Chapter 3: Money and Payments 25
CHAPTER 3
Money and Payments
TEACHING OBJECTIVES
Goals of Chapter 3
A. Describe how money is used in its roles as a medium of exchange, store
of value, unit of account, and standard of deferred payment.
B. Discuss the operation of the payments system and different types of
money (inside money, outside money, fiat money, commodity money).
C. Show how the Federal Reserve counts the money supply and whether
such measures are reasonable.
TEACHING NOTES
A. How We Use Money
1. Medium of Exchange
a) People exchange money for goods and services
b) Money reduces the transactions costs of exchanges, allowing
specialization
c) Example: POW camps in World War II used cigarettes as money
d) Desirable properties of money include being homogeneous,
durable, portable, and easy to make change with
e) Public acceptance is the key to the use of money
f) Gresham’s Law and Money in POW Camps: the best cigarettes
were hoarded and poor quality cigarettes were used in transactions
2. Unit of Account
a) Money is the item in which prices are denoted
b) Money may not be the unit of account in the case of barter or in
countries with high inflation rates
3. Store of Value
a) People keep money for some period instead of spending it right
away
b) Holding money reduces transactions costs; people face a tradeoff
4. Standard of Deferred Payment
Chapter 3: Money and Payments 26
a) Repayments of borrowed amounts are made in terms of money
b) Legal tender laws require lenders to accept money for the
repayment of debts
B. The Payments System
1. The payments system is the set of mechanisms used for making
transactions
2. Outside Money
a) Commodity (full-bodied) money
(1)Commodity money is money whose value is determined by its
b) Fiat money
(1)Money is valued mainly because the government decrees that it
has value for payment of taxes
(2)Advantage of fiat money: cheap to produce
(3)Disadvantages of fiat money: may be lost or stolen, must be
issued in proper amount or inflation will occur, requires
prevention of counterfeiting
3. Inside Money
a) Inside money is created within the private sector
b) Example: checking account at a bank
c) Inside money can’t generally be lost or stolen and is usually hard
to counterfeit, though may be disrupted by identity theft and
requires a clearing system
C. Counting Money
1. Measuring the Money Supply
a) What should be counted? Outside money and inside money, but
not credit card balances
b) Measure money services by liquidity: how easily they can be used
to purchase goods and services and how bank accounts are used
2. The Federal Reserve’s Monetary Aggregates
a) Different monetary aggregates for different purposes
b) Monetary aggregates:
(1) M1 measures money that can be spent immediately:
currency, coin, travelers checks, funds in checking accounts;
use Figure 3.1
(2) M2 measures money that can be used relatively quickly
to buy goods and services: M1, amounts in savings accounts,
Chapter 3: Money and Payments 27
money-market mutual funds (held by individuals), amounts in
small time deposits (small means < $100,000); use Figure 3.1
c) Use Table 3.1 to compare money measures in 2002 and 2012, to
provide perspective on changes in use of money
d) Use Figure 3.2 to examine data on growth rates of money
measures
(1)Since 1985, M1 has shown a different pattern from M2
(2)M1 has behaved erratically because of foreign demand
(3)M1 and M2 grew rapidly during the financial crisis of 2008
(4)M2 growth often declines before recessions
3. The Case of the Missing Currency
a) The amount of currency and coins divided by the U.S. population
equals over $3,000 per person, but people do not hold that much
b) Much of the cash is in foreign countries
c) Foreigners use dollars because of high inflation in their countries or
political instability
D. Application to Everyday Life: What Do You Do With Your Change?
1. The government earn profits on change that people store
ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION
1. The discussion about coins in this chapter lends itself to class discussion.
Ask your class how many of them carry coins with them and, ask what
they do with coins they receive in change. Then discuss how their
holding of coins without using them means that the government must
produce more coins. But, of course, the government profits handsomely
from doing so!
2. Students are often fascinated by the idea that when foreigners hold U.S.
dollars, the U.S. benefits because of the seignorage revenue earned.
They will be curious about the details of exactly how someone in a
foreign country owning a $100 bill will cause the U.S. government to
profit by $99.95, if it costs the U.S. government 5 cents to produce the
The bank then ships the bill to a foreign country, recouping the
Chapter 3: Money and Payments 28
transportation cost by charging a fee to foreigners who want the bill. A
foreigner buys the $100 bill for some amount of her own currency, which
the bank then takes to the foreign-exchange market (discussed in
Chapter 14) to get dollars in return, with a profit for its services in
providing the U.S. currency.
3. This is a good chapter in which to describe graphing data. You can assign
Numerical Exercise 12 or you can demonstrate in class if you have a Web
connection and Excel and can project your work in class. Go to the St.
Louis Fed’s Web site (research.stlouisfed.org/fred2), download the data in
levels for one of the monetary aggregates, show how it grows over time,
then use Excel to generate growth rates for the data. I like to show
students how to calculate monthly growth rates (annualized), as well as
how to calculate 12-month moving average growth rates. This gets