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Chapter 02 – Money and the Payments System

Chapter 2

Money and the Payments System

Chapter Overview

As indicated by the title, this chapter covers money and the payments system, which

includes checks and electronic payments. The implications of new technologies for

money are discussed as well as the measurement of the money supply.

Learning Objectives: Establish an Understanding of

Money and its functions

Payments system today and tomorrow

Money links inflation and economic growth

Important Points of the Chapter

To understand the impact of money on the economy—why it’s so important to the smooth

functioning of the economy and how it improves everyone’s well being—we need to

understand exactly what money is, and to quantify its impact on the economy we need to

be able to measure it. The goals of this chapter are to understand what money is, how we

use it, and how we measure it.

Application of Core Principles

Principle #3: Information. Money as a means of payment solves an information

problem; money finalizes payments so that buyers and sellers have no further claim on

each other. So long as a buyer has money, there is nothing more the seller needs to know.

Principle #1: Time. Money as a store of value saves time; holding money means not

having to convert other assets into spendable form every time we wish to make a

purchase.

Principle #1: Time. The introduction of new money market accounts in the 1980s made

M2 accounts more liquid. M1 and M2 no longer moved together and analysts stopped

looking at M1 and began to look at M2.

Teaching Tips/Student Stumbling Blocks

Most of the material in this chapter is fairly straightforward, but students will be

puzzled by the idea that credit cards are not money. The key, as pointed out in the

text, is that a credit card represents access to someone else’s money. Another way

to explain this is to note that when one uses a credit card the transaction is not

over; a bill will come and will need to be paid.

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Here’s an idea for an interesting class discussion: are impulse purchases more

likely when a credit card is available than when someone only has cash? If you

assigned a spending journal in conjunction with the coverage of Chapter 1, use it

to illustrate differences in spending patterns.

Features in this Chapter

Your Financial World: Debit Cards vs. Credit Cards

Which card should a consumer use? A debit card takes the funds from your account

immediately, while a credit card creates a deferred payment. However, if you don’t pay

your credit card debt on time there is a late fee, and if you don’t pay it all you incur

interest charges on the balance. If you can pay off your credit cards in full and on time,

it’s to your advantage to use them. Credit cards also help you build a credit history,

which you will need when you want to borrow money to buy a car or house.

Your Financial World: Paper Checks Become Digital Images

On October 28, 2004, “Check 21—the Check Clearing for the 21st Century Act” went into

effect. This meant that banks would no longer have the expensive headache of

transporting paper checks back and forth. Instead, banks can transmit digital images of

every check written. These “substitute checks” have the same legal standing as proof of

payment as the original checks, and the change is estimated to save banks $2 billion a

year. It also means eliminating the risks involved in physically transporting checks. The

bad news for consumers is that they can no longer write a check figuring they’ll have a

few days to deposit funds to cover it; speeding up paper check processing does have a

downside.

Lessons from the Crisis: Market Liquidity, Funding Liquidity, and Making Markets

A “market maker” in stocks, bonds, or other securities is usually a financial institution

that buys and sells securities on behalf of clients. If demand is greater than supply, the

market maker must be able to act as a seller to clear the market. Market liquidity and

funding liquidity are both needed to make financial markets work. A sudden loss of

liquidity was central to the financial crisis of 2007-2009. Both funding and market

liquidity dried up. Market liquidity dried up because investors began to doubt the value

of a wide class of securities. Funding liquidity followed as their lenders worried about

their potential losses.

In the News: Airtime is Money

Mobile money in Africa comes in many different forms. One old form of mobile money

is using pre-paid mobile airtime minutes as a de facto currency that can be transferred

between phones, exchanged for cash, or used in bartering. These minutes being used as a

currency don’t rely on the stability of the government for the value.

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Lessons of the Article: Almost anything can be a currency, but people

prefer currencies that provide a reasonable store of value. And they prefer

payments mechanisms that are efficient, anonymous, and allow for big and

small transfers. If there is a better currency or payments technology,

people can switch. In the story, mobile minutes are attractive for both

reasons, beating currencies with uncertain storage value and replacing both

cash and coin.

Applying the Concept: Where are all those $100 Bills?

If we take all the currency in circulation in the United States and divide it by the

population, each person should be holding about $2800 in cash! And moreover, there

must be eighteen $100 bills for each U.S. resident. Since this is not really true, where are

all those $100 bills? The answer is that they are outside the country, in countries where

people don’t trust the value of their own currencies. Everyone seems to have faith in the

U.S. dollar! The U.S. Treasury estimates that between two-thirds and three-quarters of

U.S. currency is held outside the United States; that’s more than $600 billion, and most of

it is in hundreds!

Tools of the Trade: The Consumer Price Index

The CPI is designed to answer 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?” To answer this question, every few years statisticians at the

Bureau of Labor Statistics (BLS) conduct surveys to find out what people bought. Then

the BLS collects information on the prices of thousands of goods and services.

Combining the two allows the BLS to compute the current cost of the basket. This

current cost is then compared to a benchmark to yield an index. The percentage change

in this index is a measure of inflation. Experts suggest that the CPI overstates inflation

because it does not take into account the fact that people make substitutions in the goods

and services they buy when prices change. To address this problem (called “substitution

bias”) the BLS now changes the weights used in the calculations every two years.

Additional Teaching Tools

An article on Bloomberg Businessweek

(http://www.businessweek.com/articles/2013-03-28/bitcoin-may-be-the-global-economys

-last-safe-haven) describes recent increased use of Bitcoin, a virtual cash used to buy

goods an d services online. Bitcoin was created in 2009 and has nearly 11 million

Bitcoins in circulation. Many people will tell you that the emergence of a virtual global

money supply beyond the reach and control of any government is very real and should be

taken seriously.

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The article “Shoppers’ Black Friday Weekend Spending Falls 3%” (The Wall Street

Journal, December 1, 2013) describes retail sales after the 2013 Thanksgiving weekend

sales.

The April, 2012, article on Bloomberg Businessweek, “Rise of the Barter Economy”

(http://www.businessweek.com/articles/2012-04-26/rise-of-the-barter-economy)

describes the rise of the use of barter business models. The article shows that these

models have limited use for small businesses, as money is still needed for some

purchases.

To learn more about “Check 21” visit the “frequently asked questions” page on the web

site of the Federal Reserve System at

http://www.federalreserve.gov/pubs/check21/consumer_guide.htm.

Virtual Tools

Go on a virtual field trip and the life cycle of cash at the Federal Reserve Bank of San

Francisco by visiting its web site at: http://www.frbsf.org/cash/cash-lifecycle

Students can also visit the United States Mint at:

http://www.usmint.gov/index.cfm?flash=yes

Here’s a site with lots of info about e-money and good links to other resources on the

topic:

http://www.ex.ac.uk/~RDavies/arian/emoney.html

The U.S. Secret Service Counterfeiting Division has interesting information on its site

including more about how to spot fake bills; visit them at:

http://www.secretservice.gov/know_your_money.shtml.

For More Discussion

Will there ever be a cashless society? What are the pros and cons of replacing cash with

some of the electronic payments mechanisms mentioned in this chapter? Students are

likely to point out that less cash may mean less robbery, both by “outsiders” and

“insiders” and they may also have a sense that having to count and deposit cash can be

more time-consuming and so less efficient than having transactions that are immediately

recorded. But on the negative side, students may also raise issues of privacy, and note

that high-tech crime may just replace “old-fashioned” stick-ups.

Chapter Outline

I. Money and How We Use It

As used in conversation, the word “money” can mean many things. However, we

will use the word in a narrower, more specialized sense to mean anything that can

readily be used to make economic transactions. Formally defined, money is an asset

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

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Money has three characteristics: it is a means of payment, a unit of account, and a

store of value.

A. Means of Payment

1. The primary use of money is as a means of payment.

2. Barter is an alternative to using money and doesn’t work very

well.

3. Barter requires a “double coincidence of wants,” meaning that in

order for trade to take place both parties must want what the

other has.

4. Money finalizes payments so that buyers and sellers have no

further claim on each other.

5. As economies have become more complex and physically

dispersed the need for money has grown.

B. Unit of Account

1. We measure value using dollars and cents.

2. Money is the unit of account that we use to quote prices and

record debts.

3. Money can be referred to as a standard of value.

4. Using money makes comparisons of value easy.

C. Store of Value

1. For money to function as a means of payment it has to be a store

of value too because it must retain its worth from day to day.

2. The means of payment has to be durable and capable of

transferring purchasing power from one day to the next.

3. Money is not the only store of value; wealth can be held in a

number of other forms.

4. Other stores of value can be preferable to money because they

pay interest or deliver other services.

5. However, we hold money because it is liquid, meaning that we

can use it to make purchases.

6. Liquidity is a measure of the ease with which an asset can be

turned into a means of payment (namely money).

a. The more costly an asset is to turn into money, the less

liquid it is.

b. Constantly transforming assets into money every time we

wish to make a purchase would be extremely costly; hence

we hold money.

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c. Financial institutions often use market liquidity to refer to

their ability to sell assets for money. Funding liquidity

refers to their ability to buy security or to make loans.

Financial institutions need both to operate day-to-day.

II. The Payments System

The payments system is the web of arrangements that allow for the exchange of

goods and services, as well as assets, among different people. The efficient

operation of our economy depends on the payment system and so it is a critical

policy concern that it function well. Money is at the heart of the payments

system.

A. Commodity and Fiat Monies

1. The first means of payment were things with intrinsic value like silk or

salt.

2. Successful commodity monies had the following characteristics:

a. They were usable in some form by most people;

b. They could be made into standardized quantities;

c. They were durable;

d. They had high value relative to their weight and size so that

they were easily transportable; and

e. They were divisible into small units so that they were easy to

trade.

3. For most of human history, gold has been the most common

commodity money.

4. In 1656, a Swede named Johan Palmstruck founded the Stockholm

Banco and five years later issued Europe’s first paper money.

5. The money was welcomed at first because it was easy to handle, but

the King persuaded Palmstruck to print more of them (to finance some

wars the King was fighting) and the currency lost value. Ultimately

Palmstruck’s bank failed.

6. Other people tried issuing money in the early 1700s and eventually

governments got into the act.

7. In 1775, the newly formed Continental Congress of the United States

of America issued “continentals” to finance the revolutionary war, and

twenty years later revolutionary France issued the “assignat.” Both

currencies were issued in huge quantities and both eventually became

worthless.

8. As a result, people became suspicious of government-issued paper

money.

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9. Following the end of the Civil War the U.S. government changed from

the paper money it had issued during the War back to using gold. In

the United States, gold coins and notes backed by gold circulated well

into the 20th century.

10. In the U.S., gold coins and notes backed by gold circulated well into

the 20th century.

11. Today we use paper money that is fiat money, meaning that its value

comes from government decree (or fiat).

12. A note (whether it’s a $1 or a $100 bill) costs about 6 cents to produce.

13. These notes are accepted as payment for goods or in settlement of

debts for two reasons

a. We take them because we believe we can use them in the

future.

b. The law says we must accept them; that is what the words

“legal tender” printed on the bill means.

14. Some critics of money advocate the return to the gold standard.

However, as long as the government stands behind its paper money,

and doesn’t issue too much of it, we will use it. In the end, money is

about trust.

B. Checks

1. Checks are another way of paying for things, but they aren’t legal

tender and they aren’t even money.

2. A check is an instruction to the bank to take funds from your account

and transfer them to the person or firm you designate (by writing the

name on the check).

3. When you give someone a check in exchange for a good or service, it

is not a final payment; a series of transactions must still take place that

lead to the final payment.

4. Here are the steps in the process:

a. You hand the check over to the merchant who then takes it to

the bank.

b. The bank credits the merchant’s account with the amount of

the check (either immediately or with a short lag).

c. At the end of the day, the bank sends the check (or an

electronic image of it) through the check-clearing system to

be processed (either at the check-processing center run by the

Federal Reserve or to a private check clearinghouse).

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d. The center sends the check to the bank on which it was

written (your bank).

e. The account of the bank receiving the check is credited and

the account of the bank on which the check was written is

debited.

f. On receipt of the check your bank debits your account and

most likely makes scanned images of the cleared checks

available to you, either in your paper end-of-month statement

or online. Years ago all checks were returned to their writers.

G. Though check volumes have fallen, paper checks are still

with us because a cancelled check is legal proof of payment

and, in many states laws require banks to return checks to

customers. Also, new electronic mechanisms have made

processing cheaper and easier.

H. Force of habit means that many people, when given a choice,

still opt to receive their cancelled checks with their

statements.

C. Electronic Payments

A. The third and final method of payment is electronic.

B. There are credit cards, debit cards, and electronic funds transfer.

C. A debit card works like a check and there is usually a fee for the

transaction.

D. A credit card is a promise by a bank to lend the cardholder money with

which to make purchases. When the card is used to buy merchandise

the seller receives payment immediately.

E. However, the money that is used for payment does not belong to the

buyer; rather, the bank makes the payment, creating a loan that the

buyer must repay.

F. For this reason, credit cards do not represent money; rather, they

represent access to someone else’s money.

G. Electronic funds transfers move funds directly from one account to

another. While such payments are less well known than credit card or

debit card payments, these transfers account for the bulk of the $30

trillion worth of non-cash retail payments made electronically each

year in the United States.

H. Banks use these transfers to handle transactions among themselves.

I. Individuals may be familiar with such transfers through direct deposit

of their paychecks, etc.

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J. Retail businesses are experimenting with new forms of electronic

payment, including the stored-value card (examples are long-distance

telephone cards).

K. E-money is another new method of payment that can be used for

purchases on the Internet. It is really a form of private money. M-Pesa

is an example of e-money.

III. The Future of Money

A. The time is rapidly approaching when safe and secure systems for

payment will use virtually no money at all.

B. We will also likely see fewer “varieties” of currency, a sort of

standardization of money and a dramatic reduction in the number of units

of account.

C. Finally, money as a store of value is clearly on the way out as many

financial instruments have become highly liquid.

IV. Measuring Money

A. Changes in the amount of money in the economy are related to changes in

interest rates, economic growth, and most important, inflation.

B. Inflation is a sustained rise in the general price level.

C. With inflation you need more money to buy the same basket of goods

because it costs more.

D. Inflation makes money less valuable.

E. The primary cause of inflation is the issuance of too much money.

F. Because money growth is related to inflation we need to be able to

measure how much money is circulating.

G. We compute measures of money called the monetary aggregates: M1 and

M2.

1 M1 is the narrowest definition of money and includes only

currency and various deposit accounts on which people can write

checks. Specifically, it is currency in the hands of the public,

traveler’s checks, demand deposits and other checkable deposits.

2 M2 includes everything that is in M1 plus assets that cannot be

used directly as a means of payment and are difficult to turn into

currency quickly, like small-denomination time deposits, money

market deposit accounts, and money market mutual fund shares.

M2 is the most commonly quoted monetary aggregate.

H. Up until the 1980s M1 was the most closely watched monetary aggregate,

but is no longer a useful measure of money.

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I. As new substitutes for checking accounts became more prevalent M1

became less useful than M2.

J. M2 no longer predicts inflation. It may be that still another new measure

of money is needed.

Using FRED: Codes for Data in This Chapter

Data Series FRED Data Code

Price of gold GOLDAMGBD228NLBM

M1 M1SL

M2 M2SL

Currency in the hands of the

public

CURRSL

Traveler’s checks TVCKSSL

Consumer price index CPIAUCSL

Demand deposits DEMDEPSL

Other checkable deposits OCDSL

Small‐denomination time deposits STDCBSL

Savings deposits and MMDAs SAVINGSL

Retail MMMFs RMFSL

Nominal gross domestic

product

GDP

Terms Introduced in Chapter 2

automated clearinghouse transaction (ACH)

checks

credit card

currency

debit card

demand deposits

electronic funds transfer

e-money

fiat money

funding liquidity

gross domestic product (GDP)

inflation

inflation rate

liquidity

market liquidity

means of payment

money

monetary aggregates

payments system

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store of value

stored-value card

time deposits

unit of account

wealth

Lessons of Chapter 2

1. Money is an asset that is generally accepted in payment for goods and services or

repayment of debts.

a. Money has three basic uses:

i. Means of payment

ii. Unit of account

iii. Store of value

b. Money is liquid. Liquidity is the ease with which an asset can be turned

into a means of payment.

c. For financial institutions, market liquidity is the ease with which they can

sell a security or loan for money. Funding liquidity is the ease with which

they can borrow to acquire a security or loan.

2. Money makes the payments system work. The payments system is the web of

arrangements that allows people to exchange goods and services. There are three

broad categories of payments, all of which use money at some stage:

a. Cash

b. Checks

c. Electronic payments

3. In the future money will be used less and less as a means of payment.

4. To understand the links between money, inflation, and economic growth, we need

to measure the quantity of money in the economy. There are three basic measures

of money;

a. M1, the narrowest measures, includes only the most liquid assets.

b. M2, a broader measure, includes assets not usable as means of payment.

c. M3, the broadest commonly used measure of money, includes much less

liquid assets than M2.

d. Countries with high money growth have high inflation.

e. In countries with low inflation, money growth is a poor forecaster of

inflation.

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