TOPIC 3

MONEY AND THE PAYMENT SYSTEM

CHAPTER PREVIEW
This chapter enables us to understand roles of money in the economy. To do so, we start with the exact meaning money, then the functions of money and explore how its form evolve over time. More importantly, we are going to understand the role of money in the economic activity. Topics include: 1. 2. 3. 4. 5.
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Meaning of Money Functions of Money Evolutions of Payments System Measuring Money Money and the Economy

DEFINITION
Anything that is generally accepted in payment for goods 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, can make purchases Wealth is less liquid; total collection of pieces of property that serve to store value. Wealth include money and other assets (such as stocks and bonds, cars, houses, furniture, land)
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Money vs income

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

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 from other 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

Meeting the Needs of Exchange

3 methods of exchange to gain the efficiency benefits of specialization include: barter, government allocation, and money Money can help people benefit from specialization without incurring the high trading costs of barter or the misallocations of 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 in units of money -Reduce transaction costs by reducing the number of prices that need to be considered

3. Store of Value: To store purchasing power over time

-Save purchasing power from time income is received until 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 on PRICE LEVEL
-If price level constant, ok -If price level increase twice, value of money dropped by half -During high inflation time, people reluctant to hold wealth in money form

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FUNCTIONS OF MONEY
Why hold money? LIQUIDITY
-Definition: relative ease and speed with which an asset can 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 OF PAYMENT SYSTEM

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EVOLUTION OF PAYMENT SYSTEM

Forms that money has taken over time depend on evolution of payments system: that is the method of conducting transactions 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 legal tender (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 be converted to precious metals, then evolved into fiat money -Can be accepted as medium of exchange only if there is trust in issuing authorities and small possibility of counterfeiting -Problem: Can be easily stolen and bulky 14

EVOLUTION OF PAYMENTS SYSTEM

1. Commodity money 2. Fiat money 3. Checks: Instruction from you to your bank to transfer money from your account to someone elses account when she deposits the check.
-No movement of real currency if transactions are being cancelled -Reduce transportation costs and improve economic efficiency -Up to any amount (based on balance), large transactions easier -Loss from theft greatly reduced and receipt of purchase -Problems: Time: sending checks and floating 15

EVOLUTION OF PAYMENTS SYSTEM

1. 2. 3. 4. Commodity money: Fiat money Checks Electronic payment: Doing financial transaction electronically via internet and mobile phones
-No more mailing to pay bills; transmit payment electronically -Reduce transaction costs substantially -Auto debit for recurring bills
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EVOLUTION OF PAYMENTS SYSTEM

1. 2. 3. 4. 5. Commodity money: Fiat money Checks Electronic payment E-money: Money exists in electronic form
-Debit card: electronically transferring funds directly from 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 an economic variable, we need to measure it Definitions of money supply are based on
the assets included as money and depend on how substitutable different assets are for money Liquidity
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Monetary Aggregates
Monetary authority has developed 3 definitions of money that include assets broader than currency, called monetary aggregates:
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

M2 currently considered best Aggregates move broadly together over long time periods Some significant differences in monetary aggregate movements have occurred during certain periods The different monetary aggregates give a different picture of movements in the money supply 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 + Fixed Deposits + NIDs + Repos + Foreign Currency Deposits + other deposits M3: M2 + deposits placed with other banking institutions

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MONEY AND ECONOMY

The Quantity Equation

This model allows us to understand effect that the quantity of money has on the economy To do this we must see how quantity of money is related to price and income Relationship between money and economy can be explained by the Quantity Equation: MV = PT
Where: M is money supply V is velocity: average number of times that each dollar of money supply is used to purchase good and services P is price level

The Quantity Equation

On the left hand side, M is the quantity of money, V is the velocity of money, and VM is essentially a measure of how the money is used to make transactions.

MoneyVelocity = PriceTransactions

M V = P T
On the right hand side, T is total number of transactions during some period of time, P is price of a typical transaction, and PT is the number of dollar (amount of money) exchanged in a year.

Economists usually use GDP Y as a proxy for T since data on the number of transactions is difficult to obtain.

M V = P Y

The Quantity Equation

MV = PT
V can be assumed as constant as the average number of times the dollar being spent depend on factors that do not change much (how often people got paid, frequency of going to grocery, pay bills, etc)

M=PT/V
M = PY/V Implications: (1) If T (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

Money, Prices, and Inflation

The quantity theory of money states that
the central bank, which controls the money supply, has ultimate control over the rate of inflation

If the central bank keeps the money

supply stable, the price level will be stable. If the central bank increases the money supply rapidly, the price level will rise rapidly

Future Money and Current Prices

Money, prices, and interest rates are related. The quantity theory of money explains that money supply and money demand determine price. By definition changes in price are inflationary Inflation affects the nominal interest rate via the fisher Money effect. Supply And the nominal interest rate affects money demand.

Price Level

Money Demand

Nominal Inflation Interest Rate Rate