MONEY AND BANKING (Eco 340)
Prof. Ranjit Dighe
Lecture notes to accompany Cecchetti's Chapter 2 ("Money and the Payments System")
Last revised 22-February-2008.

In these notes:
I.    Money: definition and uses
II.   The evolution of money and the payments system
III. The money supply
IV.  Prices and inflation

I.  MONEY:  DEFINITION AND USES

The dictionary has several definitions of money.  In ordinary conversation we commonly use the word money to mean income ("he makes a lot of money") or wealth ("she has a lot of money").  In this course (and in macroeconomics courses in general), we use a different definition, namely the one given in the chapter 1 notes:

money = anything that is generally accepted as payment

This is the (macro)economist's usage of the term money.  And, to reiterate, in the context of this course:

MONEY is not the same thing as INCOME or WEALTH.

Q: If money is something generally accepted as payment, then counts as money?

A:  Obviously, cash -- dollar bills, coins -- is a form of money.

Q: Is there anything else that counts as money?
A: Checking account deposits.  (And the broader measures of the money supply include all other types of bank accounts as well.)

Q: Are credit cards money?
A: No. They're not legal tender. What a credit-card purchases really represents is just an extremely convenient, pre-approved loan. It's only part of the transaction, since the merchant then goes to the bank that issued the credit card to get money, and the bank sends you a bill which must be paid with money.

Q: Are assets like stocks and bonds money?
A: No.  They have value, but they are generally not used or accepted as payment.  Financial instruments are not money.

When economists talk about the "money supply," we mean something very different from national income (~GDP) or national wealth.  The money supply is a lot smaller than national income or national wealth.  Generally speaking,
money supply = cash in circulation + bank account deposits
-- There are several measures of the money supply, or "monetary aggregates."  The narrowest, and simplest, is "M1," or "transactions money," which corresponds closely to the things that are most generally accepted as payment, namely cash (in circulation) and checking deposits.  M2, which used to be called "broad money," includes most other bank account deposits as well as money-market funds.  We'll discuss them in more detail later in these notes.

Three main functions, or uses, of money:

1. Means of payment (medium of exchange) -- Because money is a generally accepted form of payment, you can use it to buy things.

2. Unit of measurement (unit of account) -- You can use it to price things, e.g., in dollars and cents.  Ex.:  new textbook is $120, Wall St. Journal (WSJ) subscription is $20, phone call on Sprint is 10 cents a minute. Quoting prices in terms of dollars, the American unit of account, is a lot easier than quoting prices in terms of other goods -- e.g., money & banking textbook = 6 WSJ subscriptions or 1,200 minutes of long-distance calling; WSJ subscription = 1/6 textbook = 200 long-distance minutes; 1 long-distance minute = 1/1200 textbook = 1/200 WSJ subscription.  That's six barter prices to deal with, as compared with just three dollar prices.  (The number of barter prices goes up exponentially as the number of goods and services increases.  If we added a fourth commodity -- say, pizza -- to the mix, there would be twelve barter prices.)

3. Store of value -- an asset in its own right, and not a bad one -- while cash earns no interest, it's perfectly liquid (convertible into cash) and has no default risk.  Money in bank accounts earns some interest and is guaranteed against default by Federal Deposit Insurance.

Q:
Thomas Jefferson made the following argument in 1784 for using a currency like the Spanish dollar instead of the British-style pounds-shillings-pence system that was more familiar at the time:
"The most easy ratio of multiplication and division, is that by ten. Every one knows the facility of Decimal Arithmetic. Every one remembers, that, when learning Money-Arithmetic, he used to be puzzled with adding the farthings, taking out the fours and carrying them on; adding the pence, taking out the twelves and carrying them on; adding the shillings, taking out the twenties and carrying them on; but when he came to the pounds, where he had only tens to carry forward, it was easy and free from error. The bulk of mankind are schoolboys through life. These little perplexities are always great to them. And even mathematical heads feel the relief of an easier, substituted for a more difficult process."
--> Which of the three main functions of money was Jefferson saying would be better served by a decimal-based currency?  (Be sure to justify your answer.)

A: Unit of measurement.  A dollars-and-cents system is a decimal system, which is an easy system to use for addition, subtraction, and other arithmetic.  By contrast, the British system of 1 pound-20 shillings-12 pence- 4 farthings makes for much harder accounting.

II.  THE EVOLUTION OF MONEY AND THE PAYMENTS SYSTEM

The nature of money has changed over time and continues to evolve.  Money came into being thousands of years ago as a superior alternative to barter (trading goods and services directly for other goods and services).  The old type of money was COMMODITY MONEY - money made up from precious metals or other commodities that have INTRINSIC VALUE (are valuable in their own right). Examples of commodity money could include gold, cows, and pretty shells.

COMMODITY-BACKED MONEY came later.  This is money that draws its value from a commodity (ex.: gold) but does not involve physically handling that commodity on a regular basis.  An example is U.S. currency under the gold standard (~1873-1933), when people regularly used paper money that was issued by banks but was redeemable for gold according to a fixed ratio of grams per dollar.  People also used U.S. gold certificates issued by the government, which also were paper notes redeemable for gold at a fixed ratio.

More recently, governments have developed FIAT MONEY - currency, usually paper currency, which by government decree (i.e., "by fiat") is legal tender and which is not officially convertible into gold or other precious metal.

Fiat money is the type of money we have today.  Although our dollar bills have great value and are accepted all over the world, they do not have intrinsic value, because they are not really useful other than as money. Take away their monetary value (imagine, for example, that the government says they're no longer legal tender, or that people lose their faith in U.S. dollars), and they become mere pieces of paper.

A rapidly increasing share of our transactions in recent decades are electronic transactions, such as credit-card transactions. Lately there has been the rise of E-MONEY (payment arrangments that exist only in electronic form and involve transfers of money). Some forms of e-money:
* DEBIT CARD: works like a credit card but transfers funds from your personal bank account.
* AUTOMATIC BILL-PAYING: whereby money is transferred straight from your bank account to the phone company, the power company, the local tax collector, according to prior arrangements you have made.  Pay-by-phone works similarly.
* E-CASH: (like Paypal;) arrangement by which you set up an account on the Internet that is linked to your bank account. When you buy things on the Internet through this arrangement, your bank account is debited by the amount spent.
-- Are these money?  Yes and no. All three provide access to your bank account, which is already in the money supply.  These are really just more efficient and convenient ways of making payments than the old ones.

III.  THE MONEY SUPPLY

Q:  First, why should we care about the money supply?

A:  The money supply (Ms) matters because it affects three very important things:  the price level,  inflation, and economic recessions:

(1) Price level:  higher levels of the Ms are a direct cause of higher price levels.
-- Likewise, increases in the money supply tend to cause the general price level to increase.
-- Inflation (an increase in the price level) is often described as "too much money chasing too few goods." When the money supply increases faster than the productive capacity of the economy, inflation is the usual result.

(2) Inflation: faster Ms growth rates tend to cause higher rates of inflation
-- From international comparisons we see a tight relationship between money (M2) growth rates and inflation rates. A hyperinflation (explosive growth of prices, inflation rates of over 50% per month, or well over 1000% per year) is impossible without extremely rapid money-supply growth.
---- [Refer to Cecchetti's Figure 2.4, which shows a graph of M2 growth rates and inflation rates for 1960-2004.  M2 growth rates were highly correlated with inflation rates in 1960-1980; in 1990-2004, there is basically no correlation, as inflation has been relatively low and stable.  The low and stable inflation may owe something to slower M2 growth rates during that span and the preceding decade, as the public has come to trust the Fed to keep money-supply growth and inflation at moderate levels.]
------> Q: Since money supply growth is inflationary, and perfect price stability (0% inflation) seems like an ideal, wouldn't we be better off keeping the money supply perfectly stable, and not increasing it at all?
 ------ A: No. Money demand (people's demand for money for their transactions and savings) increases virtually every year as the volume of transactions (real GDP) increases, and if the money supply did not keep pace with money demand, then the economy would run into serious problems -- cash shortages, sky-high interest rates, and probably recession.  In general...

(3) Recessions may be caused by steep declines in the Ms growth rate
-- In the past 50 years, there have been eight recessions, and every single one of them was preceded by a notable decline in the money (M2) growth rate. Then again, not every decline in the M2 growth rate was followed by a recession -- thus the old joke that "economists have predicted twelve of the last eight recessions."

The "monetary aggregates" are measures of the money supply. The main ones are M1 and M2.
-- The Fed used to keep track of a broader monetary aggregate, M3, which included everything in M1 and M2 plus  large CD's, institutionally-held money-market funds, and two key sources of borrowed funds for banks, term repurchase agreements (repos) and term Eurodollars.  The Fed stopped keeping track of M3 in late 2005, after deciding that it contained no relevant economic information that was not already in M2.

M1 is the narrowest measure of the money supply, including only cash, checking account deposits, and travelers checks and money orders. M2, which used to be called "broad money," includes everything that is in M1 and also includes savings and money-market deposit accounts, small-denomination certificates of deposit (CD's or time deposits), and money-market mutual fund shares held by individuals. 

("Small" time deposits, incidentally, are defined as those of less than $100,000, perhaps because $100,000 is the amount up to which deposits are insured by the Federal Deposit Insurance Corporation, or FDIC.)

The three monetary aggregates contain the following types of money and money-market instruments:

M1 M2
(= about $1.4 trillion in Dec. 2007
~10% of GDP)		 (= about $7.5 trillion in Dec. 2007;
~53% of GDP)
Cash in circulation
+ Checking deposits
(+ Traveler's checks+money orders)		 Cash in circulation
+ Checking deposits
(+ Traveler's checks+money orders)
+ Savings accounts
+ Money-market mutual fund shares (MMF's) held by individuals
+ Money-market deposit accounts (MMDA's)
+ Small CD's (time deposits)

Note well: A money-market mutual fund, which holds only money-market assets like T-bills and commercial paper, is very different from a regular mutual fund, which typically holds mostly capital-market assets like stocks and bonds. Newspaper listings of regular mutual funds normally list each fund's share price (or "Net Asset Value"), the change in its price in the previous day, and the fund's rate of return since the year began. Newspaper listings of money-market mutual funds are much less frequent --not even the Wall St. Journal lists them every day -- and normally include little more than each fund's approximate interest rate, expressed as an average of its interest rates over the past seven days ("7-day yield"). Regular mutual fund shares, then, are a lot like stocks in the way they are bought and sold and reported; money-market funds are a lot more like bank accounts (especially money-market deposit accounts).

M1 is by far the most volatile of the monetary aggregates, in large part because people can now easily transfer money from checking accounts to savings accounts, money-market deposit accounts, and money-market funds. In fact, M1 was falling in the late 1990s, even though the other monetary aggregates, M2 and M3, were rising.

Q: Suppose that people transfer $100 million from checking accounts into money-market funds.  How will M1 be affected?  How will M2 be affected?

A: M1 will fall by $100 million.  M2 will not be affected (because the $100 million drop in checking deposits is exactly offset by a $100 million increase in money-market funds).

IV. PRICES AND INFLATION

Inflation is one of the "chronic aches and pains" of most modern economies.  It erodes many people's savings and leaves many more people worried that their incomes won't keep up with rising prices.  Since low inflation is one of the two main policy goals (along with avoiding recessions) of the Federal Reserve, we'll be hearing a lot about it in this course.  Let us turn our attention to defining inflation and seeing how the inflation rate is calculated.

Aggregate price level: an index of the average prices of goods and services in the economy
-- Two of the most important measures of the price level are the
--- CONSUMER PRICE INDEX (CPI), which measures the average price of a representative "basket" of consumer goods and services, and the
--- GDP PRICE DEFLATOR, which deals with the prices of goods and services in all the different components of GDP (consumption, business investment, government purchases, net exports) and is used to adjust measured GDP for inflation (i.e., to convert nominal GDP into real GDP).

The price level is an index, which has been set equal to 100 for a chosen base year, which we use as a basis for comparisons. Comparisons with a base of 100 are easy because the percent change calculation reduces to simple subtraction -- just subtract 100 from the current price level, and you've got the total percent change in prices since the base year.
-- Ex.:  Currently the base year for the CPI is the average of three years, 1982-84.  The CPI was about 196 in December 2005, which means that consumer prices on average were 196% as high, or 96% higher, in December 2005 than they were in 1982-84.

Inflation: a continual increase in the price level
Deflation:        "        decrease           "

Inflation rate: the yearly percent change in the price level

Aside: How to calculate a percent change in general:

                                 (New value) - (Old value)
   Percent change = ---------------------------------   ( * 100%)
                                           (Old value)

   or, a bit more compactly,

                                     (New value)
    Percent change  = { -----------------  - 1  }  (* 100%)
                                      (Old value)

To calculate the inflation rate for a given year, from price-level figures for consecutive years (or monthly figures that are twelve months apart):

                          (Price level in that year) - (Price level in the previous year)
Inflation rate = -----------------------------------------------------------------------------   (* 100%)
                                                 (Price level in the previous year)

                                  (Price level in that year)
OR                       { ------------------------------------------- - 1 } * 100%
                               (Price level in the previous year)

Ex.:
Q: Suppose the Consumer Price Index was equal to 200 in 2004 and 206 in 2005.  (If the base year is still 1982-84, then prices were 100% higher in 2004 than in 1982-84 and 106% higher in 2005 than in 1982-84. 
What was the inflation rate in 2005?
A: Inflation rate = (206-200)/200 = 6/200 = 3/100 (*100%) = 3%.
-- (Note:  It is customary to report the inflation rate to one decimal place, so we'll report it as 3.0%.)