What is money?

Chapter 03
What is it?

Economists define money as anything that is generally accepted

in payment for goods or services or in the repayment of debts.

Currency, consisting of dollar bills and coins, clearly fits this

definition and is one type of money.

When most people talk about money, they’re talking about

currency (paper money and coins).
 • To define money merely as currency is much too
narrow for economists.
• Because cheques are also accepted as payment
What is it? for purchases, chequing account deposits are
considered money as well.
• An even broader definition of money is often
needed because other items such as savings
deposits can in effect function as money if they
can be quickly and easily converted into currency
or chequing account deposits.
• As you can see, there is no single, precise
definition of money or the money supply, even
for economists.
What is it?
• People also use the word money to describe what economists call income, as in the
sentence “Sheila would be a wonderful catch; she has a good job and earns a lot of money.”
• Income is a flow of earnings per unit of time. Money, by contrast, is a stock: it is a certain
amount at a given point in time.
• If someone tells you that he has an income of $1000, you cannot tell whether he earned a
lot or a little without knowing whether this $1000 is earned per year, per month, or even
per day.
• But if someone tells you that she has $1000 in her pocket, you know exactly how much this
is.
• Keep in mind that the money discussed in this book refers to anything that is generally
accepted in payment for goods and services or in the repayment of debts and is distinct
from income and wealth.
Functions of
money
Medium of exchange
Unit of account
Store of value
Medium of exchange
• pay for goods and services
• Take the case of Ellen the Economics Professor, who can do just one
thing well: give brilliant economics lectures.
• In a barter economy, if Ellen wants to eat, she must find a farmer who
not only produces the food she likes but also wants to learn economics.
• As you might expect, this search will be difficult and time-consuming,
and Ellen may spend more time looking for such an economics-hungry
farmer than she will teaching.
• It is even possible that she will have to quit lecturing and go into
farming herself. Even so, she may still starve to death.
Medium of exchange
• So, money promotes economic efficiency by eliminating much of the
time spent exchanging goods and services.
• It also promotes efficiency by allowing people to specialize in what
they do best.
• Money is therefore essential in an economy: it is a lubricant that
allows the economy to run more smoothly by lowering transaction
costs, thereby encouraging specialization and the division of labor.
Medium of exchange
Forms of money that have satisfied these criteria have taken many
unusual forms throughout human history, ranging from wampum
(strings of beads), used by Native Americans, to tobacco and whiskey,
used by the early American colonists, to cigarettes, used in prisoner-of-
war camps during World War II.
The diversity of forms of money that have been developed over the
years is as much a testament to the inventiveness of the human race as
the development of tools and language. See, for example, the FYI box.
Unit of account
• measure value in the economy
• If the economy has only three goods, say, peaches, economics lectures,
and movies, then we need to know only three prices to tell us how to
exchange one for another:
• the price of peaches in terms of economics lectures (that is, how many economics
lectures you have to pay for a peach),
• the price of peaches in terms of movies,
• and the price of economics lectures in terms of movies.
• If there were ten goods, we would need to know 45 prices in order to
exchange one good for another; with 100 goods, we would need 4950
prices; and with 1000 goods, 499,500 prices.
Unit of account
• Imagine how hard it would be in a barter economy to shop at a
supermarket with 1000 different items on its shelves, having to decide
whether chicken or fish is a better buy if the price of a kilogram of
chicken were quoted as 4 kilograms of butter and the price of a
kilogram of fish as 8 kilograms of tomatoes.
• To make it possible to compare prices, the tag on each item would
have to list up to 999 different prices, and the time spent reading
them would result in very high transaction costs.
Unit of account
The solution to the problem is to introduce money into the economy and have all prices quoted
in terms of units of that money, enabling us to quote the price of economics lectures, peaches,
and movies in terms of, say, rupees.
At the 1000-good supermarket, there are now only 1000 prices to look at, not 499 500!

We can see that using money as a unit of account reduces transaction costs in an economy by
reducing the number of prices that need to be considered.

The benefits of this function of money grow as the economy becomes more complex.
Store of value
• repository of purchasing power over time
• Money is not unique as a store of value; any asset, whether money,
stocks, bonds, land, houses, art, or jewelry, can be used to store
wealth.
• Many such assets have advantages over money as a store of value:
they often pay the owner a higher interest rate than money,
experience price appreciation, and deliver services such as providing a
roof over one s head.
• If these assets are a more desirable store of value than money, why
do people hold money at all?
Store of value
• The answer to this question relates to the important economic concept of liquidity, the relative
ease and speed with which an asset can be converted into a medium of exchange.
• Liquidity is highly desirable. Money is the most liquid asset of all because it is the medium of
exchange; it does not have to be converted into anything else in order to make purchases.
• Other assets involve transaction costs when they are converted into money.
• When you sell your house, for example, you have to pay a brokerage commission (usually 5% to
7% of the sales price), and if you need cash immediately to pay some pressing bills, you might
have to settle for a lower price in order to sell the house quickly.
• The fact that money is the most liquid asset, then, explains why people are willing to hold it even
if it is not the most attractive store of value.
• How good a store of value money is depends on the price level, because its value is fixed in terms
of the price level. A doubling of all prices, for example, means that the value of money has
dropped by half
Characteristics of money
• Durability: A long trip to market runs the risk of sickness or death for the cow and can severely reduce its value.
Twenty-dollar bills are fairly durable and can be easily replaced if they become worn. Even better, a long trip to
market does not threaten the health or value of the bill.
• Portability: While the cow is difficult to transport to the store, the currency can be easily put in my pocket.
• Divisibility: A 20-dollar bill can be exchanged for other denominations, say a 10, a 5, four 1s, and 4 quarters. A
cow, on the other hand, is not very divisible.
• Uniformity: Cows come in many sizes and shapes, and each has a different value; cows are not a very uniform
form of money. Twenty-dollar bills are all the same size and shape and value; they are very uniform.
• Limited supply: In order to maintain its value, money must have a limited supply. While the supply of cows is
limited, if they were used as money, you can bet ranchers would do their best to increase the supply of cows,
which would decrease their value. The supply, and therefore the value, of 20-dollar bills—and money in general
—are regulated by the Federal Reserve so that the money retains its value over time (lol).
• Acceptability: Even though cows have intrinsic value, some people may not accept cattle as money. In contrast,
people are more than willing to accept 20-dollar bills. In fact, the U.S. government protects your right to use
U.S. currency to pay your bills.
Evolution of the payment system
Commodity money
Money made up of precious metals or another valuable commodity is called commodity
money, and from ancient times until several hundred years ago commodity money
functioned as the medium of exchange in all but the most primitive societies (Not really).

The problem with a payments system based exclusively on precious metals is that such a
form of money is very heavy and is hard to transport from one place to another.

This led to the next development: paper money

Fiat money

• Initially, paper currency embodied a promise that it was convertible into coins or into a
quantity of precious metal.
• However, currency has evolved into fiat money, paper currency decreed by governments as
legal tender (meaning that legally it must be accepted as payment for debts) but not
convertible into coins or precious metal.
• Paper currency has the advantage of being much lighter than coins or precious metal, but it can
be accepted as a medium of exchange only if there is some trust in the authorities who issue it
and printing has reached a sufficiently advanced stage that counterfeiting is extremely difficult.
• Major drawbacks of paper currency and coins are that they are easily stolen and can be
expensive to transport because of their bulk if there are large amounts.
• To combat this problem, another step in the evolution of the payments system occurred with
the development of modern banking: the invention of cheques.
Cheques
• An instrument from you to your bank used to transfer money from
your account to someone else’s account when she deposits the
cheque. Cheques allow
• Cheques allow transactions to take place without the need to carry
around large amounts of currency (transportation costs), improving
payment system efficiency.
• Frequently, payments made back and forth cancel each other; without
cheques, this would involve the movement of a lot of currency.
• With cheques, payments that cancel each other can be settled by
cancelling the cheques, and no currency need be moved.
Cheques
• Another advantage of cheques is that they can be written for any amount up to the
balance in the account, making transactions for large amounts much easier.
• Cheques are advantageous in that loss from theft is greatly reduced, and they provide
convenient receipts for purchases.
• There are, however, two problems with a payments system based on cheques.
• First, it takes time to get cheques from one place to another, a particularly serious
problem if you are paying someone in a different location who needs to be paid
quickly. In addition, if you have a chequing account, you know that it usually takes
several business days before a bank will allow you to make use of the funds from a
cheque you have deposited (anyone has a story to tell?). If your need for cash is
urgent, this feature of paying by cheque can be frustrating.
• Second, all the paper shuffling required to process cheques is costly.
Electronic payment

The development of inexpensive computers and the spread of the Internet now
make it cheap to pay bills electronically.

In the past, you had to pay your bills by mailing a cheque, but now banks provide
websites that allow you to log on, make a few clicks, and thereby transmit your
payment electronically.

Also, you could now settle almost all sorts of interbank payments electronically
(anybody used IBFT?). I mean I don’t remember the last time I had to use a
cheque.
E-money
• Electronic payment technology can not only substitute for cheques,
but can substitute for cash, as well, in the form of electronic money
(or e-money), money that exists only in electronic form. The first form
of e-money was the debit card.
• Smart cards: anybody heard of Apple Gift Cards?
• Mobile banking: mobile apps of banks
• Mobile wallets: Easypaisa, Omni, Jazz Cash, (anymore u know?)
• Mobile money: Anybody heard of Nayapay or Sadapay?
Are they different? How?
Measuring
money
 • The definition of money as anything that is generally
accepted in payment for goods and services tells us
that money is defined by people’s behavior.
• What makes an asset money is that people believe it
will be accepted by others when making payment.
• As we have seen, many different assets have
The idea performed this role over the centuries, ranging from
gold to paper currency to chequing accounts.
• For that reason, this behavioral definition does not
tell us exactly what assets in our economy should be
considered money.
• To measure money, we need a precise definition that
tells us exactly what assets should be included.
 Monetary
aggregates in
Canada
Measuring money
• Monetary aggregates in Pakistan
• Because we cannot be sure which of the monetary aggregates is the true measure of
money, it is logical to wonder if their movements closely parallel one another.
• If they do, then using one monetary aggregate to predict future economic performance
and to conduct policy will be the same as using another, and the fact that we are not
sure of the appropriate definition of money for a given policy decision is not too costly.
• However, if the monetary aggregates do not move together, then what one monetary
aggregate tells us is happening to the money supply might be quite different from what
another monetary aggregate would tell us.
• The conflicting stories might present a confusing picture that would make it hard for
policymakers to decide on the right course of action.
 • M = x1 + x 2 + . . . + x n
• Here xj is one of the n monetary components
of the monetary aggregate M.
Money as a • This summation index implies that all
monetary components contribute equally to
weighted the money total and it views all components as
dollar-for-dollar perfect substitutes.
average • Such an index, there is no question, represents
an index of the stock of nominal monetary
wealth, but cannot, in general, represent a
valid structural economic variable for the
services of the quantity of money.
Money as a weighted average

• Over the years, there has been a steady stream of attempts at properly weighting
monetary components within a simple-sum aggregate.
• With no theory, however, any weighting scheme is questionable. Recently, attention has
been focused on the gains that can be achieved by a rigorous use of microeconomic
theory, aggregation theory, and index number theory.
• This new approach to monetary aggregation led to the construction of weighted
monetary aggregates.
• These aggregates represent a viable and theoretically appropriate alternative to the
simple-sum aggregates.
• Moreover, recent research indicates that these new measures of money seem to predict
inflation and the business cycle somewhat better than more conventional measures
 • The initial data on the monetary aggregates
reported by the Bank of Canada are not a
reliable guide to what is happening to short-
run movements in the money supply, such
How reliable as the one-month growth rates.

are the money • However, the initial money data are

reasonably reliable for longer periods, such

data? as a year.
• The moral is that 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.