Lesson 2: Money and the Payments System

Upon completion of this lesson, you should be able to do the following:
  • Explain why an economy that uses a barter system would produce a limited number of goods and services.
  • Describe how the functions of money overcome the problems in a barter system.
  • The desirable characteristics of money, so people will use money to buy goods and services.
  • Identify the different kinds of payment systems.
  • Describe how central banks measure the money supply.

Use of the Barter System

Imagine what the economy would be like, if there were no money. Without money, the only way buyers and sellers could exchange goods is by directly exchanging one good for another good. This type of system is called barter, and barter has many problems.

1. Double coincidences of wants - If you produce shoes and you wanted Coca-Cola, you would have to search for a person who produced Cola-Cola and needs shoes. There could be considerable search time in finding that person

2. Storage - Many goods, like fruits and vegetables, deteriorate over time. Growers of perishable goods would have a difficult time storing their purchasing power.

3. No common unit of price measurement among goods - If a store had 1,000 products and there was money, this store would have 1,000 price tags. Customers could easily compare products. With barter, there would be 499,500 price exchange ratios. Each good's price would be stated in terms of all other goods.

Example of price exchange ratios:

• 1 apple = 3 bananas
• 2 Coca-Colas = 1 apple
• 1 cup of coffee = 1 Coca-Cola

The formula:

Number of Price = n (n - 1) / 2

Exchange Ratios

 n: The number of products under a barter system

4. Limited Number of Goods and Services - Business people would have difficulty in writing contracts for future payments of goods and services under a barter system. As a result, a barter society would be only able to produce a limited number of goods and services.

Use of the Currency System

Today, countries use coins and paper bills as money. The value of paper bills and coins is called currency. Money eliminates many of the problems encountered with the barter system and has four functions.

  1. Medium of exchange - Money can be used for payments of goods and services and repayment of debts. The medium of exchange function promotes efficiency. For example, I am an economics instructor. Under a barter system, I would have to go to the market and teach a another person for goods and services that I need. In this case there could be considerable search costs for people wanting economics instruction. With money, I do what I do best and teach for money. Then I take this money and go to the market and buy goods and services that I want. This function of money allows the specialization of labor to occur and eliminates the problem of double coincidence of wants under a barter system.

  2. Unit of account - Money conveniently allows a way of placing specific values on goods and services. For example, a two-liter of Coca-Cola costs $0.89 while Pepsi costs $0.99. Customers can easily judge which product is cheaper. This function is extremely important for businesses. Businessmen can place a value on buildings, machines, computers, and other assets. This information is recorded on financial statements. Investors read the financial statements and can gauge which companies are profitable. Finally, this function of money eliminates the massive number of price exchange ratios that would occur under a barter system.

  3. Store of value - Money has to retain its value. For example, if a two-liter of Coca-Cola costs $0.99 today, then it should cost $0.99 tomorrow. Inflation erodes the "store of value" of money. As the price level increases, the value of money decreases, because each unit of money buys less goods and services. Inflation causes consumers to lose their purchasing power over time. If the inflation rate becomes too high, then money as a "medium of exchange" breaks down too! In countries that have high inflation rates, people will use barter more and immediately exchange their local money for more stable money, such as German marks or U.S. dollars. However, people are still required to use money as a medium of exchange, because government laws legally require people to accept money as a means of payment to pay off a debt or to pay taxes. This legal requirement is known as "legal tender."

  4. Standard of deferred payment - This function combines the "medium of exchange" and "unit of account" of money, because debts are stated in terms of a "unit of account," and paid by "medium of exchange." This function of money is extremely important for business transactions that will occur in the future. Businesses and people can borrow or lend money based on future transactions.

Desirable Characteristics of Money

For money to be used by people and businesses, money needs five desirable properties.

  1. Acceptability - The businesses and public accept it as payment for goods and services.

  2. Standardized quality - The same units of money must be the same size, quality, color, so people are certain what they are getting.

  3. Durability - Has to be physically durable or it may lose its value quickly.

  4. Valuable relative to its weight - Large amounts of money can be used in transactions and easily carried around.

  5. Divisibility - Money must be broken down into smaller units to purchase low value goods and services.


Types of Payment Systems

Four types of money systems facilitate business transactions through the payments system.

  1. Commodity Money - one commodity is selected as money, such as gold and silver. If this commodity was not used as money, this commodity still has a purpose. Commodity money can be anything. For example, in U.S. prisons, prisoners use cigarettes as money. There are two forms of commodity money.

    1. Full-bodied money - money whose value as a good in non-money purpose is equivalent to its value as a medium of exchange. For example, if the market value of 1 ounce of gold is $400 and the government made 1 ounce gold coins, then the face value of the coin would equal $400. The coin is a full-bodied commodity money. If gold was not used as money, it still has other uses, such as jewelry, teeth fillings, wires. etc. Governments made an unusual discovery about commodity money. What if the government made 1 ounce gold coins and the face value of the coin is equal to $500, while the market value of the gold is $400? The government created a value of $100 out of thin air! The process of creating value by printing money is called seigniorage. This can be a source of revenue for the government and can cause extremely high inflation rates if government depends on this revenue source too much.

    2. Representative full-bodied money - money that inherently has little value, such as paper bills, but the money can be converted into a commodity, such as gold and silver. For example, in the United States before 1933, if you had dollar bills, you could exchange the bills for gold at the government's exchange rate ($20 per ounce). Most of mankind used some form of commodity money before the 20th century, but commodity money has been replaced by fiat money.

  2. Fiat Money - issued by governments and central banks. Most money used in the world today is this type and fiat money is a 20th century invention. In the United States, the Federal Reserve System is the authority that issues U.S. dollars. This money cannot be used as anything else, and cannot be exchanged for another commodity from government. For example, if the U.S. dollar bill was not used as money, it has no other functions other than being fancy paper. There is no authority that limits how much money the Federal Reserve System issues. If the Fed wanted to inject an additional $1 trillion into the economy, it could do so. However, there would be drastic consequences. Countries that have very high inflation rates or hyperinflation are caused by rapid growths in the money supply. A noble prize laureate in economics, Milton Friedman, concluded that "Inflation is always and everywhere a monetary phenomenon."

  3. Checks - credit money issued by financial institutions. Banks, credit unions, and other financial institutions offer checking accounts to people and businesses. The checks are the medium of exchange and can be used to purchase goods and services. Checks have many benefits. People and businesses do not have to carry cash, the check provides proof of a business transaction, and checks are convenient in transactions, such as buying a house or car. The buyer does not have to bring a suitcase of cash for this type of transaction. However, checks have two problems.

    1. Extra fees - financial institution may charge fees for using checks.

    2. Limited acceptance -the check writer abuses their account and writes checks for a greater amount than what is in the account. Some businesses and people do not accept checks, because they cannot verify if this person has sufficient funds in his account.

  4. Electronic Funds improve the efficiency of the payments system. Two major innovations were introduced.

    1. Automated teller machine (ATM) - ATMs are connected together through networks. One of the largest networks is Cirrus. The Cirrus network allows customers to not only access their accounts at financial institutions 24 hours a day, 7 days a week, but from almost every city in the United States and 67 foreign countries around the world.

    2. Debit card - many retail and grocery stores are linked to banks. When a customer makes a purchase, the customer can pay for his goods and services by having the store electronically transfer funds from the customer's checking account to the store's account. The debit card removes the uncertainty that the customer has sufficient funds in his account for the transaction.

Measuring the Money Supply

There are two approaches in defining the money supply.

  1. Transaction approach - emphasizes the money's function as a medium of exchange. Only a few assets possess this property. The reason is a total increase in the money supply by the central bank would cause people to increase their spending, causing national output, income, employment, and inflation to increase.

  2. Liquidity approach -If you take all your assets and rank them by the degree of liquidity, include all assets in a measure of money which can be easily sold at a future time at a known price with minimum costs. Therefore, the money supply will include all assets that have high liquidity. This approach emphasizes money's function as a "store of value," because if the liquid asset retains its value and is highly liquid, it can easily be used to purchase goods and services directly or indirectly. The reason for using this approach is people have portfolios of assets. When the central bank increases the money supply, people will adjust their portfolios of assets, which affects consumer spending, national output, income, and employment.

For exam purposes, please do not memorize all the specific components of the money supply from the book. Only memorize the information below for M1, M2, M3, and L. Every central bank in the world measures its money supply that is very similar to the way the United States measures its money supply. Other countries also define their money supply as M1, M2, and M3. However. the types of financial instruments that are included in these measures may differ. The different kinds of financial instruments that are used in a country depend on its legal structure, types of financial market regulations, and customs. You only need to understand the reasoning of what is included in the money supply.

  1. M1 is the narrowest definition of the money supply and uses the transaction approach in defining what financial instruments are included. Add the following 3 items together.

    • Currency held by the public and in bank vaults. It does not include currency held by the government.

    • All forms of checking accounts.

    • Traveler's Checks that are held by people and not by the banks.

  2. M2 is a broader definition than M1 and uses the liquidity approach of defining the money supply. Add the following items together.

    • Include everything from M1

    • Include all small denomination savings deposits and time accounts at all financial institutions. Small denomination in the U.S. means the account is less than a $100,000.

      • Ex: Certificate of Deposit or Savings account at banks.

  3. M3 is a broader definition than M2. Add the following items together:

    • Include everything from M2.

    • Include large denomination savings and time accounts and liquid securities with longer investment time than the financial instruments included in M2.

      • Ex: A $1 million Certificate of Deposit held by a corporation.

  4. L is broadest measure of the money supply and includes all assets that are liquid. The Fed does not try to control this measure. The "L" means liquidity. Add all the following items together.

    • Include everything from M3.

    • Includes all short-term securities, such as Treasury Bills issued by the Federal government. (Refer to the Appendix at the end of Chapter 3 for short-term securities).

What is the "Best" definition of the Money Supply? The four monetary aggregates grow at different rates, and at different times, and even in different directions. Before 1981, there was a stable relationship between M1 and GDP, but the deregulation of the financial markets in the 1970s and early 1980s obscured this relationship. Currently, many economists use the M2 definition of the money supply to explain changes in the GDP, inflation, and employment. Also the FED does not try to control M1 by formulating targets and concentrates on M2 and M3 instead.