1. 1 Lecture 5: What’s Money? Mishkin chapter 3 – part A Page 49-56

2. 2 Review financial instruments and regulation stock bond and the Lucas tree stock, money, the next person, the ‘bigger fool theory’money

3. 3 Financial instruments and regulation Def. of FI Classification of FI Why regulate?  Information (Y) bankruptcy (N) monetary policy (Y) What to regulate? 1. Increase the information available to investors. 2. Ensure the soundness of financial intermediaries, fight against bankruptcy, prevent financial panics. back

4. 4 Stock bond and the Lucas tree Situation A: sell a security for $100 and agreed to pay back $110 at the end of the year. buy a fruit tree and plant for fruit. In fall, I collect $20 worth of fruits and return $110 as promised. Situation B: sell a security for $100 and promise that as long as the tree live, I would only keep 10 fruits for my self as salary and give whatever fruits left to the security holder. Both are claims on future income and asset  Situation A: only up to the fixed limit of agreed upon 1 year time and $110 payments = principal + interest 10; earn interest  Situation B: residual rights = whole yield minus expenses forever; earn dividend + price appreciation back

5. 5 Meaning of money ‘Green paper with dead presidents’ head.’Green paper Money is defined as anything that is generally accepted in payment for goods or services or in the repayment of debts. This piece of paper is not valuable unless I expect that there is always someone else who thinks it valuable.valuable

6. 6 Compare and contrast Money  liquid  a stock variable Wealth  the total collection of pieces of property that serve to store value. e.g. painting, bonds, house, money, etc.  a stock variable Income  the cash flow of earnings per unit of time. e.g. salary  a flow variable

7. 7 Example A student works part time as a lab assistant, earning $900 per month, and has a checking account balance of $400. He also owns a car worth $1100 and books worth $500. Money  $400 Wealth  ($400 + $1,100 + $500) = $2,000 Income  $900 per month

8. 8 Functions of money 1. Medium of exchange 2. Unit of account 3. Store of value

9. 9 Medium of exchange Money is a medium of exchange: sell for money and use money to buy things. In a barter economy, double coincidence of wants is necessary for trade to happen. Money promotes economic efficiency by minimizing the time spent in exchanging goods and services, lower transaction cost. (search cost, transportation cost) based on trust.

10. 10 Criteria of a good ‘medium of exchange’:  Must be easily standardized  Must be widely accepted  Must be divisible  Must be easy to carry  Must not deteriorate quickly Medium of exchange – Cont’d

11. 11 Unit of account Money is used to measure value In the U.S., each good or service on sale is generally offered at a single quoted “dollar price”. Again, a barter economy would need multiple prices for each good or service. n goods need n*(n-1)/2 prices Money lowers transaction cost (menu cost).

12. 12 Store of value Money is used to save purchasing power. Pros:  It is the most liquid of all assets. Cons:  But could lose value during inflation.

13. 13 Evolution of the Payments System Commodity Money  e.g. precious metals like gold and silver; cattle, tobacco, tea, etc. Fiat Money  paper currency decreed by a government as legal tender but not convertible into precious metal. Checks Electronic payment: ‘wire transfer’ E-Money: e.g. debt card

14. 14 Recap Money  def.  three functions (esp. efficiency of Barter vs. monetary payment systems )  evolution