includes: currency, checks, checking and saving account deposits.

Not the same as:Wealth: total collection of pieces of property that serve as store of value (e.g. stocks, bonds, lands), or Income: flow of earnings per unit of time. While money is a stock: certain amount at a given point in time.

Functions of Money

1.Medium of exchange: used to pay for goods and services.

Money promotes economic efficiency by:1) reducing transaction costs (that arise from barter) and 2) leading to specialization  (in what people do best).

Features of Money: 1) easy to standardize, 2) widely accepted, 3) divisible, 4) easy to carry, and 5) doesn’t deteriorate quickly.

2.Unit of account: used to measure the value of goods

and services in the economy. Thus reduces the number of prices needed to measure value.

4

Example: Money as a medium of exchange

Individual A

Offers bread

Demands soda

Individual B

Offers soda

Demands bananas

Individual C

Offers bananas

Demands bread

Individual D

Offers bananas

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.

3.Store of value: a repository (storage) of purchasing power over time. It is used to save purchasing power from the time income is received until the time it is spent.

Other assets have three features money does not have:1) They have higher returns2) Their prices, generally, increase overtime3) They deliver services (by themselves)

Money:

Advantage: liquid relative to other assets and less risky.Definition: liquidity is relative easiness and speed to convert an asset into a medium of exchange.Disadvantage: loses value with inflation

 

Evolution of the Payments System Payment system:

Method of conducting transactions in the economy. Means of payment:

1. Commodity Money 2. Fiat Money 3. Checks4. Electronic means of payment 5. Electronic money

7

Commodity money

Commodity money is a means of payment made out of precious metals such as gold or silver or other valuable commodities.

It has been the prevailing medium of exchange in most societies since classical times up to around two hundred years ago.

Roman circus coin (Hadrianus) 1878 Brasher doubloon

8

Commodity money

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

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 in history.

2. Commodity money is generally heavy and hard to transport.

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

9

Fiat Money

The development of bank notes – originally backed by a convertibility guarantee – succeeded commodity money.

Paper money quickly converted into fiat money: money issued by governments as legal tender, but without any right of convertibility

10

Fiat Money

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 and the integrity of the monetary authority build the main pillar on which a fiat money system is based upon. Once people stop believing in the value of fiat money, the system falls apart.

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

11

Checks

Checks are an instruction to a bank to transfer money from one person’s account to the bank account of the recipient once he or she deposits the check.

Checks, thus, solve the problem of transport for large amounts of money and facilitate transactions in a number of other ways.

However, two problems arise with the use of checks: Moving checks from one point to another takes time The processing of checks does not come for free and imposes

a transaction cost by itself to society

12

Electronic payment

Increasingly common forms of means of transaction are electronic 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 or have your money automatically deducted on a regular basis

Electronic payment is a very common means of transaction in many countries.

13

E-Money

Not only checks get increasingly substituted by electronic forms of payment, 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

Value of Plastic Cards’ Transactions (million KDs)

Dr. Reyadh Faras 14

Description Points of Sale (POS) Transactions

Automatic Teller Machine (ATM) Transactions

Grand Total

Local Abroad Total Local Abroad Total

2007

Local Bank Cards

2,254.2 260.1 2,514.3 5,433.0 210.2 5,643.2 8,157.5

- Credit Cards 231.2 204.2 435.3 191.9 29.1 221.0 656.3

- Debit Cards 2,023.0 55.9 2,079.0 5,241.1 181.1 5,422.2 7,501.2

Foreign Bank 120.9 120.9 235.2 235.2 356.0

Total 2,375.1 260.1 2,635.2 5,668.2 210.2 5,878.3 8,513.5

2008

Local Bank Cards

2,652.6 289.5 2,942.0 5,666.8 211.0 5,877.8 8,819.8

- Credit Cards 205.7 216.8 422.5 123.1 25.1 148.2 570.7

- Debit Cards 2,446.9 72.7 2,519.6 5,543.7 186.0 5,729.6 8,249.2

Foreign Bank Cards

107.6 107.6 260.4 260.4 368.0

Total 2,760.2 289.5 3,049.7 5,927.1 211.0 6,138.2 9,187.8

2009

Local Bank Cards

2,925.4 292.2 3,217.5 6,466.8 240.6 6,707.4 9,925.0

- Credit Cards 193.7 203.8 397.5 101.2 21.3 122.5 520.0

- Debit Cards 2,731.7 88.4 2,820.0 6,365.6 219.3 6,585.0 9,405.0

Foreign Bank Cards

119.8 119.8 315.9 315.9 435.7

Total 3,045.1 292.2 3,337.3 6,782.7 240.6 7,023.4 10,360.7

2010

Local Bank Cards

3,327.3 333.2 3,660.5 6,944.9 240.7 7,185.5 10,846.0

- Credit Cards 203.4 232.1 435.5 119.5 14.1 133.6 569.1

- Debit Cards 3,123.9 101.1 3,225.0 6,825.4 226.5 7,052.0 10,276.9

Foreign Bank Cards

137.8 137.8 346.8 346.8 484.6

Total 3,465.1 333.2 3,798.3 7,291.7 240.7 7,532.3 11,330.6

15

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 to measure the actual stock of money in an economy at a specific point in time

Kuwait’s Money Supply (Million KDs)

Year

Currency Issued

(1)

Cash with Local Banks

(2)

Currency inCirculation

3=1-2

Sight Deposits

in KD(4)

MoneySupply (M1)

5=3+4

Quasi-Money

(6)

Money Supply (M2)

7=5+6

2004 606.3 75.3 531.0 2643.3 3174.2 8481.0 11655.2

2005 684.6 105.9 578.7 3148.7 3727.4 9358.8 13086.2

2006 804.9 148.6 656.3 2893.9 3550.3 12370.3 15920.6

2007 756.7 115.2 641.5 3505.2 4146.7 14813.2 18959.9

2008 869.1 161.4 707.8 3662.5 4370.3 17579.9 21950.2

2009 943.8 168.1 775.7 3938.3 4714.0 20181.8 24895.8

2010 1006.7 163.7 842.9 4782.1 5625.0 20009.2 25634.2