Chapter 2

Money and the Payments

System

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Money and the Payments System
The Big Questions
1. What is money?
2. How do we use money?
3. How do we measure money?

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Money and the Payments System
A Roadmap
• Money and how we use it
• The Payments System
• The Future of Money
• Measuring Money

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 Money:
The Definition

Money is an asset that is generally

accepted as payment for goods and
services or repayment of debt.

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 Money:
Characteristics
1. Means of payment
Used in exchange for goods & services
2. Unit of account
Used to quote prices
3. Store of value
Used to move purchasing power
into the future

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 Money:
How We Pay for Things (I)
• Commodity Money:
Objects with intrinsic value
• Fiat Money:
Value comes from government decree (or fiat)
• Checks:
Instructions to the bank to shifts funds from your
account to that of the person or firm whose name is

written in the “Pay to the Order of” line.

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The Path of a Paper Check

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• Checks are legal proof of payment
• Customers wanted them back
• Starting in 2004
– Banks can transmit digital images
– Substitute checks are proof of payment
• Paper checks are now disappearing

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 Money:
How We Pay for Things (II)
• Credit Cards
• Debit Cards
• Electronic Funds transfers
especially automated clearing house
(ACH transactions)
• Stored Value Cards
• E-Money

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• Debit cards:
– Like a check
– Electronic message to your bank to
transfer funds immediately
• Credit cards:
– Deferred payment
– Issuer makes payment for you
– You have to pay it back

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•Scan the numbers at
the bottom of the
check.
•Check Conversion:
Turns a check into an
ACH transaction
•Similar to using a
debit card

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 The Future of Money

Which function of money will be

with us for a long time?
– Means of payment: disappearing
– Unit of account: likely to remain
– Store of value: disappearing

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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?

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 Measuring Money

• Changes in the quantity of money are

related to
– Interest Rates
– Economic Growth
– Inflation
• How do we measure money?

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 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

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 Liquidity:
Definition

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 of money are based

upon degree of liquidity.

M1: Narrowest definition

Only most liquid assets

M2: Broader definition

Includes assets not used
as means of payment.

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Monetary Aggregates

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Growth Rates in M1 and M2

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Money Growth and Inflation

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 Money Growth and Inflation

• When inflation is high, money growth

helps forecast inflation.
• When inflation is low, the relationship is
not as close.

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• In 2007 there was $2500 of U.S.
currency in circulation for each U.S.
resident.
• As much as 2/3rds of this is abroad

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• The CPI answers the question:
"How much more would it cost for people to
purchase today the same basket of goods
and services that they actually bought at
some fixed time in the past?“

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• Computing CPI Inflation
– Survey people to see what they bought
– Figure out what it would cost to buy the
same basket of goods & service today.
– Compute the percentage change in the
cost of the basket of goods.

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 Measures of Inflation

• Fixed-weight Index - CPI

• Deflator – GDP or Personal

Consumption Expenditure Deflator

• Chain-weight index – Half way

between fixed-weight and a deflator.

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 Chapter 2

End of Chapter

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.