Role of Money in Modern Economics

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Chapter11: Money, Banking & the Financial Sector

I. Money
A. Money is defined as anything people accept for goods and services. In modern economies, money is national currency. B. In the absence of money, societies use a “barter” system in which goods are exchanged for goods. 1. Barter economies require a “Double Coincidence of Demand” in that the two market participants must each be supplying what the other demands. 2. Barter also implies negotiations over the exchange (a cost modern economies often avoid), which have the economic cost of the time spent for each purchase an individual makes. C.In a more Modern System, paper currency is the means of exchange. Society’s acceptance of it for goods and services gives money its value. President Nixon took the US off the gold standard in 1971 in response to a massive wave of people redeeming gold for dollars. The panic was induced by double-digit inflation. D.Functions of Money:

1.As a “Medium of exchange,” money exchanges are far more convenient than barter, as they do not require any double coincidence of demand. 2.As a “Standard of value” or monetary unit, the value of any good or service can be compared, whether the goods being compared are very similar to each other or extremely different. 3.As a “Store of value” money enables saving, although inflation can diminish this function. It does not deteriorate (rot) like many commodities, and the ability to earn interest increases the utility of this function. 4.As a “Means of deferred payment,” money facilitates the credit system (includes credit cards and payment plans for durable good purchases) and all other types of loans. E.The purposes people hold money are:

1.Transaction – regular purchases
2.Precautionary – emergency costs or unexpected income adjustments 3.Speculative – stocks or goods purchased in the expectation their value will increase in the future.

II. Money Supply: Money in our economy is demand deposits plus currency and coin. A.“Demand deposits” are checking accounts held at financial institutions known as “Depository Institutions.” Mostly these are commercial banks. B.Besides demand deposits, the Money Supply also includes currency and coin in circulation (held by people). C.“Fiat” money has less value as a commodity itself, and more value as a money. If our coins were solid gold, then it would not be fiat money. Literally, fiat means by declaration; in this case, it is the government declaring a national currency as the accepted means of exchange. D.Specifically, the government declares their national currency to be “Legal Tender,” or money that must be accepted for payment of public or private debt. E.The solid gold coin would be called “non-debased” if its value as a metal equals its value as a currency. Modern fiat money is “debased” by the definition of fiat money. F.“Gresham’s Law” is that debased money will drive non-debased money from circulation. This is partly because non-debased money has other uses (e.g., for gold, jewelry and crafts) and partly because non-debased money has become an item for collectors, bidding up its value beyond the original value as money. These factors significantly prevent non-debased money from circulating in the US economy. G.Money is debt, and the supply of money is the monetization of certain forms of debt, meaning your demand deposits and currency holdings are in the form of money (monetized) and it is debt since the demand deposits are a liability to the bank, which must have the money there for account-holders to withdraw, and currency is a liability for the Fed, which ensures that it will provide a new bill in exchange for an old bill. H.Measuring the Money Supply

1.M1: demand deposits, plus currency and coin in circulation. 2.M2= M1 + near monies
i.“Near Monies” will store value but cannot themselves be in circulation for purchases. Savings deposits, small time deposits (e.g. a 3-month certificate of deposit), and...
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