Chapter 1 An Introduction to Money and Banking
What is money?
There has always been some form of confusion when someone uses the word “money”. He/she can use the word “money” to represent different thing depending on the scenario:
1. Currency: “Do you hav e enough money for lunch?”
2. Income: “How much money do you make a month?”
3. Wealth: “Is she from a family with a lot of money?”
From the above example, we know that money can represent different things. The most common scenario associated with money is currency (or cash). As we will discuss later, money can take on many forms, hence it is more important for us to look at money in terms of what it does rather than what it is physically. The functions of money can be generally classified into three categories:
(i) Medium of exchange
As a medium of exchange, it facilitates the exchange of goods and services between individuals. Prior to the invention of money, goods and services are exchange in the form of barter. In other words, you trade with an individual who has what you want, and also wants what you have. As a result, bartering requires a double coincidence of wants.
It is very difficult to find another individual who has what you want, and wants what you have. In this case, the cost of transaction is very high for bartering. With the invention of money, you no longer need to find another individual who has what you want, and wants what you have. All you need to do is find someone who has what you want, and you buy it from him/her with “money”. With the invention of money, it reduces the cost of transaction (because it facilitates the exchange of goods and services).
In addition, the invention of money also improves the productivity of the economy. How is that so? That is because with the invention of money, it allows an individual to specialize what he/she does the best (rather than being a jack of all trade in a bartering system). As a result, money is fundamental to the development of an economic system since specialization will lead to an
increase in productivity.
(ii) Store of value
With money playing a role as the medium of exchange in the economy, it also provides the function of a store of value (or purchasing power) at the same time. In a bartering system, an individual’s sale of goods and serv ices has to occur simultaneously with the purchase of goods and services. For example, Farmer Bob went to the market with some of his corn to trade for some fish with Fisherman John. In this situation, the “sale” of Farmer Bob’s corn has to occur at the same time as his “purchase” of fish from Fisherman John.
With the existence of money in the economy, it allows individuals to separate their sales of goods and services from the purchases of goods and services because money allows them to store their value or purchasing power. Returning to our previous example, Farmer Bob can sell his corn to Rancher Jane (to feed her cattle) for some units of money. Farmer Bob can then turn around to buy fish from Fisherman John to day or some other day. In this example, we see that money allows the separation of sales and purchases of goods and services over time.
It is important to note that money can be used to store two types of purchasing power: temporary and permanent purchasing power.
1. Temporary purchasing power: This is the type of purchasing power we have discussed earlier
in our Farmer Bob example. Temporary purchasing power represents transaction that we intend to conduct in the very near future. For example, carrying cash in your wallet or purse when you go to the store.
2. Permanent purchasing power: This represents the store of value for the very distant future. For
example, stashing cash under the mattress for retirement.
It is important to know that cash is not the only asset available for storing value on a permanent basis. There are other assets that also serve the function of store of value. Some examples are stocks, bonds, real estate, collectibles, etc. Money (or cash) has one disadvantage relative to those other assets: cash does not earn a return. As a result, there is an opportunity cost in holding cash. In addition, cash as a store of value is that it is vulnerable to inflation, i.e. inflation will erode the purchasing power of cash.
On the other hand, cash has one advantage over the other assets as a store of value: liquidity. You can use cash to buy anything you want, but you cannot simply use a share of stock to buy anything.
Hence, cash will still be used to store a portion of an individual’s permanent purchasing power because of the convenience it provides.
(iii) Unit of account
As a unit of account, “money” becomes the yardstick for measuring the values and prices of goods and services. Before the invention of money (i.e. in the stage of bartering), prices are expressed in relation to the goods traded.
For example, John traded 2 cows for 20 bushels of wheat with Mary. In this case, 1 cow is worth 10 bushels of wheat. If John has traded 3 cows for 6 sheep with Steve, each cow is worth 2 sheep. What is the price of sheep if Mary and Steve trade with each other?
time is money
With the invention of money, a yardstick has been chosen to measure the prices of goods and services. This makes comparing the prices among goods and services easier. For example, the cow is worth 50 units of “money”, the sheep 25 units, a nd a bushel of wheat 5 units.
Characteristics of money
莫扎特《小夜曲》Money has taken many forms throughout the history of mankind and it is continuing to evolve as of to
day. Many different types of commodity or specie have been used to represent money (or currency) in our society. They include wampum, tobacco, gold, silver, cows, coffee, paper money etc.
The forms that money has taken on depend heavily on how well it performs the three roles we have discussed earlier: (especially) medium of exchange, store of value, and unit of account. The following are some of the characteristics a commodity or specie needs to possess to perform the three roles of money efficiently:
(1)Nonperishable
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(2)Divisible
(3)Widely accepted (in payment of goods and services and for settling other business
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(4)Easily standardized (i.e. homogenous)
教育的名言名句(5)Portable
(6)Limited in supply
(7)Supply is relatively stable
(8)High in value (i.e. its physical size is small relative to its value)
(9)Not easily counterfeited
Among the nine characteristics listed above, the two most important ones are limited in supply and not easily counterfeited. With the advancement in technology (such as the development of digital cash), characteristics such as divisibility and portability no longer become an issue.
However, new problems have surfaced with the development of digital cash. Since digital cash is made up of bits of digital information, it can be “counterfeited” a lot of easier than traditional paper money. This becomes a major concern because easy duplication leads to an unlimited amount of digital cash, which makes it valueless. In addition, digital cash is much easier to transport than paper money because it is transferred digitally. This makes transferring money across border a lot easier, which means money from illegal sources (such as drug money) can be easily “transmitted” out of the country. Finally, unlike paper money, digital cash does not allow an individual to remain anonymous when conducting certain types of transaction. Since privacy is a major issue for most individuals, this problem will have to be resolved to make digital cash widely accepted.1
Different measurements of money
In our earlier discussions, we have equated money with cash. However, in the eye of economists and the federal government there is a broader measure of what money is in the U.S. There are 3 general measures of money used by the U.S. government (or more specifically the Federal Reserve System): M1, M2 and M3.
(i) M1
M1 is the narrowest measure of money. It includes the following items:
1 If you are interested in digital cash, there are many articles and books on this topic. One of such books is by Seth Godin entitled Presenting Digital Cash.
deposits)
checkable other  (ie. accounts  checking  bearing  interest +deposit)
demand  (ie. accounts  checking  bearing  interest -non +AMEX) (eg. issues  nonbank  of  checks  s traveler'+coins) and  (notes  n circulatio  in  currency M =1
Note:    1. Traveler’s checks issued by banks are grouped under demand deposits.
2. Some examples of interest bearing checking accounts are NOW (negotiable order of withdrawal), ATS (automatic transfer from savings), and credit union share drafts.
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M1 is considered by the Federal Reserve as transaction balances. In other words, they are perfectly liquid assets, i.e. pure medium of exchange.
(ii) M2
M2 is a broader measure of money than M1. It includes items that are contained in M1 and a few other items:
adjustment  ion consolidat +r
Eurodolla overnight +agreement
repurchase  overnight +nal)institutio -(non  shares funds  mutual  market money +(CDs)
deposits  time  small +accounts
deposit  market money  and  deposits  savings M M +=1
2
Note: 1. You can write a limited number of checks on money market deposit accounts (i.e.
interest bearing account).
2. Small time deposits are CDs with amount less than $100,000.
3. Money market mutual funds are interest-bearing shares in pools of funds accumulated by investment companies. The funds are invested in short-term securities.
4. The consolidation adjustment is included to avoid double counting of short-term
repurchase agreement and Eurodollars held by money market mutual funds.
The components of M2 (other than M1) are considered as nontransaction balances. In other words, the assets emphasize the function of money as a store of value. However, they can also be used as medium of exchange (with some delay).
(iii) M3