Lecture 2: What is money?
Meaning of Money
A commodity or device of some kind used for the purpose of completing transactions in goods and
services. Anything generally accepted in payment for goods or services or in payment of debts. It
does not refer to only banknotes and coins.
It is only a part of wealth. Although people earn money for their income, income is a flow of
earnings per unit of time, while money is a stock.
Why Money?
Barter Economy: An economy in which there is no money to serve as a standard of value or
medium of exchange. Goods and services are exchanged for other goods and
services without the use of money.
Consider a barter economy with goods, X, Y and Z, we have three prices, X Y, Y Z, X Z,
How about 100 goods? We will have 4950 prices!
In barter, exchange of goods and services is in-kind transaction. It is also inconvenient.
Monetary System: If there are 100 goods, we have 100 prices.
In addition, barter economy usually requires a double coincidence of wants. A double coincidence
of wants is a situation in which two individuals each has precisely the goods that the other wants.
The coincidence of wants problem is caused by the improbability of the wants, needs or events that
cause or motivate a transaction occurring at the same time and the same place. A monetary system
can avoid the problem of a double coincidence of wants.
Example: You like Snoopy. Your hall-mate has a Snoopy figure but (s)he loves Stormtrooper for
many years. You plan to exchange your figure of “White Soldier” for her/his Snoopy
after the graduation photo day. However, your friend has just loved Panda after an
exchange programme in “Sichuan”. Now you may have to search a person who likes
your “Soldier” and also like to give up his/her own Panda at first.
Money cannot be an input which contributes to the output of goods and services directly; but money
is productive because it saves a lot of valuable time and resources which could perform other uses.
Money facilitates the exchange. There will be a higher degree of specialization and division of
labour in a monetary economy than in a barter economy. In addition, the emergence of money can
reduce the cost of transactions arising from the difficulties of barter. The transaction costs include
information, absence of common numeric measure in barter, non-synchronization of payment and
receipts.
Hence, a money system improves social welfare or human well-being.
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Functions of Money
Medium of Exchange:
Money can be used to pay or exchange for goods and services. This is the main function. A double
coincidence of wants is no longer required and thereby buyers can be separated from sellers. You
do not have to want to buy a good or service if you want to sell one. It is for settlement of trade and
everyday financial transactions. A standard of postponed or debt payment is an extension of this
function when the payment is spread over a period of time.
Unit of Account:
In the economy, stable money may provide an anchor or a standardized way of measuring value
of different goods or services in exchange, for example, haircut, hairpin, car… It is a measure or
standard of relative worth and deferred payment. It is used to measure and record financial
transactions as also the value of goods or services produced in a country over time. Money helps us
to save cost in calculation of prices.
Store of Value
Money is a storehouse for purchasing power. It enables individuals to hold their wealth and
postpone purchases for their own transaction-plans. It also enables the government to hold
international reserves in terms of different international currencies. If someone wishes to save some
of his current income for future use, he can get money and hold it until the future date arrives. Other
assets like stocks, bonds, and real estate may also serve the same function. Why do people still hold
money? It is because money is the most liquid asset.
Tracking
Personal consumption or expenditure pattern could be traced technically. Economic activities
would be analyzed by some institutions to smooth both consumption and production. Indeed, there
may be a tradeoff between convenience and privacy.
Why Study Money?
Money is linked to changes in economic variables that are important to the health of the economy.
For example: inflation, interest rate, business cycles, etc.
Business Cycles (Expansion – Peak – Contraction – Trough – Expansion ……): periodic but
irregular up and down movement in economic activity measured by other macroeconomic
variables.
Recession: A contraction in the level of economic activity in which real GDP declines in two
successive quarters.
Depression: A deep business cycle trough.
Inflation: A continual increase in the general price level.
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Properties of Good Money
Being accepted as a medium of exchange, transaction cost should be reduced by several properties.
1. Scarcity: Relative scarcity and limited supply of money prevents the money from losing its value
easily. It helps keep stability.
2. Homogeneity / Uniformity: Money must be uniform or consistent in physical quality and
appearance. All version of the same denomination of currency must have the same purchasing
power. The investigation cost is very high if recognition is difficult.
3. Stability: The value of money must be relatively stable. The frequent change in exchange ratio
results in higher information cost.
4. Durability: To save the cost, money has to be passed from one person to another many times in a
long period.
5. Portability / Transportability: The size or weight of money cannot be too large or heavy
respectively. Movement is easy or convenient from one location to another for completing
exchanges because the transportation cost of money could be greatly reduced.
6. Divisibility: It can facilitate transaction in small quantities.
7. Genuineness with malleability: Money is possessed of value or purchasing power. It cannot be
easily duplicated but money should be malleable so that it could be made into new money and the
people can take cognizance of it.
8. Acceptability: It is the necessary condition. In general, everyone must accept it to purchase
goods and services.
Evolution of Money
A society’s monetary standard is the basis of its monetary arrangements. Broadly speaking, there are
two main types of monetary standards in our history.
Commodity Money (or Standard)
Money made up of precious metals or valuable commodities. For example, silver, gold. But there is
a great problem of portability.
Fiat Money (or Standard) - (法 定 貨 幣)
Currency decreed by a government as legal tender but not convertible into precious metals. For
example, the $20 note in your pockets.
“Legal Tender” is a financial asset, which by law cannot be refused as payment.
“Credibility for Making Money”
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Plastic Money and Electronic Money (e-money)
1. Debit Cards and Credit Cards
Debit cards, which look like credit cards, enable consumers to purchase goods by transferring
funds directly from their bank accounts to merchant’s account. The money is deposited with the
card issuer. Your ATM card typically can function as a debit card.
Most banks and financial institutions issue credit cards. People need not pay instantly as they
are allowed to borrow money from the card issuer up to a certain limit in order to buy the goods
or services. It offers liquidity but also leads higher risk of overdraft, overspending, or debt.
2. Stored-Value Cards
Stored-value cards also look like debit and credit cards but differ in that they contain a fixed
prepaid amount of digital cash which can be used anonymously. The balance is tied directly to
the card itself. The simplest form of stored-value cards is purchased for a preset dollar amount
that the consumer spends down. The more sophisticated one is known as smart card. It contains
its own computer chip so that it can be loaded with digital cash from its owner’s bank account
whenever needed. Smart cards can be loaded either from ATM machines, personal computers,
or specially equipped telephones, e.g. Octopus.
3. Electronic Cash
Electronic cash, or e-cash, is a form of digital or electronic money product that can be used on
the Internet to purchase goods or services without resorting to paper or coin currency. A
consumer gets e-cash by setting up an account with a bank that has links to the Internet and then
has the e-cash transferred to consumer’s personal electronic device, e.g., personal computer.
When a consumer wants to buy an item with e-cash, and surfs to an Internet store and selects the
buy option for that particular item, whereupon the e-cash is automatically transferred from
buyer’s device to the merchant’s computer. The merchant can then have the funds transferred
from the consumer’s bank account before the goods are shipped. There are some major digital
wallets in Hong Kong such as PayMe, Wechat Pay, AlipayHK, PayMe, Apple Pay, Google Pay.
4. Electronic Checks (Cheques)
Electronic checks allow users to pay their bills directly over the internet without having to send a
physical paper check. Electronic checks are signed by the payer and endorsed by the payee.
They are affixed with digital signatures, using a combination of smart cards and digital
certificates. The user has a device that writes the equivalent of a check and then sends the
electronic check to the other party. It cannot be physically stolen or altered, and there is no need
to provide account number to the recipient. Once the recipient’s bank verifies that the electronic
check is valid, it transfers money from the originator’s bank account to the recipient’s account.
The whole process is done electronically, it is far cheaper more convenient than using paper one.
Electronic money is money that is stored electronically, and, it takes several forms. It does not
change the value of the fiat currency (euro, US dollar, RMB, etc.). New digital currencies generally
do not have a classical physical form of fiat currency. It can be cryptocurrency, virtual currency and
central bank digital currency.
E-money has some advantages over coins and notes:
(i) It is convenient, accurate and efficient because there is no need to worry about change.
(ii) Transactions take place instantaneously and fast process saves resources and time.
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Digital technology is everywhere nowadays. It facilitates us to make user-friendly payments with
the popularity of financial technology. From contactless cards to mobile apps and cryptocurrencies,
however, cashless society does not appear straight away because:
(i) Electronic means of payment is convenient but may be also very expensive.
(ii) Use of checks (cheques) can provide physical receipts for evidence.
(iii) Use of checks (cheques) gives consumers several days of “float”.
(iv) Security and privacy concern.
Measuring Money (Money Supply / Money Stock)
Definitions of the Money Supply
M1: M1 refers to the sum of legal tender notes and coins held by the public and customers’
demand deposits placed with licensed banks.
M1 = Currency in circulation + demand deposits (Nov. 2024: HK$ 2,756 b)
Demand Deposits: Deposits must be repaid to the makers without having given prior notice (that is,
the funds must be returned “on demand”). Such accounts pay little or no interest
but cheques can be written against them.
M2: M2 refers to the sum of M1 + customers’ savings and time deposits with licensed banks +
negotiable certificates of deposits (NCDs) issued by licensed banks held outside the banking
sector. (Nov. 2024: HK$ 18,302b)
Time Deposits: Time deposits are made for a fixed term. Early withdrawal required notice (often
not enforced) and normally means a significant loss of the fairly high interest the
deposits would earn if left until maturity. Such accounts are not checkable.
M3: M3 refers the sum of M2 + customer deposits with restricted license banks (RLBs) and
deposit-taking companies (DTCs) + negotiable certificates of deposits issued by RLBs and
DTCs held outside the banking sector. (Nov. 2024: HK$ 18,346 b)
(Licensed) banks, restricted licence banks (RLBs), and deposit-taking companies (DTCs) are
authorized Institutions in Hong Kong.
Among these series, M1 exhibits a significant seasonal pattern, whereas there is no strong evidence
of seasonality in broad money (M2 and M3). Seasonally adjusted series of M1 and its components
(i.e. cash held by the public and demand deposits) are compiled and published by the HKMA.
The money supply (or money stock) is the amount of money in an economy that is easily available
for use in payments. The above different measures of money supply or money aggregates reflect
there is no consensus on what actually money is. M1 stresses on the medium of exchange function;
M2 and M3 will consider the store of value function. The measurement of monetary aggregates
becomes ambiguous as the technology makes some methods or deposits to have the medium of
exchange function.
Liquidity is another way of explaining the existence of three different measures of money supply. In
traditional view, only currency and demand deposits or M1 is the only legitimate measure of the
most liquid money supply. If money is defined in terms of liquidity, currency is the most liquid
among all assets, and then demand deposits, and then savings and then time deposits.
As a store of value and a means of exchange, these two functions are potentially in conflict. More
money greases the wheels of trade but excess money can destroy it.
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Money supply and Inflation
As a store of value and a means of exchange, these two functions are potentially in conflict. More
money greases the wheels of trade but excess money can destroy it.
Quantity theory of money states that money supply and price level in an economy are in direct
proportion to one another.
M V= P Q or %ΔM + %ΔV = %ΔP + %ΔQ
Inflation is the increase in the price of goods and services over time. It is caused if the money
supply in an economy grows at faster rate than the economy's ability to produce goods and services.
(Velocity of money is assumed to be stable.)
Demand-pull inflation happens when the demand for certain goods and services is greater than the
economy's ability to meet those demands. Cost-push inflation is the increase of prices when the cost
of wages and materials goes up. These costs are usually passed down to consumers in the form of
higher prices for those goods and services.
If the economy is an open economy, inflation can be imported. Depreciation or devaluation of
currency usually triggers an inflation.
In Brazil, a country that was undergoing a rapid inflation before 1994, many transactions were
conducted in US dollars rather than in real, the domestic currency. It is because the domestic
currency, the real, is a poor store of value in a rapid inflation. Most people would rather hold
dollars, which are a better store of value, and use them in their daily shopping.
Hyperinflation (extreme inflation) is defined as a period of time in which the average price level of
goods and services rise by more than 50% a month. In a period of hyperinflation no one would want
to hold money, it is also called “hot potato”.
Extreme examples:
Austria Hungary
Index (Jan. 1921 = Index (Jan. 1921 =
100) 100)
100,000 100,000 Price level
Price level
10,000 Money 10,000
supply Money
1,000 1,000 supply
100 1921 1922 1923 1924 1925 100 1921 1922 1923 1924 1925
Germany Poland
Index (Jan. 1921 = Index (Jan. 1921 =
100) 100)
100 trillion Price level 10 million
Price level
1 trillion Money 1 million
10 billion supply Money
100 million 100,000
supply
1 million 10,000
10,000
1,000
100
100
1921 1922 1923 1924 1925 1921 1922 1923 1924 1925
