© The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin

Chapter 2

Money and the Payments System

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Money and the Payments SystemThe Big Questions

1. What is money?2. How do we use money?3. How do we measure money?

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Money and the Payments SystemA Roadmap

• Money and how we use it• The Payments System• The Future of Money• Measuring Money

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Money:The Definition

Money is an asset that is generally accepted as payment for goods and services or repayment of debt.

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Money:Characteristics

1. Means of payment Used in exchange for goods & services

2. Unit of account Used to quote prices

3. Store of value Used to move purchasing power into the future

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Money:How We Pay for Things (I)

• Commodity Money: Objects with intrinsic value

• Fiat Money: Value comes from government decree (or fiat)

• Checks: Instructions to the bank to shifts funds from your account to that of the person or firm whose name is

written in the “Pay to the Order of” line.

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The Path of a Paper Check

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• Checks are legal proof of payment• Customers wanted them back• Starting in 2004

– Banks can transmit digital images– Substitute checks are proof of payment

• Paper checks are now disappearing

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Money:How We Pay for Things (II)

• Credit Cards• Debit Cards• Electronic Funds transfers

especially automated clearing house (ACH transactions)

• Stored Value Cards• E-Money

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• Debit cards:– Like a check– Electronic message to your bank to

transfer funds immediately• Credit cards:

– Deferred payment– Issuer makes payment for you– You have to pay it back

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•Scan the numbers at the bottom of the check.

•Check Conversion:Turns a check into an ACH transaction

•Similar to using a debit card

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The Future of Money

Which function of money will be with us for a long time?

– Means of payment: disappearing– Unit of account: likely to remain– Store of value: disappearing

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• Technological advances create new methods of payment.

• Cell phones and other types of hand-held mobile devices are providing access to the payments system.

• What will be next?

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Measuring Money

• Changes in the quantity of money are related to – Interest Rates– Economic Growth – Inflation

• How do we measure money?

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Inflation and the Inflation Rate

• Inflation: The rate at which the general price level is increasing over time

• Inflation rate: The measure of the inflation process

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Liquidity:Definition

Liquidity a measure of the ease an asset can be turned into a means of payment (Money).

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The Liquidity Spectrum

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Measuring Money

Different Definitions of money are based upon degree of liquidity.

M1: Narrowest definition Only most liquid assets

M2: Broader definition Includes assets not used

as means of payment.

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Money Growth and Inflation

• When inflation is high, money growth helps forecast inflation.

• When inflation is low, the relationship is not as close.

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• The CPI answers the question:"How much more would it cost for people to purchase today the same basket of goods and services that they actually bought at some fixed time in the past?“

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• Computing CPI Inflation– Survey people to see what they bought– Figure out what it would cost to buy the

same basket of goods & service today.– Compute the percentage change in the

cost of the basket of goods.

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Measures of Inflation

• Fixed-weight Index - CPI

• Deflator – GDP or Personal Consumption Expenditure Deflator

• Chain-weight index – Half way between fixed-weight and a deflator.