Chapter 3

What Is Money?

Meaning of Money

What is it?

Money (or the “money supply”): anything that

is generally accepted in payment for goods

or services or in the repayment of debts.

A rather broad definition

Meaning of Money

Money (a stock concept) is different from:

Wealth: the total collection of pieces of

property that serve to store value

Income: flow of earnings per unit of time

(a flow concept)

4-4

Methods of Exchange

Functions of Money

Medium of Exchange:

Eliminates the trouble of finding a double coincidence of needs (reduces transaction costs)

Promotes specialization

A medium of exchange must

be easily standardized

be widely accepted

be divisible

be easy to carry

not deteriorate quickly

Functions of Money

Unit of Account:

used to measure value in the economy

reduces transaction costs

Store of Value:

used to save purchasing power over time.

other assets also serve this function

Money is the most liquid of all assets but loses

value during inflation

Evolution of the Payments System

Commodity Money: valuable, easily

standardized and divisible commodities (e.g.

precious metals, cigarettes).

Fiat Money: paper money decreed by

governments as legal tender.

Evolution of the Payments

System

Checks: an instruction to your bank to transfer

money from your account

Electronic Payment (e.g. online bill pay).

E-Money (electronic money):

Debit card

Stored-value card (smart card)

E-cash

Rush to Anwer

Of money’s three functions, the one that

distinguishes money from other assets is its function

as a ( )

A. store of value.

B. unit of account.

C. standard of deferred payment.

D. medium of exchange.

E. All of the above

Rush to Answer

in a barter economy, if there are four goods in a

barter economy, then one needs to know _____

prices in order to exchange one good for another.

( )

A. 4

B. 5

C. 6

D. 8

Rush to Answer

As the payments system evolves from barter to a

monetary system, ( )

A. commodity money is likely to precede the use of

paper currency.

B. transaction costs decline.

C. the number of prices that need to be calculated

increase rather dramatically.

D. all of the above.

E. only (a) and (b) of the above.

Measuring Money

How do we measure money? Which

particular assets can be called “money”?

Construct monetary aggregates using the

concept of liquidity:

M1 (most liquid assets) = currency +

traveler’s checks + demand deposits + other

checkable deposits.

Measuring Money

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 shares.

Table 1 Measures of the

Monetary Aggregates

Monetary Aggregates

Currency

Traveler’s Checks

Demand Deposits

Other Check. Dep

M1 M2

M3

Small Den. Dep.

Savings and MM

Money Market Mutual Funds Shares

M1 vs. M2

Does it matter which measure of money is

considered?

M1 and M2 can move in different directions

in the short run (see figure).

Conclusion: the choice of monetary

aggregate is important for policymakers.

FIGURE 1 Growth Rates of the M1

and M2 Aggregates, 1960–2008

Sources: Federal Reserve Bulletin, p. A4, Table 1.10, various issues; Citibase databank;

www.federalreserve.gov/releases/h6/hist/h6hist1.txt.

How Reliable are the Money Data?

Revisions are issued because:

Small depository institutions report infrequently

Adjustments must be made for seasonal

variation

We probably should not pay much attention

to short-run movements in the money supply

numbers, but should be concerned only with

longer-run movements

Table 2 Growth Rate of M2: Initial and Revised Series,

2008 (percent, compounded annual rate)

Rush to Answer

There is no single precise measure of money or

the money supply for economists because ( )

A. the government considers money supply statistics

to be confidential and refuses to publish them.

B. deciding what is generally accepted in payment for

goods and services or in the repayment of debt is

difficult to determine.

C. economists cannot agree if currency should be

considered money.

D. of each of the above.

E. of both (a) and (b) of the above.

Rush to Answer

Which of the following is not included in the

measure of M1? ( )

A. NOW accounts

B. Demand deposits

C. Currency

D. Repurchase agreements

E. None of the above

Which of the following is included in the M1

measure of money but is not included in the M2

measure of money? ( )

A. Currency

B. Checkable deposits

C. Traveler’s checks

D. All of the above

E. None of the above

Which of the following is not included in the M1

measure of money but is included in the M2 measure

of money? ( )

A. Currency

B. Traveler’s checks

C. Demand deposits

D. Small denomination time deposits

If an individual moves money from currency to a

money market deposit account, ( )

A. M1 decreases and M2 stays the same.

B. M1 stays the same and M2 increases.

C. M1 stays the same and M2 stays the same.

D. M1 increases and M2 decreases.

Which of the following statements accurately

describes the three different measures of the money

supply—M1, M2, and M3? ( )

A. The three measures do not move together, so they

cannot be used interchangeably by policymakers.

B. The three measures’ movements closely parallel each

other, even on a month-to-month basis.

C. Short-run movements in the money supply are

extremely reliable.

D. Both (a) and (c) of the above.