Money and Banking

1
Money and Banking

• Spring 2007
• Martin Andreas Wurm
• University of Wisconsin - Milwaukee

2
What is Money?

• Required Reading Mishkin, Chapter 3

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2. Defining Money

• 0. A new wizard?
• Much attention has been paid
• to Ben Bernanke taking over
• as Chairman of the Fed on
• February 1st 2006 after Alan
• Greenspan has been the highest
• keeper of the Worlds most
• important currency for almost
• 20 years.
• He started his career in times of
• concerns about ongoing inflation
• an the burst of a housing bubble in
• U.S.

Source CBS News
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2. Defining Money

• 1. Clarifying a misunderstanding
• In our everyday lives we often refer to money
  as one of three things
• Coins and paper money (currency)
• (Hand over your money or Ill shoot you)
• A persons wealth
• (Bill Gates has a lot of money)
• A persons income
• (Working in finance is a fantastic job and you
  earn a lot of money)

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2. Defining Money

• 1. Clarifying a misunderstanding
• When economists refer to money, they have a
  different connotation in mind
• Money is anything that is generally accepted
  in payments for goods or services or in the
  repayment of debts.
• - Mishkin, F. The Economics of Money, Banking
  and Financial Markets, p. 44

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2. Defining Money

• 1. Clarifying a misunderstanding
• This definition deviates from the above mentioned
  colloquial definitions of money
• Ad 1. Currency fits the economic definition of
  money, but it is only part of it. There are
  other forms of media of exchange, such as e.g.
  checks. Even money holdings in savings
  accounts affect the money stock of an economy.
  Currency, therefore, is too narrow for a good
  definition
• Ad 2. A persons wealth, on the contrary,
  consists of many items which do not fit the
  definition of money provided above, such as
  stocks, bonds, houses, etc, which cannot be
  transferred into media of exchange easily.
  Wealth, therefore, is too broad for a good
  definition
• Ad 3. Income often is transferred in form of
  money. However, money is defined as a stock,
  while income is a flow. Moreover, part of a
  persons income can be non-monetary, such as
  health benefits, etc.

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2. Defining Money

• 2. Functions of Money
• Commonly, individuals hold money for three
  reasons.
• Money acts as a medium of exchange
• Money is used as unit of account
• Money is a store of value
• What mainly distinguishes money from other assets
  such as bonds or stock is its use as a medium of
  exchange

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2. Defining Money

• 2. 1. Money as a medium of exchange
• Imagine an economy without money a barter
  economy.
• In such an economy all goods and services have to
  be exchanged directly for each other.
• Exchange in such an economy requires what is
  known as the dual coincidence of wants
• Both trading partners have to mutually offer a
  good or service that their counterpart demands.
  Otherwise no trade occurs.
• This method of exchange complicates trade
  immensely and creates high transaction costs.

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2. Defining Money

• 2. 1. Money as a medium of exchange

Individual A Offers bread Demands soda
Individual C Offers bananas Demands bread
An example of a barter economy Trade in this
barter economy only takes place, if individual A
decides to trade its bread against individual Cs
bananas, which in turn A can exchange against Bs
bananas. Individual D cannot trade in this
economy since within this group nobody is
offering anything D wants. D, however,
potentially has bananas to offer, which remain
unused.
Individual D Offers bananas Demands education
Individual B Offers soda Demands bananas
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2. Defining Money

• 2. 1. Money as a medium of exchange
• In most of the transactions in modern economies
  money, therefore, is used as a medium of exchange
  reducing transaction costs involved with barter
  (mainly in form of time).
• Any commodity used as a medium of exchange must
  show certain features
• 1. It must be easily standardized
• 2. It must be widely accepted
• 3. It must be divisible
• 4. It must be portable
• 5. It must not deteriorate in value quickly

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2. Defining Money

• 2. 2. Money as a unit of account
• Money is the most common measure of economic
  value in an economy
• Prices of goods and services are typically not
  indicated relative to all other goods and
  services, but are usually referenced to a single
  numeraire good, namely money.
• Again this creates a huge informational and
  therefore cost advantage over a barter economy,
  since we do not have to worry whether 5 eggs at
  the supermarket are worth 0.05 economics
  lectures, 6 bananas, 2 ounces of titanium, 0.01
  gallon of gas, etc.

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2. Defining Money

• 2. 3. Money as a store of value
• The third function of money reflects its capacity
  to maintain part of its value over time
• Individuals use part of their income for
  consumption and part of their income for saving.
• There are numerous assets that can be used for
  saving. Bonds, stock, houses, even consumption
  goods are often mainly held for purposes of
  postponing consumption. Money is merely one of
  them.

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2. Defining Money

• 2. 3. Money as a store of value
• Many of these assets have clear advantages over
  money. Bonds for example pay coupons or gain in
  price, houses produce housing services, etc.
• The only rent money provides is inflation, which
  is (usually) negative.
• So why do people hold money for saving purposes
  in the first place?
• The answer to that question is liquidity.

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2. Defining Money

• 2. 3. Money as a store of value
• Liquidity indicates how easily and quickly an
  asset can be transformed into a means of payment.
  Since the world we live in is uncertain,
  liquidity is desirable
• Money, apparently, is the most liquid asset. It
  does not need to be transformed into anything
  else for purposes of transaction, being the
  medium of exchange itself.
• Other assets such as checking, saving or time
  deposits also have a high degree of liquidity and
  are, therefore, often considered part of the
  money stock (see 2.4.).

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2. Defining Money

• 2. 3. Money as a store of value
• Is money a good store of value?
• The answer to this question depends as already
  indicated on inflation, since the value of
  money is fixed in the price level.
• During normal phases of inflation, money is a
  relatively good store of value
• During phases of high inflation or hyperinflation
  (inflation rates above 50), however, money can
  loose its value very quickly.

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2. Defining Money

• 3. A brief history of the payment system
• The payment system is the method of conducting
  transactions in an economy.
• Historical forms of means of payment are the
  following
• Commodity money
• Fiat money
• Checks
• Electronic payment
• E-Money

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2. Defining Money

• 3.1. Commodity money
• Commodity money is a means of payment made out of
  precious metals such as gold or silver or other
  valuable commodities.
• It has been the prevailing medium of exchange in
  most societies since classical times up to around
  two hundred years ago.

Roman circus coin (Hadrianus)
1878 Brasher doubloon
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2. Defining Money

• 3.1. Commodity money
• Commodity money fulfills the criterion of general
  acceptance, because it consists of materials
  which are already high in demand.
• It comes with a number of problems, however
• Its value is not necessarily easily to prove for
  everyone. Problems of forgery or debasing have
  been common in history.
• Commodity money is generally heavy and hard to
  transport.
• The value of commodity money varies with the
  value of the underlying commodity and, therefore,
  is subject to fluctuations of supply and demands
  for these goods.

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2. Defining Money

• 3.2. Fiat Money
• The development of bank notes originally backed
  by a convertibility guarantee succeeded
  commodity money.
• Paper money quickly converted into fiat money
  money issued by governments as legal tender, but
  without any right of convertibility

US Dollar
10.000 Reichsmark (during the German
hyperinflation)
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2. Defining Money

• 3.2. Fiat Money
• Fiat money is easier to transport and it is not
  subject to demand and supply fluctuations like
  commodity money
• However, it can only be used as a medium of
  exchange as long as it is generally accepted,
  which is not always a safe bet
• Individuals expectations on the value of paper
  money and the integrity of the monetary authority
  build the main pillar on which a fiat money
  system is based upon. Once people stop believing
  in the value of fiat money, the system falls
  apart.
• Fiat money, moreover, has similar problems as
  commodity money. It is easily stolen and often
  subject to counterfeit

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2. Defining Money

• 3.3. Checks
• Checks are an instruction to a bank to transfer
  money from on persons account to the bank
  account of the recipient once he or she deposits
  the check.

A check
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2. Defining Money

• 3.3. Checks
• Checks, thus, solve the problem of transport for
  large amounts of money and facilitate
  transactions in a number of other ways.
• However, two problems are connected to the use of
  checks
• Moving checks from one point to another takes
  time
• The processing of checks does not come for free
  and imposes a transaction cost by itself to
  society

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2. Defining Money

• 3.3. Electronic payment
• Increasingly common forms of means of transaction
  are electronic payment services offered online by
  banks.
• Instead of mailing out a check for every single
  payment, you simply log on to the banks web site
  or have your money automatically deducted on a
  regular basis
• Electronic payment is a very common means of
  transaction in Europe and increasingly popular in
  the U.S.

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2. Defining Money

• 3.3. E-Money
• Not only checks get increasingly substituted by
  electronic forms of payment, cash has also been
  partly replaced by other instruments
• Common forms of E-money include
• Debit and credit cards
• Money cards or smart cards
• E-cash

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2. Defining Money

• 4. Measuring money
• We defined money as anything generally accepted
  in payment for goods and services
• Since many commodities have had this function in
  history, we need a closer definition of money to
  measure the actual stock of money in an economy
  at a specific point in time

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2. Defining Money

• 4. Measuring money
• The common measures of the money stock are given
  in the definition of the monetary aggregates
  issued by the Fed.
• Due to the large number of financial innovations
  of the last decades the definition of these
  aggregates have been frequently revised.
• There are three common aggregates of money very
  imaginatively labeled M1, M2 and M3 (M3 has
  been discontinued in 2006).

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2. Defining Money

• 4. Measuring money M1

Value as of December 2002 (billions) M1
Currency 626.5 Travelers checks
7.7 Demand deposits
290.7 Other checkable deposits
281.2 Sum 1,206.1
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2. Defining Money

• 4. Measuring money M2

Value as of December 2002 (billions) M2
M1 1,206.1 Small denomination time
deposits and repurchase agreements
1,332.3 Savings deposits and money
market deposit accounts 2,340.4 Money
market mutual fund shares (non-institutional)
923.7 Sum 5,802.5
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2. Defining Money

• 4. Measuring money M3

Value as of December 2002 (billions) M3
M2 5,802.5 Large denomination time
deposits and repurchase agreements
1,105.2 Money market mutual fund
shares (institutional)
767.7 Repurchase agreements
511.7 Eurodollars 341.1 Sum
8,528.2