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MTSU Econ 3210 - Chapter 2

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Stuart Fowler

on 27 August 2014

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Transcript of MTSU Econ 3210 - Chapter 2

Chapter 2, "Money and the Payments System"
What is Money?
Do We Need Money? Money's Role and Function
Technology Changes Money's Role.
The Payments System
How to Measure Money?
The Value of Fiat Money
Can We Create Our Own Money?
The Link between Money, Inflation,and the real economy
Def: Money is anything that is generally accepted as payment for goods and services or in the settlement of debts.

Very broad definition!

Ex: Currency and coins are generally accepted. Also, checks on checking accounts and traveler’s checks. Also, electronic funds (debit cards) can be considered money.

Q: Are credit cards considered money? They could. But for the most part, they are not generally accepted. For example, you can't pay your taxes via credit card. Many places still don't accept credit cards (The Boro, Farmer's Market, etc.)
Ex: Money can be specific to an economy. MTSU's Flexbucks are considered money at MTSU.

Ex: Radford (1945) describes how cigarettes were used as money in WWII P.O.W camps:
People left their surplus clothing, toilet requisites and food there until they were sold at a fixed price in cigarettes. Only sales in cigarettes were accepted - there was no barter [...] Of food, the shop carried small stocks for convenience; the capital was provided by a loan from the bulk store of Red Cross cigarettes and repaid by a small commission taken on the first transactions. Thus the cigarette attained its fullest currency status, and the market was almost completely unified.[2]

Ex: Arrowhead, rice, goldflakes. Also, silver, copper, peppercorns, large stones (such as Rai stones), decorated belts, shells, alcohol, cigarettes, barley etc
No, money is not required. We could barter - trade goods for goods.
Economies without money, however, are very inefficient
There are 4 inefficiencies with barter
There must be a double coincidence of wants. The time spent searching are called transactions costs.
Each good has many prices.When there are N items then # of prices = N(N-1)/2.
There is a lack of standardization.
It is difficult to accumulate wealth.
Money Solves these inefficiencies! Its roles are:
It acts as a medium of exchange.
It is a unit of account.
It is a store of value.
It offers a standard of deferred payment.
Yes. There is no Federal statute that requires private businesses, persons, or organizations to accept dollars

But, cannot counterfeit dollars
For an asset to be money, it must be generally accepted. Acceptance means it must overcome the problems with barter (otherwise barter will be used). Economists have found that assets that are suitable for money if they are:
Standardized in terms of quality
Valuable relative to its weight
Hard to counterfeit
Note: even if an asset doesn't meet all these criteria it still may be better than barter and thus used as money
Q: Which of these criteria do arrowheads, rice, and gold flakes have?
Coin clipping is the act of shaving off a portion of a coin. The clippings could be saved up and melted into bullion or used to make new coins
Coins now have the rim of the coin marked with stripes, text (engraving) or some pattern that would be destroyed if the coin were clipped
Modern coins are made of hard, cheap metals such as steel, copper or a copper-nickel alloy, reducing wear and removing the incentive to clip them.
Commodity Money:
Arrowheads, rice, etc
Precious metals
Precious metal coins
Fiat Money:
Paper money
Cheap metals
Checking accounts
Electronic funds

Barter is inefficient

Def: A good used as money that also has value independent of its use as money is called commodity money.

An economy’s reliance on gold and silver coins alone makes for a cumbersome payments system.

To get around this problem, early banks stored gold coins in safe places and issue paper certificates. In effect, paper currency had been invented.

In modern economies, the central bank issues paper currency but does not exchange it for gold or any other commodity money.

Def: Fiat money has no value apart from its use as money.

Society’s willingness to use green pieces of paper makes them an acceptable medium of exchange
Def: The payments system is the mechanism for conducting transactions in the economy.
Def: M1 is the sum of currency in circulation, checking account deposits, and holdings of traveler’s checks.

Def: M2 is all assets that are included in M1, as well as time deposits with a value of less than $100,000, savings accounts, money market deposit accounts, and noninstitutional money market mutual fund shares.
As a rule, the equation of exchange is true.

The equation of exchange,
M*V = P*Y,
states that the quantity of money, M, multiplied by the velocity of money, V, equals the price level (or GDP deflator), P, multiplied by the level of real GDP, Y.

Note that PY equals nominal GDP, and that velocity, V, is the average frequency with which a unit of money is spent.

The equation of exchange expressed in percentage changes is: %Change(M)+%Change(V)=%Change(P)+%Change(Y).

Note that the percentage change in the price level is inflation
Q: Is money measured by adding up all currency?

No. Checks, debit cards, traveler's checks are typically used as money. Leads to broader definitions
Q: How could checking accounts be greater than currency? Aren't they backed by currency?
Economist Irving Fisher turned the equation of exchange into the quantity theory of money by asserting that velocity is constant.
Irving Fisher's though experiments
Q: How Accurate Are Forecasts of Inflation Based onthe Quantity Theory?
It is true that countries where the money supply grew rapidly tended to have high inflation rates.
But, velocity is erratic in the short run than in the long run.
Thus, the the quantity theory can make better predictions of inflation in the long run.
Q: Why is the dollar more valuable than the Mexican peso?

It can purchase more. Not because we like money for the sake of money (i.e.Scrooge McDuck)
A general formula:

value of money = 1/P where P is the general
price level of the economy (called the purchasing power of money)
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