Chapter 1 what is money

Chapter 1 what is money © 2013 Pearson Education, Inc All rights reserved 3 1 Required Chapters • 1) Why study Money, Banking and FMs? • 2) An overview of the Financial System • 3) What is Money? • 4) Understanding the interest rates • 5) The behavior of interest rate • 6) Risk and Term structure of Interest rate • 8) An Economic Analysis of Financial Structure • 10) Banking Management of FIs • 13) Central Banks Federal Reserve System • 15) The tools of Monetary Policy • 17) The Foreign Exch.

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Required Chapters

• 1) Why study Money, Banking and FMs?

• 2) An overview of the Financial System

• 3) What is Money?

• 4) Understanding the interest rates

• 5) The behavior of interest rate

• 6) Risk and Term structure of Interest rate

• 8) An Economic Analysis of Financial Structure

• 10) Banking & Management of FIs

• 13) Central Banks & Federal Reserve System

• 15) The tools of Monetary Policy

• 17) The Foreign Exchange Market

Chapter 1

Overview of Finance and Money

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What is Finance?

• “The study of how individuals, institutions,

governments and businesses acquire,

spend, and manage money and other

financial assets” (Melicher & Norton, 2013)

• Finance is the study of concepts,

applications, and systems that affect the

value (or wealth) of individuals, companies,

and countries over the short and long term

(Erik Banks, 2015)

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Meaning of Finance

• The study of how money is managed and the actual process of acquiring needed funds

• Individuals, business & government entities need funding to operate

• à Personal finance, corporate finance & public finance

Public Finance

• The study of the income and expenditure of

the Government

• the collection of funds and their allocation

between various branches of state activities

Corporate Finance

• The financial activities related to running corporation

• Goal: Maximing shareholder value

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Personal Finance

• Apply principles of finance to the monetary

decisions of an individual or family unit

• Obtain, budget, save and spend monetary

resources over time, taking into account

various financial risk and future life events

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Goals of finance

• To maximize the value of operation

• To manage liquidity and solvency – Liquidity: a sufficiency of cash (or assets that can be quickly converted to cash) to pay bills and cover any surprises or emergencies (“thanh khoản”)

– Solvency: a sufficiency of capital to meet unexpected losses (“thanh toán”)

• To manage risk: operating risk, financial risk, legal risk, environmental risk

•

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What is money?

Khái niệm tiền tệ

Money

Stock

Bond

Commodities

gold

Land

Real estate

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Meaning of Money

• What is it?

• Money (or the “money supply”): anything that is generally accepted in payment for goods or services or in the repayment of debts

Meaning of Money (cont’d)

• Money (a stock concept) is different from:

• Wealth: the total collection of pieces of

property that serve to store value (e.g

stocks, bonds, lands)

• Income: flow of earnings per unit of time

(a flow concept)

The Evolution of Money

If money did not exist, what would the world be like?

-> Barter Economy-moneyless economy that relies on trade or barter

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Early Money

• Early Societies developed forms of

proto-money which were commodities that

everyone agreed to accept in trade

• Examples:

Aztecs-Cacao Beans (aka cocoa beans)

Norwegians-Butter

Colonists- Tobacco leaves, animal hides

China, India, Thailand, and West Africa-Cowrie

shells

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Money in Primitive Societies

Commodity Money- money that has an alternative use as an economic good, or commodity

Fiat Money- money by governmental decree

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Money in Colonial America

• Both fiat money and commodity money were used in the original thirteen colonies

– Commodity money in America was used to settle debts, make purchases, or for personal consumption – In Massachusetts the local government gave wampum shells a monetary value

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Early Paper Currency

• Early paper money was backed

by gold or silver deposits, served as currency for immediate area

• States printed money in form

of tax anticipation notes which supplies and meet other expenditures until they received taxes and redeemed the notes

• 1775 Continental Congress printed money that was not backed by gold or silver

• Issues??

Specie in the Colonies

Specie- money in the form of gold or silver

coins

• Most desirable form of money because of

mineral content, and limited supply

• 1776 there was $12million dollars worth of

coin vs $ 500 million in paper money

The Characteristics of Money

Portability- can be easily transferred from one person to another, and makes the exchange of money for products easier

Durable- does not deteriorate when handled and can be easily replaced

Divisible- should be able to be broken down into smaller units so that people can use only as much as needed for a transaction

Limited Supply- can not have to much of something because then it becomes worthless

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So does our money meet all the

necessary requirements?

•

Portability-light weight, convenient, easily transferable

•

Durable-Coins tend to last over 20 years, and paper

currency lasts 18 months in circulation before

being replaced

•

Divisible-Penny is small enough for almost all purchases,

and can write checks for exact amounts

• Limited

Supply/Stability-Fluctuates, grew at a rate of 10-12 percent a

year in 1970’s, but for the most part there is a

stable and limited supply

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Which of these items meet the four characteristics of

money?

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Functions of Money

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• a medium of exchange:

– When any good or service is purchased, people use money

– Money makes it easier to buy and sell because money is universally accepted

– Money, then, provides us with a shortcut in doing business

• By acting as a medium of exchange, money

performs its most important function

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• A Medium of Exchange:

– Eliminates the trouble of finding a double

coincidence of needs (reduces transaction costs)

– Promotes specialization

• A medium of exchange must

– be easily standardized

– be widely accepted

– be divisible

– be easy to carry

– not deteriorate quickly

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Example: Money as a medium of exchange

Individual A

Offers bread Demands soda

Individual B

Offers soda Demands bananas

Individual C

Offers bananas Demands bread

Individual D

Offers bananas Demands

An example of a barter economy Trade in this 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.

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Money As a Medium of Exchange

• Money does not have to have any inherent

value to function as a medium of

exchange

• All that is necessary is that everyone believes

that other people will exchange it for their

goods.

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Functions of Money (cont’d)

• Unit of Account (Measure/ Standard of Value)

– Used to measure value in the economy – Without money, we would have to measure the value of goods and services in terms of other goods and services.

– reduces transaction costs

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Functions of Money (cont’d)

• Unit of Account

No of

Products =

n

No of prices in non-monetary economy

= n(n-1)/2

No.of prices in a monetary economy = n

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Store of Value

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• Store of Value:

– used to save purchasing power over time – other assets also serve this function – Money is the most liquid of all assets but loses value during inflation

• Money is a financial asset that can be used to store wealth (income that you have saved and not consumed).

• As a store of wealth, money pays no interest, but is perfectly liquid.

• Money’s usefulness as a store of wealth depends on how will it maintains its value.

Store of Value

• If you could buy 100 units of goods and

services with $100 in 1982, how many

units could you buy with $100 in 2010?

– Answer: you could have bought <50 units

– During this period, inflation robbed the dollar

of almost half of its purchasing power

• Over the long run, particularly since

World War II, money has been a very

poor store of value

– However, over relatively short periods of

time, say, a few weeks or months, money

does not lose much of its value

Standard of Deferred Payment

• Many contracts promise to pay fixed sums of money well into the future – A couple of examples are 30-year corporate bonds and a 20-year mortgage

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Evolution of the Payments System

• Payment system:

Method of conducting transactions in the economy

• Means of payment:

1 Commodity Money

2 Fiat Money

3 Checks

4 Electronic means of payment

5 Electronic money

Commodity money

– Commodity money is a means of payment made out of

precious metals such as gold or silver or other valuable commodities.

– It has been the prevailing medium of exchange in most

societies since classical times up to around two hundred years ago.

Roman circus coin (Hadrianus) 1878 Brasher doubloon

Commodity money Commodity money fulfills the criterion of general acceptance,

because it consists of materials which are already high in

demand.

It comes with a number of problems , however:

1 It’s value is not necessarily easily to prove for everyone.

Problems of forgery or debasing have been common in

history.

2 Commodity money is generally heavy and hard to

transport.

3 The value of commodity money varies with the value of

the underlying commodity and, therefore, is subject to

fluctuations of supply and demands for these goods.

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Fiat Money

qThe development of bank notes – originally backed

commodity money.

q Paper money quickly converted into fiat money:

money issued by governments as legal tender, but without any right of convertibility

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Checks

– Checks are an instruction to a bank to transfer money from

one person’s account to the bank account of the recipient once

he or she deposits the check.

– Checks, thus, solve the problem of transport for large

amounts of money and facilitate transactions in a number of

other ways.

– However, two problems arise with the use of checks:

• Moving checks from one point to another takes time

• The processing of checks does not come for free and imposes a

transaction cost by itself to society

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Electronic payment

qIncreasingly common forms of means of transaction

are electronic payment services offered online by banks.

qInstead of mailing out a check for every single

payment, you simply log on to the bank’s web site or have your money automatically deducted on a regular basis

qElectronic payment is a very common means of

transaction in many countries.

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E-Money

Not only checks get increasingly substituted by

electronic forms of payment, cash has also been partly

replaced by other instruments

Common forms of E-money include

q Debit and credit cards

q Money cards or “smart” cards

q E-cash

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THE FUTURE OF MONEY

Question: Which function of money will be

with us for a long time?

Answer:

– Means of payment: disappearing – Unit of account: likely to remain – Store of value: disappearing

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FYI Are We Headed for a Cashless

Society?

• Predictions of a cashless society have been

around for decades, but they have not come

to fruition

• Although e-money might be more

convenient and efficient than a payments

system based on paper, several factors

work against the disappearance of the paper

system

• Still, the use of e-money will likely still

increase in the future

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• Technological advances create new methods

of payment

• Cell phones and other types of hand-held mobile devices are providing access to the payments system

• What will be next?

TECHNOLOGICAL ADVANCES AND PAYMENT METHODS

Measuring money

qWe defined money as anything generally accepted

in payment for goods and services

qSince many commodities have had this function in

history, we need a closer definition of money to

measure the actual stock of money in an economy at

a specific point in time

Measuring Money

• Changes in the quantity of money are related to

– Interest Rates – Economic Growth – Inflation

• How do we measure money? Which particular assets can be called “money”?

• Construct monetary aggregates using the concept of liquidity

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DEFINITION OF LIQUIDITY

Liquidity: a measure of the ease an asset

can be turned into a means of payment

(Money)

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THE LIQUIDITY SPECTRUM

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Measuring Money (Different

Definitions for the Money Supply)

• M1- component of the money supply relating to money’s role

as a medium of exchange

– Currency (Coins and Paper Money) – All checkable deposits (travelers checks, checking account)

• M2- component of the money supply relating to money’s role

as a store of value

– Savings (savings deposit & money market deposit account)

– Small time deposits (6 mo CD) – Money market funds (mutual fund)

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Table 1 Measures of the Monetary Aggregates

Monetary Aggregates

Currency

Traveler’s Checks

Demand Deposits

Other Check Dep

M1 (4) M2 (4+3)

M3 (4+3+4)

Small Den Dep.

Savings and MM Money Market Mutual Funds Shares

KHỐI TIỀN (tt)

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M1 vs M2

• Does it matter which measure of money is

considered?

• M1 and M2 can move in different directions

in the short run (see figure)

• Conclusion: the choice of monetary

aggregate is important for policymakers

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Figure 1 Growth Rates of the M1 and M2 Aggregates, 1960–2011

Sources: Federal Reserve Economic Database (FRED); Federal Reserve Bank of Saint Louis;

http://research.stlouisfed.org/fred2/categories/25

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