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Chapter 2
Money and the Payments System
Brief Chapter Summary and Learning Objectives
2.1 Do We Need Money? (pages 24–26)
Analyze the inefficiencies of a barter system.
Money reduces the transactions costs of exchange as well as other inefficiencies of the barter
system.
2.2 The Key Functions of Money (pages 26–29)
Discuss the four key functions of money.
Money serves four key functions in the economy: It acts as a medium of exchange, a unit of
account, and a store of value, and it offers a standard of deferred payment.
2.3 The Payments System (pages 29–32)
Explain the role of the payments system.
The efficiency of the payments system has increased over time as new instruments have reduced
the cost of settling transactions.
2.4 Measuring the Money Supply (pages 32–35)
Explain how the U.S. money supply is measured.
There are currently two measures of the money supply in the United States, M1 and M2.
M1 includes liquid assets that can directly be used as a medium of exchange, while M2 includes
short-term assets that are less liquid but can readily be converted to currency and be used as a
medium of exchange.
2.5 The Quantity Theory of Money: A First Look at the Link Between Money and Prices
(pages 36–43)
Use the quantity theory of money to analyze the relationship between money and prices
in the long run.
The quantity theory of money helps to explain the long-run relationship between the growth of
the money supply and inflation.
Key Terms
Barter A system of exchange in which individuals
trade goods and services directly for other goods
and services.
Checks A promise to pay on demand money
deposited with a bank or other financial institution.
Commodity money A good used as money that
has value independent of its use as money.
E-money Digital cash people use to buy goods
and services over the Internet; short for electronic
money.
Fiat money Money, such as paper currency,
which has no value apart from its use as money.
Hyperinflation A rate of inflation that exceeds
50% per month.
Legal tender The government designation that
currency is accepted as payment of taxes and
must be accepted by individuals and firms in
payment of debts.
M1 A narrower definition of the money supply:
The sum of currency in circulation, checking
account deposits, and holdings of traveler’s
checks.
M2 A broader definition of the money supply: all
the 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.
Medium of exchange Something that is
generally accepted as payment for goods and
services; a function of money.
Monetary aggregates Measures of the quantity
of money that are broader than currency; M1 and
M2.
Money Anything that is generally accepted as
payment for goods and services or in the
settlement of debts.
Quantity theory of money A theory about the
connection between money and prices that
assumes that the velocity of money is constant.
Specialization A system in which individuals
produce the goods or services for which they have
relatively the best ability.
Standard of deferred payment The characteristic
of money by which it facilitates exchange over
time.
Store of value The accumulation of wealth by
holding dollars or other assets that can be used to
buy goods and services in the future; a function of
money.
Transactions costs The costs in time or other
resources that parties incur in the process of
agreeing and carrying out an exchange of goods
and services.
Unit of account A way of measuring value in an
economy in terms of money; a function of money.
Wealth The sum of the value of a person’s assets
minus the value of the person’s liabilities.
Chapter Outline
Who Hates the Federal Reserve?
Inflation has averaged 2.5% since 1994. If it rose significantly above that rate, those who already have
loans would benefit by paying back their debt with dollars that were losing value. But high rates of
inflation typically cause problems for the economy. The Fed is often blamed for the high inflation of the
1970s. Since that time, the Fed has made keeping inflation low a top priority. Some economists and
members of Congress took the view that the actions of the Fed during the financial crisis had the potential
to significantly increase inflation. In addition, some of the Fed’s actions during that period went beyond
normal monetary policy. As a result, several bills were introduced in Congress to increase Congressional
oversight of the Fed. Fed Chair Ben Bernanke argued that passing these bills would reduce the
independence of the Fed, thereby increasing the risk of higher inflation. In the end, Congress did not pass
any of the bills.
Teaching Tips
For most students, Sections 2.1, 2.2, and 2.4 on the functions and definitions of money should be a review
of material they learned in their principles class. It is possible to cover this material very briefly with
well-prepared students. Section 2.3 discusses the payments system—a term that may be unfamiliar to
many students—including electronic funds and electronic cash, which are topics not always covered in
principles classes.
Section 2.5 contains material on the quantity theory that is likely to be less familiar to students. Given the
debate over the likely outcome of Fed policies that have resulted in large increases in the money supply,
students are often interested in this material. For this reason, the authors cover it early in their classes.
The material on hyperinflations is interesting to most students and may help to reinforce the discussion of
the quantity theory. Nevertheless, if you are pressed for time, the material can be omitted. Similarly, the
background on the quantity theory and hyperinflation helps motivate the last section on central bank
independence, although discussion of this material can be postponed to later in the course.
2.1 Do We Need Money? (pages 24–26)
Learning Objective: Analyze the inefficiencies of a barter system.
A. Barter
Barter is a system of exchange in which individuals trade goods and services directly for other
goods and services. Sources of inefficiency for barter includes (1) the time and effort spent
looking for trading partners; (2) each good having many prices (in terms of all other goods with
which it can be exchanged); (3) a lack of standardization of the products being traded; and (4)
difficulty in accumulating wealth (people need to store various products).
B. The Invention of Money
Money reduces transactions costs as well as other inefficiencies of barter. Money allows for
specialization, a system in which individuals produce the goods or services for which they have
relatively the best ability.
2.2 The Key Functions of Money (pages 26–29)
Learning Objective: Discuss the four key functions of money.
A. Medium of Exchange
Medium of exchange describes the role of money as a generally accepted payment for goods
and services.
B. Unit of Account
Unit of account is the function of money in which money can be used to measure value in an
economy.
C. Store of Value
Money is a store of value in that it allows for the accumulation of wealth by holding dollars or
other assets that can be used to buy goods and services in the future.
D. Standard of Deferred Payment
Money is considered a standard of deferred payment in that it facilitates exchange over time.
E. Distinguishing Among Money, Income, and Wealth
Money, like other assets, is a component of wealth, which is the sum of the value of a
person’s assets minus the value of the person’s liabilities. A person’s income is equal to his or
her earnings over a period of time.
F. What Can Serve as Money?
An asset is suitable to use as money if it is (1) acceptable to (that is, usable by) most people;
(2) standardized in terms of quality, so that any two units are identical; (3) durable, so
that it does not quickly become too worn out to be usable; (4) valuable relative to its weight,
so that amounts large enough to be useful in trade can be easily transported; and (5) divisible,
because prices of goods and services vary.
G. The Mystery of Fiat Money
Money, such as paper currency, that has no value apart from its use as money is called fiat
money. The most important reason why paper currency circulates as a medium of exchange is
the confidence of consumers and firms that if they accept paper currency they will be able to
pass it along when they need to buy goods and services.
2.3 The Payments System (pages 29–32)
Learning Objective: Explain the role of the payments system.
A. The Transition from Commodity Money to Fiat Money
Centuries ago, people had difficulty transporting large numbers of gold coins to settle transactions
and also ran the risk of having their gold robbed. To get around this problem, beginning around
the year A.D. 1500 in Europe, governments and private firms—early banks—began to store
gold coins in safe places and issue paper certificates. In modern economies, central banks issue
fiat money.
B. The Importance of Checks
It can be expensive to transport paper money to settle large commercial or financial
transactions. Checks are promises to pay on demand money deposited with a bank or other
financial institution.
C. Electronic Funds and Electronic Cash
Breakthroughs in electronic telecommunication have improved the efficiency of the payments
system, reducing the time needed for clearing checks and for transferring funds. Examples of
computerized payment-clearing devices include debit cards, Automated Clearing House (ACH)
transactions, automated teller machines (ATMs), and e-money.
Teaching Tips
Ask students if they have bought items on eBay. Next, ask how many would have still bought the items if
they could not have used PayPal. The discussion that follows should help them to understand how money
evolves over time and how increased efficiency of the payments systems allows for more economic activity.
2.4 Measuring the Money Suply (pages 32-35)
Learning Objective: Explain how the U.S. money supply is measured.
A. Measuring Monetary Aggregates
M1 is a narrow definition of money that includes traditional mediums of exchange: currency,
traveler’s checks and checking deposits. M2 is a broader definition of money that includes short-term
investments that can be easily converted to currency including time deposits valued under $100,000,
savings deposits, money market deposits held at banks, and noninstitutional money market shares.
B. Does it Matter which Definition of the Money Supply We Use?
M2 has grown more over time as people increase their holdings of money market mutual fund shares
and CDs. M1 has been more volatile, soaring during the recession years of 1990–1991, 2001, and 2007–
2009 as investors desired the safety of liquid assets. The strengths and weaknesses of each measure
will be discussed in future chapters.
Teaching Tips
There has been much discussion about how the Fed “printed money” and more than doubled the size of
the money supply during the financial crisis. As a result, some commentators have predicted that the
United States will experience hyperinflation. Have students look at Figure 2.2 on page 35 (both panel (a)
and panel (b)) to see how much the money supply has really grown since the start of the crisis in fall 2008
(pay particular attention to M2). You can use this figure to reinforce the meaning of the money supply and
the limits to the Fed’s ability to increase it (though you should save the discussion of the difference
between the monetary base and the money supply for a future chapter). Though M1 displays a couple of
bursts of growth, neither was sustained. The growth of M2 does not differ much from its historical
behavior.
2.5 The Quantity Theory of Money: A First Look at the Link between Money
and Prices (pages 36–43)
Learning Objective: Use the quantity theory of money to analyze the relationship between money
and prices in the long run.
A. Irving Fisher and the Equation of Exchange
The velocity of money is defined as the number of times a dollar is used to purchase a good or
service in GDP or V PY/M, where V is the velocity of money; Y is real GDP, P is the price
level (so P × Y is nominal GDP), and M is the money supply. Rearranging terms, we obtain the
equation of exchange, M × V P × Y (which is true by definition). Irving Fisher assumed that
the velocity of money is constant to develop the quantity theory of money. Therefore, if the
money supply (M) increases more quickly than real GDP (Y), the difference is inflation (P).
B. The Quantity Theory Explanation of Inflation
We can rewrite the equation of exchange in percentage terms as: the percentage change in M plus
the percentage change in V equals the percentage change in P plus the percentage change in Y.
Because V is assumed to be constant, the percentage change in V is 0. Therefore, if the money
supply (M) increases more quickly than real GDP (Y), the difference is inflation (P).
C. How Accurate Are Forecasts of Inflation Based on the Quantity Theory?
Because velocity can move erratically in the short run, we would not expect the quantity
equation to provide good forecasts of inflation in the short run. Over the long run, however,
there is a strong link between changes in the money supply and inflation.
D. The Hazards of Hyperinflation
When there is hyperinflation, prices rise so rapidly that a given amount of money can purchase
fewer and fewer goods and services each day. Households and firms may refuse to accept money
at all, in which case money no longer functions as a medium of exchange. When economies do
not use money, the degree of specialization necessary to maintain high rates of productivity
breaks down.
E. What Causes Hyperinflation?
The quantity theory indicates that hyperinflation is caused by the money supply increasing
far more rapidly than real output of goods and services. The ultimate cause of hyperinflation
is usually governments spending more than they collect in taxes, which results in government
budget deficits. If private investors are not willing to purchase the government bonds and the
government controls the central bank, the government sells the bonds to the central bank. The
central bank increases the money supply to buy the bonds, resulting in monetizing the debt.
F. Should Central Banks Be Independent?
Research has shown that countries with highly independent central banks have lower inflation
rates than countries whose central banks have little independence. The more independent a
central bank is of the rest of the government, the more it can resist political pressures to
increase the money supply, and the lower the country’s inflation rate is likely to be.
Policymakers continue to debate whether Congress and the president should change the law to
reduce the Fed’s independence, although, historically, curtailing the independence of a central
bank has resulted in higher inflation rates.
Teaching Tips
Have students consider the implications of Figure 2.4 on page 42 regarding the independence of the
Federal Reserve. Discussion can involve what would likely happen to inflation in the United States if
Congress reduced the independence of the Fed.
