Functions and Definitions of Money

Landskroner Money slide 1

Prof. Yoram Landskroner

Functions and Definitions of Money


1. Nature and Functions of Money

• Definition: generally acceptable as payment for goods or services and discharge of debt.

• Today most common definition: currency and coins held by the public + checkable (transaction) accounts of the public (M1).

• US government decreed: currency and coins are legal tender; checkable accounts are not but banks are required to redeem them in legal tender.


Functions of Money

Monetary economy Vs. a barter economy

• 1. Standard of value or unit of account – money is a “numeraire” (common denominator) in measuring value in exchange simplifies exchange: in a barter economy

each good (service) will have an exchange rate (price) in terms of each of the other goods

large number of “prices”


Consider an economy with N goods how many prices will we have in a barter economy?

How many prices will be in a monetary economy?

Example

2

1

NNN B


Money as common denominator greatly simplifies exchange, reduces information and transaction costs

• 2. Medium of exchange- means for conducting transactions. Allows for the separation of transactions: purchases from sales. In a barter economy requirement of “double

coincidence of wants “ high cost of search Money increases efficiency in the economy:

reduces cost of exchange (time and resources).


• 3. Store of value- related to medium of exchange function. Allows for separation over time between flow of income and flow of consumption. Money is not unique; other financial assets can

serve as store of value. Money however is the most liquid: ease (cost) with which an asset can be converted into a medium of exchange.

What happens in periods of substantial inflation to the value of money and its functions?

• Value of money inverse of price level


2. Types of Money

Evolution of money (payment system): commodity money, credit-fiat money and electronic money.

1)Commodity Money• earliest form of money •Definition: commodity with intrinsic or non-monetary value close to value in exchange (monetary) valueeffective floor to the value of money, enhances its acceptability.


•Required properties of commodity money:scarcity and stability of supply durability divisibility

•Metallic money fulfilled these requirements: iron and copper; silver; gold.


Special case of commodity money :•The Gold Standard- full bodied money:

monetary value = non-monetary valueto maintain the system the government must:

(1)fix the value of gold in terms of the monetary unit ($).

(2) be willing to buy all gold at that price.

(3) legalize melting down of gold coins.

•figure


•Characteristics of the gold standard: government has no control over the money supply production of money is expensive

•Representative Full Bodied MoneyWith economic development coins were supplemented with fully backed paper money. The system functioned exactly as a pure commodity money system.In the US 1900-1933, later partial backing only, gold standard abolished in 1968.


2)Credit, Fiat Money

•Not convertible into comparable value as commodity

•Value based on faith in government: value in terms of purchasing power stability.

•Definition: money that has a value in exchange greater than its value as a commodity.


Two types:

•paper currency and coins issued by the government and decreed as legal tender

•banking money, IOU payable on demand in the form of checks. (See later: deposit/ money creation)

Reduces cost of transactions (transportation)


(3) Electronic Money (Paperless)•Paper money (checks) shuffling is costly and takes time to clear.•Development of computer and information technology enabled new stage in money:• e- money- money stored electronically,

Several forms: debit cards- electronic transfer of funds from bank account to merchant’s account


Stored-value cards- (electronic wallet), contain fixed amount of funds, the smart card can be reloaded. Modex smart card transfer of funds with wireless device also between individuals. Used in Europe less (trials) in the USAElectronic cash- funds used on the Internet to purchase goods and services.Electronic Checks used to pay bills on the internet, equivalent of check is sent .


•Advantages of e-money: cost saving, more efficient

•Disadvantages:Large initial investment in systempaper checks provide receiptspaper checks give the benefit of the “float”security and privacy concerns of e-money

•Slow rate of adoption


3. Measures of Money

•Need precise definition of what assets to be included: theoretical and empirical approaches.

•Theoretical approach: focus on medium of exchange aspect, not clear-cut.

•Empirical approach: objective in defining money (supply) is to control that variable that can be used to stabilize/affect economic activity- monetary aggregate, which can be managed by the government and is closely correlated with economic activity, findings are mixed.


A number of measures are used by the Federal Reserve, from narrow to broad definition in decreasing order of liquidity:M1= currency + demand deposits and other checkable depositsM2= M1+ small time deposits + savings and money market deposits + money market mutual funds (non-institutional)M3= M2 + large TD, MMMF (institutional) +repurchase agreements+EurodollarsL = M3+ highly liquid assets (securities)


Measures of Monetary AggregatesValue as of May 2004 ($billions)

•M1=Currency 671.7+Traveler’s checks 7.8+Demand deposits 315.8+Other checkable deposits 323.8

•Total M1 1319.1•M2=M1

+Small denomination time deposits 798.8+Saving deposits and MMDA 3406.4+ Retail Money Market Mutual Funds 742.5

•Non M1 M2 4949.7•M3=M2

+Large denomination Time deposits 986.8+ Institutional Money Market Mutual Funds 1119.1+Term repurchase agreements 517.8+Term Eurodollars 299.8

•Non M2 M3 2923.5• Source: Board of Governors of the Federal Reserve System, Statistical Release H.6, Tables 4-6.

Documents

Functions and Definitions of Money