1. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 2 Money and the Payments System

2. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 2-2 Meeting the Needs of Exchange 3 methods to gain the efficiency benefits of specialization include barter, government allocation, and money Money can help people benefit from specialization without incurring the high trading costs of barter or the misallocations of government allocation

3. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 2-3 Figure 2.1 Methods of Exchange

4. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 2-4 Functions of Money Medium of exchange Unit of account Store of value Standard of deferred payment

5. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 2-5 Criteria for Medium of Exchange Acceptable to most traders Standardized quality Durable Valuable relative to its weight Divisible

6. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 2-6 Payments Systems Commodity money –Physical goods (precious metals) by which trade was accomplished Fiat money –Money authorized by a central bank is the definitive money and doesn’t have to be exchanged for gold or commodity money Checks –Promises to pay definitive money on demand, drawn on money deposited in a financial institution Electronic funds –Computerized payment-clearing

7. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 2-7 Measuring the Money Supply To understand money’s role as an economic variable, we need to measure it. Definitions of the money supply are based o the assets included as money and depend on how substitutable different assets are for money. Liquidity refers to the cost at which an asset can be converted into definitive money.

8. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 2-8 Monetary Aggregates The Federal Reserve has developed 3 definitions of money that include assets broader than currency, called monetary aggregates:  M1  M2  Broader monetary aggregates

9. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 2-9 Figure 2.2 Measuring Monetary Aggregates, February 2006

10. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 2-10 Selecting Monetary Aggregates M2 currently considered best. Aggregates move broadly together over long time periods. Some significant differences in monetary aggregate movements have occurred during certain periods The different monetary aggregates give a different picture of movements in the money supply over time.

11. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 2-11 Figure 2.3 Growth Rates of M1 and M2, 1960-2006