Chapter 2 Money and the Payments System

1. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Chapter 2
Money and the Payments
System

2. 2-2
Money and the Payments System
The Big Questions
1. What is money?
2. How do we use money?
3. How do we measure money?

3. 2-3
Money and the Payments System
A Roadmap
• Money and how we use it
• The Payments System
• The Future of Money
• Measuring Money

4. 2-4
Money:
The Definition
Money is an asset that is generally
accepted as payment for goods and
services or repayment of debt.

5. 2-5
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

6. 2-6
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

8. 2-8
• 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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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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• 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.

22. 2-22
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.