Lecture 2.1 What is Money?
In this lecture, we explore the functions of money, looking at why and how it promotes economic efficiency, tracing how its forms have evolved over time, and examining issues in how it is measured.
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Source: Mishkin Ch 3
Learning objectives
Describe what money is
List and summarize the functions of money
Identify different types of payment systems
Compare and contrast the different money supply concepts, and consider issues in defining and measuring the money stock
Meaning of money
Money (or the “money supply” or “money stock”): anything that is generally accepted as payment for goods or services or in the repayment/settlement of debts.
Distinction between stock and flow:
stock units are measured at a point in time
flow units are expressed per unit of time
Money (a stock concept) is different from:
Wealth: the total set of assets (property, money and securities) that serve to store value; this is a stock but is much broader than money
Income: flow of earnings per unit of time
(a flow concept)
Direct and indirect exchange
Any economic system requires specialization
we generally don’t consume exactly the same mix of goods and services that we produce
Specialisation requires exchange
Exchange can be either direct (barter) or indirect
Direct exchange: one good or service directly swapped for another
example: a baker takes a loaf of bread to the hairdresser in exchange for a haircut
Indirect exchange: buying and selling in exchange for some generally accepted item that can be used in a further transaction
The problem of double coincidence of wants
Direct exchange is possible only if you can find a counterpart who wants to do the equal and opposite transaction to the one desired
This is costly and impractical
Most economic exchange is therefore indirect
Functions of money
Historically, monetary economics has identified three separate functions of money
Medium of exchange (or, equivalently, a means of payment):
Allows indirect exchange to take place using a widely accepted medium
Eliminates the trouble of finding a double coincidence of wants (reduces transaction costs)
Promotes specialization in production/labor services
Desirable characteristics of a medium of exchange
A medium of exchange must be:
easily standardized (ie, one dollar is the same as another)
widely accepted (money as a social construct, may be supported by legal system)
divisible (to facilitate exact payments)
portable (allows immediacy)
durable (re-usable at low cost)
Important point: A medium of exchange can have these characteristics without being otherwise valued in its own right. That is, it is valued purely for its use as a medium of exchange.
Functions of money, continued
Unit of account (or, of measurement):
Used to measure value in the economy
Reduces transaction costs – facilitates comparison of relative values
example: suppose we want to know the relative values of:
a loaf of bread
a litre of fuel
without a unit of account, these relative values are cumbersome to express (eg 1 loaf of bread is worth 1.2 haircuts)
analogous to measurement units in the physical sciences
Functions of money, continued
Store of value:
Money can be used to save purchasing power over time
Other assets (e.g. securities) can also serve this function, but:
Money (M) is the most liquid of all assets: that is, it can be relied upon as an acceptable means of payment at all times
Securities are generally claims on money (eg a government bond)
Distinction between real and nominal value: money has a fixed nominal value. But its real value (purchasing power) can be eroded by inflation
So money is, more precisely, a store of nominal value
Evolution of money as a means of payment
Commodity money: valued in its own right, easily standardized and divisible (e.g. precious metals, cigarettes in prison)
Coins: standardized metallic commodity money
Paper bank notes: certificates of claim on metallic commodity money (gold or silver)
Fiat money: paper money decreed by governments as legal tender
Fiat (latin) = ‘let it be so’ (creation of money by decree)
The first five pound note of the Bank of England
Issued in 1793, hand signed by the Chief Cashier
Evolution of the payments system, continued
Cheques (checks, US sp.): an instruction to your bank to transfer money from your deposit account to another (now falling out of widespread use)
Electronic Payment (e.g. online bill pay and electronic deposit transfers)
Fund transfer function on mobile devices
E-Money (electronic money):
Debit card
Stored-value card (smart card)
Are we headed for a cashless society?
Predictions of a cashless society have been around for decades, but they have not come true
Although e-money might be more convenient and efficient than a payments system based on paper, several factors work against the disappearance of the paper system.
However, the use of e-money will likely still increase in the future
Ongoing advantages of cash include:
low technology requirements
universal availability
RBA data on household payment methods in Australia
Trends in card and cash payments
Per cent of number of payments
Source: RBA
Measuring money: U.S. definitions
M1 (the most liquid assets) = currency + traveler’s checks + demand deposits + other checkable deposits
M2 (adds to M1 other assets that are not so liquid) = M1 + small-denomination time deposits + savings deposits and money market deposit accounts + money market mutual fund (MMMF) shares
(“Shares” for MMMFs are basically cashable at original value.)
To avoid double counting, all measures count holdings only of the non-bank public (that is, they exclude inter-bank claims)
The Federal Reserve’s Monetary Aggregates
M1 versus M2: Does it matter which measure of money is considered?
M1 and M2 can move in different directions in the short run (see next graph).
Conclusion: Yes, the choice of monetary aggregate can lead to a range of different conclusions
This is one reason why monetary aggregates have become less useful as a policy indicator
Figure 1. Growth rates of the U.S. M1 and M2 aggregates, 1960–2016
Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2
Measuring money: key Australian definitions
Currency: notes and coin held by the non-bank public
M1: currency, plus “current deposits” (transferable deposits) with commercial banks
M2: definition no longer in use (this used to include deposits at savings banks which were separately regulated
M3: currency, plus all bank deposits (current and fixed)
Broad Money: M3 plus deposits with non-bank depository institutions
An interesting question: who holds the currency in Australia
This is not observable, because money is anonymous
Measuring money: key Australian definitions
M1 has become little-referred-to in monetary analysis in most advanced countries. Its usefulness is reduced by the fact that deposits within M1 no longer have a clear distinction from deposits not in M1.
There is no M2 in Australia
However, we can look at the currency aggregate if we are interested in developments in a narrow money concept.
Australia’s Broad Money is the concept of money closest to M2 in the US, because Broad Money includes both bank and nonbank deposits.
Measuring Money: January 2021
Currency = $93.7 bn
M3 = $2.46 trn
Broad Money = $2.47 trn
Most of what we call ‘money’ is held in the form of bank deposits
about three-quarters of that is deposits with the four major banks
Question: who holds the currency?
There is $100.4 bn of currency held by the non-bank public in Australia, in a population of 25.7 million
This equates to about $3900 cash per person
Cash holdings are anonymous and can’t be traced
Estimates from RBA research on how cash holdings are used
Purpose/use Per cent
Legitimate transactions 15 – 35
Hoarded 50 – 75
Tax evasion 3 – 5
Drugs 1 – 2
Other illegal activity <1
Lost 5 – 10
Growth rates of the Australian money and credit aggregates
201620112006200119962021 0 5 10 15 20 % 0 5 10 15 20 % MonetaryAggregatesGrowth Year-ended M3 Currency Sources:APRA;RBA
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