Money

Prof. S. Siva Kumar

Meaning of Money
 Money (money supply)—anything that is
generally accepted in payment for goods
or services or in the repayment of debts;
a stock concept. Money supply is the total
amount of money available in the
economy. (stock)
 Wealth—the total collection of pieces of
property that serve to store value (stock)
 Income—flow of earnings per unit
of time (flow)
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Definitions of Money
 From most liquid (narrow) to the least
liquid (broad), M0, M1, M2, M2Y, M3..
 M0 = paper currency and coins
 M1 = M0+ Checking Accounts+ Traveler
Checks
 M2 = M1 + Savings Accounts
 M2Y = M2 + Forex Accounts

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Evolution of the Payments System
 Commodity Money: Gold, Silver, other precious
metals, certain stones, Cigarettes, etc.
 Representative money that is backed 100 %
by precious metals (banknotes)
 Fiat Money: No consumption or investment use:
intrinsically useless pieces of paper.
 Checks
 Electronic Payments: EFTs, wire trasfers.
 E-money: Debit cards (POS), etc.

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 The Four Jobs of Money

• Medium of exchange
• Standard of value
• Store of value
• Standard of deferred payment

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 13-4
 Medium of Exchange
• The most important job of money is to serve as a
medium of exchange
– When any good or service is purchased, people use
money
– Money makes it easier to buy and sell because money is
universally accepted
– Money, then, provides us with a shortcut in doing
business
• By acting as a medium of exchange, money
performs its most important function

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 13-5
 Money as a Medium of Exchange
• Money facilitates exchange by reducing the
cost of trading.
• Without money, we would have to barter.
 Money As a Medium of Exchange
• Money does not have to have any inherent
value to function as a medium of exchange.

• All that is necessary is that everyone

believes that other people will exchange it
for their goods.
 Standard of Value
• Money is a common denominator in
which the relative value of goods and
services can be expressed
– A job that pays $2 an hour would be nearly
impossible to fill, while one paying $50 an hour
would be swamped with application

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 13-6
 Money as a Unit of Account
• Money is used as a common denominator to
measure the relative values of goods and
services.
• Without money, we would have to measure the
value of goods and services in terms of other
goods and services.
• Money is a useful unit of account only if its value
relative to the average of all other prices doesn’t
change too quickly.
 Store of Value
• If you could buy 100 units of goods and services
with $100 in 1982, how many units could you
buy with $100 in 2000?
– Answer: you could have bought just 51 units
– During this period, inflation robbed the dollar of
almost half of its purchasing power
• Over the long run, particularly since World War
II, money has been a very poor store of value
– However, over relatively short periods of time, say, a
few weeks or months, money does not lose much of
its value

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 13-7
 Money as a Store of Value

• Money is a financial asset that can be used

to store wealth (income that you have
saved and not consumed).
• As a store of wealth, money pays no
interest, but is perfectly liquid.
• Money’s usefulness as a store of wealth
depends on how will it maintains its value.
 Standard of Deferred Payment

• Many contracts promise to pay fixed sums

of money well into the future
– A couple of examples are 30-year corporate
bonds and a 20-year mortgage

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 13-8
 Standard of Deferred Payment

• When Dave Winfield signed a 10-year, $23

million contract with the New York Yankees in
1980, he really got stuck
– Because over the next 10 years the consumer price
index went up by almost 59%
– Today when a professional ballplayer, entertainer,
or virtually anyone else signs a long-term contract,
she or he is generally protected by an escalator
clause, which calls for increased payments to
compensate for any future inflation

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 Standard of Deferred Payment

• How well does money do its job as a

standard of deferred payment?
– About as well as it does as a store of value
– Usually quite well in the short run, but not well
at all over the long run of, say, three years or
more

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 13-10
Money Supply (MS)= the quantity of
money that circulates in an economy.
Central banks determine the money
supply.
In the US: the Federal Reserve System.
The Federal Reserve directly regulates the
amount of currency in circulation.
It indirectly controls the amount of checking
deposits issued by private banks.

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• Money demand = the amount of assets that people are
willing to hold as money (instead of illiquid assets).
• What influences individuals’ willingness to hold money?
– Expected returns/interest rate on money relative to the
expected returns on other assets.
– Risk: from unexpected inflation, which unexpectedly reduces
the purchasing power of money. But many other assets have
this risk too, so this risk is not very important in money demand.
– Liquidity: A need for greater liquidity occurs when either the
price of transactions (P) increases or the quantity of goods
bought in transactions increases.

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