1. AP/IB Economics Spring 2006 Mr. Elliott
Money
AP/IB Economics
Spring 2006
Mr. Elliott

2. Defining Money 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 I’ll shoot you”)
A person’s wealth
(“Bill Gates has a lot of money”)
A person’s income
(“Working in finance is a fantastic job and you earn a lot of money”)

3. Defining Money 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

4. 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

5. Defining Money Money as a medium of exchange
Imagine an economy without money – a so called 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 or otherwise no trade takes places.
Apparently this complicates trade immensely and creates high transaction costs.

6. Defining Money 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 the indicated barter economy only takes place, if individual A decides to trade its bread against individual C’s bananas, which in turn A can exchange against B’s 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 B
Offers soda
Demands bananas
Individual D
Offers bananas
Demands education

7. Defining Money 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

8. Defining Money 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.

9. Defining Money Money as a store of value
The third function of money reflects its capacity to maintain part of its value over time
As you know from your introductory macroeconomics class, 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.

10. Defining Money 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.

11. Defining Money 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 show a high degree of liquidity and are, therefore, often considered part of the money stock (see 4.).

12. Defining Money 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.

13. Defining Money 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

14. Measuring Money
The common measures of the money stock is 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

15. } } Measuring Money The Money Supply } M1 Measuring money – M1
Currency
(coins & paper money)
Checkable accounts
Traveler’s Checks }
} M1
Measuring money – M1
Narrowest definition and measure of money supply
Assets used primarily for transactions
Measuring money – M2
Broader measure of money stock
Includes items used as store of value
M1 +
Measuring money – M3
Even Broader definition of money supply
Includes items that serve as a unit of account
M2 +
M1 plus
Savings deposits,
including Money
Market deposit
accounts
Small time deposits
Money Market Mutual
Funds M2 M3
M2 plus
Large Time Deposits

16. Money Supply and Monetary Policy
The Federal Reserve Bank uses the supply of money in the economy to influence interest rates, and thus influence the Aggregate Demand

17. The Purpose of Monetary Policy is to:
Encourage economic growth
Promote employment
Control inflation
Build a sustainable balance of trade in the international markets

18. Can you put that in English?
Basically, the Fed is charged with controlling the amount of money in circulation.
Fed policy can increase or decrease the money supply, which increases or decreases interest rates.
Decrease
Interest Rates
Decrease
Money Supply
Increase
Money Supply
Increase
Interest Rates
Leads to
Leads to

19. How does monetary policy impact me?
Federal Reserve actions influence
interest rates
purchasing power
prices of goods and services
potential job growth
exchange rates

20. Real Life Example Let’s say you want to buy a house:
$200,000 Home with $20,000 down payment
30 year loan at 6% interest rate
$44,000 to $50,000 annual salary
Monthly Payment (P & I): $1,080
Fed implements contractionary Monetary Policy making money more scarce
30 year loan at 8% interest rate
$53,000 to $60,000 annual salary
Monthly Payment (P & I): $1,321

21. Your First Condo in Denver
So you want to buy your first Condo…
Assume
$125,000 Purchase Price
Loan term 30 years
$20,000 down payment (thanks grandma!)
Interest Rate
Monthly
Payment (P & I)
Salary Required
6.5%
$663.67
$28K - $32K 7%
$698.57
$29K - $34K 8%
$770.45
$32K - $37K 9%
$844.85
$35K - $40 K
$30,000 annual salary is roughly equal to an hourly wage of: $15 per hour