G. Stephen CECCHETTI Kermit L. SCHOENHOLTZ
Chapter Two
Money and the Payments System
McGraw-Hill/Irwin
Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Goals of the Chapter
To understand what money is.
To understand how we use money.
To understand how we measure money.
2-2
Money and How We Use It
Money is an asset that is generally accepted as
payment for goods and services or repayment
of debt.
Income is a flow of earnings over time, where
wealth is the value of assets minus liabilities.
2-3
Money and How We Use It
Money has three characteristics:
1. It is a means of payment
2. It is a unit of account, and
3. It is a store of value.
The first of these characteristics is the most
important
The average dollar bill lasts 21 months in circulation
2-4
Money and How We Use It
1. It is a means of payment
People insist on payment in money.
Barter requires a double coincidence of wants.
Money is easier and finalizes payments so no
further claim on buyers and sellers.
Fiat money (pg 24) has no value other than its ability to buy, i.e. US
currency. It is not backed by gold or silver.
2-5
Money and How We Use It
2. It is a unit of account.
Money is used to quote prices and record
debts - it is a standard of value.
Prices provide the information needed to
ensure resources are allocated to their best
uses.
Using dollars makes relative price
comparisons easier.
2-6
When you shop, should you use a debit card or
a credit card?
A debit card works like a check only faster.
Funds are immediately removed from your account.
A credit card makes a deferred payment.
If not paid on time, there is a late fee.
If not paid fully, there is interest on the debt.
But if you do pay on time and fully, it is an interest
free loan for a period of time.
Credit cards allow you to build a credit history.
2-7
Money and How We Use It
3. It is a store of value
A means of payment has to be durable and
capable of transferring purchasing power
from one day to the next.
Paper currency does degrade, but is accepted
at face value in transactions.
Other forms of wealth are also a store of
value: stocks, bonds, houses, etc.
2-8
Money and How We Use It
3. Store of Value (cont.)
Although other stores of value are sometimes
better than money, we hold money because it
is liquid.
Liquidity is a measure of the ease with which
an asset can be turned into a means of
payment.
The more costly it is to convert an asset into
money, the less liquid it is.
2-9
Money and How We Use It
It is a store of value (cont.)
Financial institutions use:
Market liquidity - the ability to sell assets for
money.
Funding liquidity - ability to borrow money to buy
securities or make loans.
2-10
The Payments System
The payments system is a web of arrangements
that allow for the exchange of goods and
services, as well as assets.
It is critical this functions well.
Money is at the heart of the payments system.
2-11
The Payments System
The possible methods of payment are:
1. Commodity and Fiat Monies (Cash/Note)
2. Checks paper debit
3. Electronic Payments
1.
2.
3.
4.
5.
6.
Debit Card
Credit Card
Charge Card dont charge interest but there are penalties if not
paid off at the end of each month, i.e. American Express
Stored-Value Cards smart cards, Visa gift cards
EFT/ACH pg 27
E-money
2-12
Commodity and Fiat Monies
Commodity monies are things with intrinsic
value.
Included items like silk and salt.
To be successful, must be:
Usable by most people,
Able to be made into standardized quantities,
Durable,
Easily transportable, and
Divisible into smaller units.
2-13
Commodity and Fiat Monies
Gold has been the most common as it meets
these requirements.
In 1656, Stockholm Banco issued Europe's first
paper money
King of Sweden printed too many to try to finance
a war and the bank failed.
In 1775, the Continental Congress of the
United States of America issues continentals
to finance the Revolutionary War.
2-14
Commodity and Fiat Monies
Because of huge quantities issued, people
became suspicious of government-issued paper
money.
In 1862, the Confederate and the Union
governments printed money with no backing.
After the Civil War, the US reverted to using
gold as money.
2-15
Commodity and Fiat Monies
Gold coins and notes, backed by gold, were
used into the 20th century.
Todays paper money is called fiat money,
because its value comes from government
decree, or fiat.
We are willing to accept these bills as payment
because the US government stands behind its
paper money.
In the end, money is about trust.
2-16
Checks
A check is an instruction to the bank to take
funds from your account and transfer them to
another account.
A check is therefore not a final payment as
currency is.
A check sets in motion a series of transactions
as seen in Figure 2.1.
2-17
Figure 2.1: The Path of a Paper
Check
2-18
Why have checks not disappeared?
Checks are legal proof of payment.
Customers wanted them back.
Starting in 2004
Banks can transmit digital images.
Substitute checks are proof of payment.
Electronic mechanisms for clearing checks have
lowered costs and kept checks as an attractive
means of payment.
2-19
Electronic Payments
Electronic payments take the form of:
Credit and debit cards
Electronic funds transfers
Stored-value card
E-money
2-20
Electronic Payments
Debit Cards
Works like a check - tells the bank to transfer funds
from your account to another.
Credit Cards
A promise by a bank to lend the cardholder money
to a make purchase.
They do not represent money.
2-21
Electronic Payments
Electronic funds transfers
Movements of funds directly from one account to
another.
Most common form is the automated clearinghouse
transaction (ACH).
Used for recurring payments like paychecks.
Banks use electronic transfers for bank to bank
transactions, sending money through Fedwire.
2-22
Electronic Payments
Stored-value card
Take it to a bank or an ATM, transfer money to the
card, then use the card at a merchant.
Limited usefulness so far.
Limited in what can be purchased with them.
Require specific hardware.
2-23
Electronic Payments
E-money
Can be used to pay for purchases on the Internet.
You open an account by transferring funds to the
issuer of the e-money.
When shopping online, you instruct the issuer to
send your e-money to the merchant.
Really a form of private money.
2-24
Market liquidity and funding liquidity are both
needed to market financial markets function
smoothly.
2007-2009 financial crisis lead to a sudden loss
of liquidity.
2-25
Before the crisis
Financial institutions relied on short-term
borrowing to hold long-term financial instruments.
They believed funding liquidity would remain
readily available.
They also believed markets would also be liquid.
They would always be able to sell the securities
and loans they held.
2-26
In 2007, doubt lead to a double liquidity
shock increasing cash holdings.
This reduced loan supplied intensifying the
decreasing liquidity.
One lesson: Liquidity is a highly valuable
resource that can disappear when most needed.
2-27
2-28
The Future of Money
The future of the three functions of money:
Means of payment: disappearing due to ease of
electronic transactions.
Unit of account: likely to remain.
Will always be needed to quote values and
prices because it is efficient.
But, will we move to one global unit of account?
Store of value: disappearing due to liquidity of
many financial instruments.
2-29
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?
2-30
Measuring Money
Changes in the quantity of money are related to
Interest Rates
Economic Growth
Inflation
2-31
Measuring Money
Inflation:
The process of prices rising.
Inflation rate:
The measurement of the process.
With inflation, you need more money to buy
the same basket of goods.
The primary cause of inflation is too much
money.
pg 30
2-32
Measuring Money
The value of the means of payment depends on
how much of it is circulating.
We therefore must be able to measure how much is
circulating.
Defining money means defining liquidity (see
figure 2.2).
2-33
Figure 2.2 - The Liquidity
Spectrum
2-34
Measuring Money
Different definitions of money are based upon degree of
liquidity.
Drawing the line in different places has led to several
measure of money called the money aggregates: M1
and M2.
M1: Narrowest definition.
Only the most liquid assets.
M2: Broader definition.
Includes assets not used as means of payment.
2-35
Table 2.1: The Monetary
Aggregates
2-36
Measuring Money
What do the money aggregates mean?
As of winter 2010, nominal US gross domestic
product (GDP) was $14,500 billion.
Using the data in Table 2.1 above:
GDP is nearly nine times as large as M1.
GDP is about 70 percent larger than M2.
2-37
Measuring Money
Which M do we use to understand inflation?
Until the early 1980s we used M1.
But with changes in accounts, M2 became more
useful.
M2 represents nearly one-half of GDP, so M1 is no
longer a useful measure of money.
Figure 2.3 shows the Ms growth rates.
2-38
Figure 2.3: Growth Rates of the
Money Aggregates
2-39
Measuring Money
How useful is M2 in tracking inflation?
When the quantity of money grows quickly, it
produces high inflation.
Figure 2.4 shows the inflation rate versus M2 two
years earlier for the US.
Positive correlation up until 1980.
From 1990-2000 - no correlation.
Growth in M2 stopped being a useful tool for
forecasting inflation.
2-40
Figure 2.4: Money Growth and
Inflation
2-41
Measuring Money
Why does M2 no longer predict inflation?
Maybe the relationship only applies at high levels
of inflation.
Maybe it only shows up over longer periods of
time.
Maybe we need a new measure of money.
We do know that at low levels of money
growth, inflation is likely to stay low.
2-42
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?
2-43
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.
Cost of Basket in Current Year
CPI =
* 100
Cost of Basket in Base Year
2-44
Table 2.2: Computing the
Consumer Price Index
CI01 P 00
P 1 CI 1
2
I fai n ae 01
n to R 21 = 2
l
t
*0
10
CI00
P1
2
2-45
In 2009 the public held about $880 billion in
US currency.
You can compare this to each person holding
$2800.
80% of this money was in $100 bills.
Many of these bills are in other countries.
People in other countries hold other currencies
that are more stable than their own.
2-46
Stephen G. CECCHETTI Kermit L. SCHOENHOLTZ
End of
Chapter Two
Money and the Payments System
McGraw-Hill/Irwin
Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.