In this chapter you will learn to:

• Describe what money is

• List and summarize the functions of money
• Identify different types of payment systems
• Compare and contrast the M1 and M2 money
supplies
• Economists define money as anything that
is generally accepted as payment for goods or
services or in the repayment of debts.

• Currency, consisting of paper bills and coins,

clearly fits this definition and is one type of
money. When most people talk about money,
they’re talking about currency.
• Economists make a distinction between money
in the form of currency, demand deposits and
other items that are used to make purchases,
and wealth.

• Wealth is the total collection of pieces of

property that serve to store value. Wealth
includes not only money but also other assets
such as bonds, common stock, art, land,
furniture, cars, and houses.
• People also use the word money to describe
what economists call income.

• Income is a flow of earnings per unit of time.

Money, by contrast, is a stock: It is a certain
amount at a given point in time.
• If someone tells you that he has an income
of $1,000, you cannot tell whether he earns a
lot or a little without knowing whether this
$1,000 is earned per year, per month, or even
per day.

• But if someone tells you that she has $1,000 in

her pocket, you know exactly how much this is.
“Money is anything that is generally accepted
as payment for goods and services or in the
repayment of debts and is distinct from
income and wealth”.
• In almost all market transactions in our economy,
money in the form of currency or checks is a
medium of exchange; it is used to pay for goods
and services.
• The use of money as a medium of exchange
promotes economic efficiency by minimizing the
time spent in exchanging goods and services.

• A barter economy, one without money, in which

goods and services are exchanged directly for
other goods and services.
• The time spent trying to exchange goods or
services is called a transaction cost.

• “Double coincidence of wants”.

Money is therefore essential in
an economy: It is a lubricant
that allows the economy to run
more smoothly by lowering
transaction costs, thereby
encouraging specialization
and division of labor.
For a commodity to function effectively as money, it
has to meet several criteria:
(1) It must be easily standardized, making it simple
to ascertain its value.
(2) It must be widely accepted.
(3) It must be divisible, so that it is easy to “make
change”.
(4) It must be easy to carry.
(5) It must not deteriorate quickly.
Using money as a unit of account lowers transaction
costs in an economy by reducing the number of
prices that need to be considered.
• In a barter economy, if the economy has only three
goods: peaches, economics lectures, and movies.
If there were 10 goods, 100 goods, 1000 goods,…

• The formula for telling us the number of prices we

need when we have N goods.
N(N−1)
2
• This function of money is useful because most of
us do not want to spend our income immediately
upon receiving it, but rather prefer to wait until we
have the time or the desire to shop.

• Money is not unique as a store of value. Any asset

- whether money, stocks, bonds, land, houses, art,
or jewelry - can be used to store wealth.
• The answer to this question relates to the
important economic concept of liquidity, the
relative ease and speed with which an asset can
be converted into a medium of exchange.

• Money is the most liquid asset of all because it is

the medium of exchange; it does not have to be
converted into anything else to make purchases.

• How good a store of value money is depends on

the price level (inflation).
• At one point, precious metals such as gold were
used as the principal means of payment and were
the main form of money.
• Later, paper assets such as checks and currency
began to be used in the payments system and
viewed as money.
• Money made up of precious metals or another
valuable commodity is called commodity money.
• The problem with a payments system based
exclusively on precious metals is that such a form
of money is very heavy and is hard to transport
from one place to another.
• Imagine the holes you’d wear in your pockets if
you had to buy things only with coins! Indeed, for a
large purchase such as a house, you’d have to
rent a truck to transport the money payment.
• Initially, paper currency carried a guarantee that it
was convertible into coins or into a fixed quantity
of precious metal.
• However, currency has evolved into fiat money,
paper currency decreed by governments as legal
tender (meaning that it must be accepted as legal
payment for debts) but not convertible into coins or
precious metal.
• Major drawbacks of paper currency and coins are
that they are easily stolen and can be expensive to
transport in large amounts because of their bulk.

• To combat this problem, another step in the

evolution of the payments system occurred with
the development of modern banking: the invention
of checks.
• A check is an instruction from you to your bank to
transfer money from your account to someone
else’s account when she deposits the check.

• The use of checks thus reduces the transportation

costs associated with the payments system and
improves economic efficiency.
• They can be written for any amount up to the
balance in the account, making transactions for
large amounts much easier.

• Checks are also advantageous in that loss from

theft is greatly reduced and because they provide
convenient receipts for purchases.
• Money that exists only in electronic form.

• The first form of e-money was the debit card.

• Credit card, Prepaid card, Electronic wallet

• To measure money, we need a precise definition
that tells us exactly which assets should be
included.

• The Federal Reserve System (the Fed), the

central banking authority responsible for monetary
policy in the United States, has conducted many
studies on how to measure money.

• Monetary aggregates
• The narrowest measure of money reported by the
Fed is M1, which includes the most liquid assets:
currency, checking account deposits, and traveler’s
checks.
• The M2 monetary aggregate adds to M1 other
assets that are not quite as liquid as those included
in M1: assets that have check-writing features
(money market deposit accounts and money market
mutual fund shares) and other assets (savings
deposits and small-denomination time deposits) that
can be turned into cash quickly and at very little
cost.
1. Jane Doe has the following assets:
- $100 in her wallet.
- $800 in her checking account.
- $1,000 in her savings account.
- A $20 traveler’s check from her last business
trip to China.
- A $300 outstanding credit card bill.
- $3,000 in a small certificate of deposit.
- A car worth $5,000.
- A house, worth $200,000.
Answer these questions:
a. Identify which are in M1, which are in M2, or
in neither M1 nor M2.
b. Suppose she takes the $100 in her wallet and
deposits it in her checking account. What is
the change in M1 and M2?
c. Suppose she takes $400 from her checking
account and deposits it in her savings
account. What is the change in M1 and M2?
2. Suppose Tabatha takes $500 from her savings
account and deposits it in her checking account.
What is the change in M1 and M2?
a. M1 increases and M2 decreases
b. M1 increases and M2 remains unchanged
c. M1 and M2 both increase
d. M2 increases and M1 remains unchanged
e. M1 and M2 both remain unchanged
3. Which of the following is NOT a
component of the M2 definition of the money
supply?
a. Certificates of deposit
b. Checking account deposits
c. Retail money market funds
d. Travelers checks
e. All of these are components of the M2
definition of the money supply.
4. True/False. Explain:
Nelson takes a $100 bill he had in his
wallet and deposits it into his checking
account. Thus, M1 increases by $100.

5. Identify the components of M1 and

M2?