ECMC48 Chapter 3.docx

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Economics for Management Studies
Jack Parkinson

Chapter 3: What is Money? 1. Money (Definition): a) Money - anything that is generally accepted in payment for goods & services OR in the repayment of debts; a stock concept (at a given point of time) b) Wealth - the total collection of all pieces of property that serve to store value (money, stock, bonds, art real estate etc) c) Income - flow of earnings per unit of time d) An even broader definition of money (than simply coins & notes in circulation) is often needed because other items such as savings deposits can in effect function as money if they can be quickly and easily converted into currency OR chequing account (demand) deposits 2. Function of Money a) Medium of Exchange i. Money in the form of currency (coins & notes), cheques or demand deposits is used to pay for goods & services in most market transactions in an economy ii. Function as Medium of Exchange 1. Money promotes economic efficiency by minimizing the time spent in exchanging goods and services (lower transaction cost) 2. Money also promotes productive efficiency by allowing people to specialize in what they do best (specialization & the division of labour) with time saved from producing a whole array of goods & services to trade under barter 3. Money is essential in an economy because by acting as a means of payment it provides liquidity which acts as a lubricant that allows the economy to run more smoothly by lowering production & transaction costs b) Unit of Account i. Used to measure value (of assets & liabilities) in the economy ii. Function as Unit of Account 1. introduce money (a single reference good) into the economy and have all prices quoted in terms of units of that money 2. Using money as a unit of account reduces transaction costs in an economy by reducing the number of prices that need to be considered and the benefits of this function of money grow as the economy becomes more complex c) Store of Value i. Used to save purchasing power; most liquid of all assets but loses value during inflation ii. Money acts as a repository of purchasing power from the time income is received until the time it is spent iii. Function as Store of Value 1. Money is not unique as a store of value in which other assets like bonds, stocks, and real estate are not only used to store wealth, but also have advantages over money when they often pay the owner a higher interest rate, experience price appreciation, and deliver services such as providing a roof over one’s head 2. One characteristic that money has as a store of value in which other assets lack is liquidity (the relative ease and speed with which an asset can be converted into a medium of exchange) 3. Liquidity is highly desirable and money is the most liquid asset of all because it is the medium of exchange itself (whereas other assets involve transaction costs when they are converted into money) 4. How good a store of value money is depends on the price level because its value is fixed in terms of the price level (doubling the price level will cut the real value of money in half) 5. During an inflation, price level is increasing rapidly, money loses value rapidly, and people will be more reluctant to hold their wealth in this form (at least in domestic currency form). Transaction declines and barter becomes dominant. Output in the economy fell sharply during hyperinflation when transaction costs skyrocketed 3. Evolution of the Payments System a) Payments system is the method of conducting transactions in the economy b) Gresham’s Law i. The bad money drives out the good (money) c) Barter i. Barter is the direct exchange (trade) of goods & services for goods & services ii. Pros – Allows agents to obtain a wider array of goods & services (i.e. do not have to be self-sufficient). More prod’n specialization & jobs iii. Cons – There can be significant search costs (looking for a double coincidence of wants), high transactions costs, lots of relative prices (& these can be volatile), problems of indivisibilities & lack of anonymity d) Commodity Money (Gresham’s Law) i. Commodity money – Money made up of (or backed by) precious metals or some other valuable commodity (any object that clearly has value to everyone is likely candidate to serve as money) 1. Since this commodity is scarce/valuable it is a store of value. 2. If people start measuring assets & liabilities in units of this commodity it is now a unit of account. 3. If people use/accept it as a means of payment it is a medium of exchange. ii. Pros – No longer need double coincidence of wants. Lowers search & transactions costs, fewer (usually more stable) prices, (greater) divisibility, anonymous, greater production specialization, more trade & commerce. All the benefits of fixed exchange rates (e.x. M exogenous & QTM). iii. Cons – One problem with money based exclusively on precious metals is this form of money is very heavy and is hard to transport, inspect & store, and it is not easily divisible without wastage. All the negatives of fixed exchange rates (e.x. if S M suddenly rises & QTM). iv. Criteria 1. must be easily standardized making it simple to ascertain its value 2. must be widely accepted 3. must be divisible so that it is easy to ‘make change’ 4. must be easy to carry 5. must not deteriorate quickly or be counterfeited easily e) Paper notes (Gresham’s Law)
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