Learning Unit #2

Money and Payment System

in the U.S.

Objective of Learning Unit

• Define Money

• Understand Functions of Money

• Present Evolution of Payment System

• Explain Measurement of Money in Economy

Money

• Money: Anything that is generally accepted in payment for goods or services or in the repayment of debt– Important!! Term “money” defined in Money &

Banking is different from commonly used word “money” in everyday conversation!

Example of MoneySo, what can you use for payment at Wal-Mart, McDonald’s, and Exxon gas station?– Currency (cash) including coins and bills

• Cash is an asset. If you have $20 bill, you can spend up to $20 worth of goods and services (e.g. gasoline).

– Check & debit card (electronic version of check)• A check is a means of payment, but it is worthless piece of paper

unless you write a payment and sign it.

• Can you write $23,770 check at Toyota dealer to purchase Prius? Yes, only if you have that amount at your bank.

• You can write a check up to an amount in your checking account without bouncing your check.

• Your checking account balance is money, not check itself.

– Credit card? Not really.

Money by DefinitionNot every means of payment is money. Money by definition must be– An asset (for repayment of debt)

• A credit card is not money because the credit card is a means of borrowing (not payment, but deferred payment).

• Once charged, you are expected to pay your credit card bill by check or cash (a.k.a. money).

– Generally accepted • If you can use only one or few places, then it is not

money.

• Ex. Disney dollar is not money because it can be used only at Disney store or Disney World.

Three Functions of Money

Money has three primary functions in any economy.• Medium of Exchange

– Anything used to pay for goods and services

• Unit of Account

– Anything used to measure value in economy

• Store of Value

– A repository of purchasing power over time

Money as Medium of Exchange• Every modern economy needs money for efficient exchange of

goods and services among people.• Barter exchange: Exchange goods for goods

Ex. You have a fish and wants to eat a loaf of bread.

(You) Fish Bread (???)

You must find someone who has a loaf of bread and wants your fish. Is it easy to find? It will take too long to find a perfect match (high transaction costs).

• Monetary exchange: Exchange of goods through moneyEx. You simply sell your fish to someone who has money (no need to have a loaf of

bread) and use the money to purchase a loaf of bread. Even though this involves two exchanges, actually it will take less time for exchanges.

(You) Fish Money (???) Bread (???)

– Since money comes between two goods in exchange, it is a medium of exchange.– Money increases efficiency in economy: people can spend more time for

production of goods and services rather than exchange.

Money is Means not Ends

• Money is important for any economy because of its medium-of-exchange function.→ Thus, money is defined as medium of exchange.

• Everyone likes to have money not because you feel satisfaction of having money, but because you get satisfaction by spending it!– Money is not you end needs, but means (medium) to get

your ends.– This is true for all financial assets (e.g. stock, bonds)

because financial assets do not provide satisfaction to owner’s of the assets, but can be used to obtain end needs.

Criteria as Medium of Exchange

• Any commodity can be used as money, but to function effectively as money it must be– Widely Acceptable: this is the definition of

money itself (i.e. generally accepted).

– Easily Standardized: easy to recognize it as money and simple to ascertain its value.

– Durable: should not deteriorate quickly.– Easy to Carry: should not be too bulky or heavy.– Divisible: easy to make change.

Examples of Medium of Exchange Many commodities have been used as money in various civilizations in history. Some form of money is better medium of exchange than others.– Yap stone money

– American Indian wampum– Cigarette in U.S. prisons – Cowries seashell in the South Pacific and Africa• Which is better medium of exchange, Yap stone

money or metal coin?

U.S. Dollar Bills• In modern U.S. economy we use dollar bills and coins as

medium of exchange.• Dollar bills are called “Federal Reserve Note” because they

are IOU (note payable) issued by the Federal Reserve Banks. They are assets for holders (households, firms, governments, and foreigners) of IOUs, but liabilities for issuers (the Federal Reserves) of IOUs.

Money and Generally Accepted

• Money must be generally accepted by definition.• In modern U.S. economy we use worthless paper

money rather than valuable commodity.• We accept worthless paper money because we expect

they are accepted by others.• If no one accepts money, money will seize its primary

function in an economy.• The government guarantees its general acceptance by

making it “legal tender”.

Money as Unit of Account

• In the U.S. a value (price) of every good and service is quoted in dollars and cents.– By using “dollar and cent” as a standard unit of

value, we can easily compare value of one good with others.

– Ex. How much is a Big Mac? Around $3.99. How much is a cheeseburger? About $1.00. So, you know which is more valuable.

Money As Store of Value

• Money can keep its purchasing power over time.

• When you receive your paycheck, you do not need to spend every dollar right at that moment. You can keep it in bank account or cash on hand, and spend it later.

• Money is not unique in this function. There are many assets (financial assets and commodity) which can serve as store of value.

Comparing Store of ValueAny assets can serve as store of value. One may serve as a better store of value than another.

− Ex. Your hardcover textbook can serve as store of value. You spent $120 to get it, and will sell it at $40. It preserves $40 value over time.

− Ex. Saving account, bonds, stocks, gold, house

• Liquidity: the relative ease and speed with which an asset can be converted into medium of exchange

− Money is the most liquid store of value.

• Purchasing Power: Amount of goods and services money can purchase.

− In an inflation, money loses purchasing power.

Evolution of Payment System

Over time, methods of payment evolve as the technology and economy change.

Changes in payment system reduces transactions cost (less time and effort to exchange) and create even better medium of exchange.• Traditional methods of payment• Electronic payment

Traditional Methods of Payments

• Commodity Money– Money made up of precious metals or other

valuable commodity– Physical goods that have a value as a commodity

equal to its value as a medium of exchange

• Fiat money– Paper currency decreed by government as legal

tender– Money which does not have a value as a

commodity equal to its value as a medium of exchange

• Checks

Electronic Payment (POS)When you purchase goods and services at stores, you may pay it electronically, where funds in your bank account are automatically and immediately transferred to seller’s bank account at point of sales.• Debit cards• Electronic check (conversion)

− Bank and account information are extracted from your paper check (converting to electronic version of paper check), and the fund will be transferred electronically.

− Paper checks are no longer used for settlement. • Payment by smartphone

− At casher you just pass your smartphone to make a payment.

− It transmits a bank account information (transfer funds directly from your bank account), a cell phone account information (charged to cell phone bill), a credit card information, or a prepaid account information.

Electronic Payment (online)When you shop online, you may make payments online electronically.• Electronic Funds Transfer (EFT) through Automatic Clearing House

(ACH)− You provide your bank account information, then funds are transferred from

your bank account to seller’s account.− You can set up at your bank to make a regular payment automatically through

EFT. − Ex. Monthly automatic payment to your cell phone company.

• Electronic Bill Presentment and Payment (EBPP)− You receive an electronic bill (e-mail) and with a click you can make a

payment online by providing your credit card information or setting up EFT• Digital Wallet

− A computer software to store all of your financial information such as credit card information or your bank account (EFT). When it comes to fill your payment information during an online shopping, the program automatically fill all information (Internet Explore can perform some of this function).

Electronic MoneyElectronic money (e-money) is money that is stored electronically.• Stored-value card: usually issued by service providers,

required to make deposits, and makes payments out of deposits for a specific service.− The balance information may be stored on a card or maintained at an

issuer’s server.– Prepaid card: Ex. Metro Card, Telephone card– Smart card: a card with integrated circuits to hold and process

information. Ex. Medical smart card • Electronic cash (e-cash): money only existent in electronic

form and exchanged only electronically through online or by electronic devises.− Ex. PayPal, Bitcoin

So, what is AggieOne card?

Measuring Money Supply

• Money supply (Money aggregate): Amount of money in economy

• Why measuring money supply?– How people spend is an important factor affecting the

whole economy. How much people spend depends partly on how much money they have for purchasing (medium of exchange). Through the monetary policy the Federal Reserve affects people’s spending by changing the amount of money in the U.S. economy.

– In order to control money, the Federal Reserve must first know how much money are in an economy.

Fed → Money → Spending → Economy

Two Approaches to Measure Money Supply

• Money as medium of exchange– Focus on the definition of money as medium of exchange and include

only assets that clearly act as a medium of exchange M1 = Currency + Checkable deposits + Travelers Checks

• Money as monetary policy tool– Focus on the measure of money supply which best predicts changes in the

economic condition– Many people can spend more than they have in checking accounts or cash

by simply transferring funds from very liquid assets.– Include highly liquid assets which can affect spending M2 = M1 + CDs + Saving deposits + Money market accounts/mutual funds

Money Aggregates

• About one half of M1 is currency and other half is checkable deposits.• About one quarter of M2 is M1, other three-quarters are CDs, saving

accounts, and money market account/mutual funds.

Money Supply Data

Money supply data are available on Internet:

• Barron’s reports the latest information of M1 and M2 in the U.S. economy.– See “How to Interpret Money Supply of Barron’s”

on Blackboard

• Federal Reserve Bank of St. Louis provides time-series data of various monetary aggregates and their components since 1960s.– See “How to Obtain M1 Data from FRED” on

Blackboard.

Selecting Monetary Aggregates

• These two money supply measurements do not always move together in short time periods.– If one up, the other down, which one should the Fed choose for

controlling the money?

• The Fed should not be concerned with changes in money supply measurements in short time period.– They are affected by numbers of factors.– They are revised frequently: Ex. Initially reported up, but later changed

to down as more data become available.

• The Fed should keep its eye on their trends over long time period and how they affect the whole economy over time.– Many erratic factors affecting the money supply in short time period

offset each others over time.– The money supply measurements move broadly together over long

time period.

Figure 1Growth Rates of M1 and M2 Aggregates

• Both M1 and M2 moved roughly together from 1960 to 1990.• Since 1990 M1 tends to move more erratically up and down than M2.• Although they are apart, since 1995, both M1 and M2 show similar patterns of up and down

trends.

Disclaimer

Please do not copy, modify, or distribute this presentation without author’s consent.

This presentation was created and owned byDr. Ryoichi Sakano

North Carolina A&T State University