Introduction To Money Payment System-2

Lecture 1
Introduction to
Money & Payment System
Introduction
• There are 6 parts in a financial system :
– Money
– Financial Instruments
– Financial Markets
– Financial Institutions
– Government Regulatory Agencies
– Central Banks (e.g. Hong Kong Monetary Authority
HKMA)
• Five Core Principles of Money & Banking :

– Time has value
– Risk requires compensation
– Information is the basis for decisions
– Markets determine prices & allocate resources
– Stability improves welfare
2
Six Parts of the Financial System
1. Money
To buy goods & services, and store wealth.
2. Financial Instruments
To transfer resources from savers to investors and risk to those best
equipped to bear it.
3. Financial Markets
Physical or virtual places for buying & selling financial instruments.
4. Financial Institutions
To provide access to financial markets, collect information & provide
services.
5. Government Regulatory Agencies

To provide oversight for financial system.
6. Central Banks
To monitor financial Institutions and stabilize the economy.
3
1. Money
– Has been changed from gold/silver coins
to paper currency and then electronic
funds.
– e.g. Cash can be obtained conveniently
from ATM anywhere in the world.
– Bills can be paid and transactions can be
checked online.
2. Financial Instruments
– Transfers resources from savers (e.g.
depositors) to investors (e.g. borrowers).
– Buying and selling individual stocks used
to be available to wealthy people only.
– Today we have mutual funds and other
investment products available through
banks and other financial institutions.
3. Financial Markets
– Allow and facilitate the buying and selling
of financial instruments.
– Can be well-organized markets such as
the New York Stock Exchange (NYSE),
Hong Kong Stock Exchange (HKEx)
– Now transactions are mostly handled by
electronic markets, which
• reduce the cost of processing financial
transactions, making way for a much
broader array of financial instruments
available.
4. Financial Institutions
– Provide all kinds of services such as
providing access to financial markets and
gathering information.
– Banks began as vaults, then developed
into institutions that accepted deposits
and gave loans, and evolved to financial
supermarket.
5. Government Regulatory Agencies

– Make sure the elements of the financial
system are operated safely and reliably.
– Design and set up financial regulations,
rules, and supervisory framework; and
examine the systems the bank use to
manage their risks.
– The 2007 - 2009 financial tsunami led
governments to greater regulation, such
as the Dodd-Frank Wall Street Reform
and Consumer Protection Act.
6. Central Banks
– Monitor and stabilize the financial system.
– Began as large private banks to finance
wars.
– Control the money supply and credit to
promote low inflation, high economic
growth and stability of financial system.
– Policymakers also strive for transparency
in their operations.
– The Financial Tsunami of 2007 - 2009 led
the US central bank to try many new
policy tools.
Five Core Principles of Money and Banking
1. Time has value (‘Time Value of Money (TVM)’)
– Time affects the value of financial instruments.
– Interest payments come from the time properties of financial
instruments.
2. Risk requires compensation

– Individuals will accept risky investments only if they are
adequately compensated.
3. Information is the basis for decisions

– Collecting and processing of information is the basis of the
financial system.
– People need enough information before making a decision.
– The more important the decision, the more information people
want.
10
Five Core Principles of Money and Banking
4. Markets determine prices & allocate resources
– The physical or virtual places where buyers &
sellers “meet” and carry out transactions.
– Help channel economic resources and
minimize the cost of collecting information and
making economic transactions.
5. Stability improves welfare

– A stable economy is a desirable quality and
reduces risk and improves everyone's welfare.
– e.g. risk of losing job, risk of company failure.
11
Money and the Payments System
 What is Money ?
 The Payments System.
 Money Measurement and Money
Aggregates.
12
Defining Money
Money is an asset generally accepted as payment
for goods & services, or repayment of debt.
It may also be defined as anything that :
1. has instant purchasing power, and,

2. can be converted into means of payment without
delay, and without the risk of capital and interest
loss.
13
Defining Money
It has 3 main characteristics :
1. Means of payment
Used in exchange for goods & services.
2. Unit of account
Used to quote prices and as a standard of
value.
3. Store of value
Used to move purchasing power from now to
the future. It provides good liquidity (a measure
of how easy to turn an asset into a means of
payment).
14
Defining Money
Means of Payment
• People insist on payment in money.
– Barter requires a “double coincidence of
wants”.
• Money can finalize payments easily so there
is no further claim on buyers and sellers.
• The increase in the numbers of buyers and
sellers requires something like “money” to
make transactions smoother.
Defining Money
Unit of Account
• Money is used to quote prices and record
debts - it is a standard of value.
• Prices provide the information needed to
ensure resources are allocated to their best
uses.
• Using dollars makes relative price
comparisons easier.
Defining Money
Store of Value
• A means of payment has to be durable and
capable of transferring purchasing power from
one day to the next.
• Paper currency does degrade, but is accepted
at face value in transactions.
• Other forms of wealth can also store value :
stocks, bonds, real estates etc.
Defining Money
Store of Value (cont.)

• Although other stores of value are
sometimes better than money, we hold
money because it is liquid.
• Liquidity is a measure of the ease with which
an asset can be turned into a means of
payment.
– The more costly it is to convert an asset
into money, the less liquid it is.
Defining Money
Store of Value (cont.)

• For financial institutions :
– Market Liquidity - the ability to sell assets

for money.
– Funding Liquidity - ability to borrow money
to buy securities or make loans.
The Payments System
• The payments system is a web of
arrangements that allows for the exchange of
goods, services, and assets.
– The efficient operation of the economy
depends on the payments system.
• Money is at the heart of the payments system.

The Payments System
The possible methods of payment are :
1. Commodity and Fiat Monies

2. Checks (or cheques)
3. Electronic Payments
Commodity and Fiat Monies
• Commodity monies : with intrinsic value.

– E.g. gold, silver.
• A commodity money must be :

– usable by most people;
– can be made into standardized quantities;
– durable;
– easily transportable; and,
– divisible into smaller units.
• Gold has been the most common commodity
money as it meets all these requirements.
• In 1661, Stockholm Banco issued Europe's

first paper money
– King of Sweden printed too much to try to
finance a war and the bank finally failed.
• In 1775, the Continental Congress of the

United States of America issued
“continentals” to finance the Revolutionary
War.
– Both governments issued too much and
the currency became worthless.
• Because of the failures, people became
suspicious of government-issued paper
money.
• In 1862, the Confederate and the Union

governments printed money with no explicit
backing.
• After the Civil War, the US reverted to using

gold as money.
• Gold coins and notes are backed by gold and
were used into the 20th century.
• Today’s paper money is called fiat money and

its value comes from government decree, or
fiat.
• We accept these bills as payment because the

government (e.g. US government) stands
behind the paper money. (i.e. value of bills is
based on the credit standing of the
government)
• Some critics claim the US should return to the
gold standard because of the fear of
governments issuing too much paper money,
especially after the financial tsunami.
• A gold standard may not be time consistent.

– In a crisis, a government can renege on the
use of a gold standard to stabilize the
economy.
– Movement away from the gold standard was
prompted by the Great Depression.
• A fiat currency must be limited in volume of

circulation to be credible.
Checks
• A check (or cheque) is an instruction to the
bank to take funds from your account and
transfer them to another account.
– A check is therefore not a final payment as
currency is - it only sets in motion a series
of transactions.
• The series of transactions put in motion can

be illustrated by the diagram on next page.
The Path of a Paper Check
Electronic Payments
• Electronic payments take the form of :
– Credit and Debit Cards

– Electronic Funds Transfers
– Stored-Value Cards
– E-Money
– Others (??)
Electronic Payments
• Debit Cards
– Works like a check - tells the bank to
transfer funds from your account to
another.
– After 2007, the use of debit cards increased
significantly.
• Credit Cards
– A promise by a bank to lend the cardholder
money to make a purchase.
– They do not represent money.
Electronic Payments
• Electronic Funds Transfers
– Movements of funds directly from one
account to another.
– Most common form is the Automated

Clearinghouse Transaction (ACH).
• Used for recurring payments like paychecks or
utility bills.
• Have surpassed the value of checks.
– Banks use electronic transfers for bank-to-

bank transactions, sending money through
Fedwire (in US).
Electronic Payments
• Stored-Value Cards
– e.g. Take it to a bank or an ATM, transfer
money to the card, then use the card at a
merchant.
– Limited in what can be purchased with
them.
– Require specific hardware by businesses.
Electronic Payments
• E-Money
– Can be used to pay for purchases online.
– Open an account by transferring funds to
the issuer of the e-money.
– When shopping online, you instruct the
issuer to send your e-money to the
merchant.
– A form of private money, so it is not
guaranteed by the government.
– Examples ????
Measuring Money
• Changes in the quantity of money are related
to :
– Changes in Interest Rates

– Economic Growth
– Inflation
34
Inflation and the Inflation Rate
• Inflation
– The rate at which the general price level is
increasing over time.
• Inflation rate
– The measure of the inflation process.
35
Liquidity : Definition
Before we discuss the measure of money,
we start with a discussion about liquidity.
Liquidity is a measure of the ease an asset

can be turned into a means of payment
(money) without significant loss of value.
36
The Liquidity Spectrum
37
Measuring Money
Different definitions of money are based upon
liquidity.
These money aggregates include :
M1: Narrowest definition

Includes only currency & various deposit
accounts on which people can write checks.
M2: Broader definition

Includes M1 plus assets that are not used
directly as a means of payment. (e.g. small-
denomination time deposits that cannot be
withdrawn without advance notice).
38
Selecting Monetary Aggregates
• M2 is currently considered the best.
• During 1980s & 1990s, economists &

policymakers considered M2 the best measure of
the money supply.
• Aggregates move broadly together over long

time periods.
• The different monetary aggregates give a

different picture of movements in the money
supply over time.
2-39
Money Supply Definitions
Money Supply Definitions in Hong Kong :
• M1
It is the sum of legal tender notes & coins held by
the public, plus customers’ demand deposits in
HK dollars and foreign currencies placed with
licensed banks.
• M2
It is the sum of M1, plus customers’ savings and
time deposits with licensed banks, plus
Negotiable Certificate of Deposits (“NCD”) issued
by the licensed banks held outside of the banking
sector.
40
Money Supply Definitions
Money Supply Definitions in Hong Kong :
• M3
It is the sum of M2 plus customers’ deposits with
Restricted Licensed Banks (“RLBs”) and Deposit-
Taking Companies (“DTCs”), and NCDs issued by
RLBs and DTCs and held outside the banking
sector.
Remarks :
We will discuss more on the banking & financial
system in HK later.
41
- End of Lecture 1 -
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Lecture 1

• Five Core Principles of Money & Banking :

5. Government Regulatory Agencies

5. Government Regulatory Agencies

2. Risk requires compensation

3. Information is the basis for decisions

5. Stability improves welfare

It may also be defined as anything that :

1. has instant purchasing power, and,

Store of Value (cont.)

Store of Value (cont.)

– Market Liquidity - the ability to sell assets

• Money is at the heart of the payments system.

1. Commodity and Fiat Monies

• Commodity monies : with intrinsic value.

• A commodity money must be :

• In 1661, Stockholm Banco issued Europe's

• In 1775, the Continental Congress of the

• In 1862, the Confederate and the Union

• After the Civil War, the US reverted to using

• Today’s paper money is called fiat money and

• We accept these bills as payment because the

• A gold standard may not be time consistent.

• A fiat currency must be limited in volume of

• The series of transactions put in motion can

– Credit and Debit Cards

– Most common form is the Automated

– Banks use electronic transfers for bank-to-

– Changes in Interest Rates

Liquidity is a measure of the ease an asset

These money aggregates include :

M1: Narrowest definition

M2: Broader definition

• During 1980s & 1990s, economists &

• Aggregates move broadly together over long

• The different monetary aggregates give a

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