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Chapter 2

Money and the Payments System


The McGraw-Hill Companies, Inc., 2008



Money and the Payments System The Big Questions

1. What is money? 2. How do we use money? 3. How do we measure money?


Money: The Definition

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


Money: Characteristics
1. Means of payment
Used in exchange for goods & services

2. Unit of account
Used to quote prices

3. Store of value
Used to move purchasing power into the future


Barter System
Direct exchange of one commodity or service for another without the use of money. It is a Money Less Economy.


Difficulties of Barter System

Double co-incidence of wants Common Measure of Value Tax Collection Store of Value Transfer of Wealth Divisibility Problem Economic Measurements Estimation & Budgeting Problems

Stages of Evolution of Money

b) c)

Commodity Money: Skin, arrows, cattle, wheat, rice etc. Metallic Money: gold & silver Coins:
11th Century BC in China Full Bodied Coins of Gold & Silver Now a days only Token Coins are issued. Initiated in 17th century in Sweden. Currency Notes are used as Legal Tender now a days.

d) e)

Paper Money:

Bank Deposits: The final stage of evolution so far.


Money & Currency

Currency refers to legal tender which is issued by the government or the Central Bank in the form of Metallic Money and Paper Money. Money is a wider terms and not only includes Currency but also the Credit Money, which includes bank drafts, cheques, B/Ex etc. Credit money dont have the Legal Authority by the Govt. Near Money:
Not the Legal Tender but quite like Money e..g. Cheques, Bills of Exchange, and other Money Market Instruments


Functions of Money
Primary Functions:
Medium of Exchange Store of Value Unit of Measurement

Secondary Functions
Monetary & Fiscal Management Deferred Payments / Future Payments Economic Activities & Determination of Prices Promotion of Foreign Trade Transfer of Wealth Basis for Credit System

Demerits of Money
Cause of Crime Inequalities in Distribution Fluctuations in Value Cyclic Fluctuations Good servant & Bad master


Money: How We Pay for Things (I)

Commodity Money:
Objects with intrinsic value

Fiat Money:
Value comes from government decree (or fiat)

Instructions to the bank to shifts funds from your account to that of the person or firm whose name is written in the Pay to the Order of line.


The Path of a Paper Check


Checks are legal proof of payment Customers wanted them back Starting in 2004
Banks can transmit digital images Substitute checks are proof of payment

Paper checks are now disappearing


Money: How We Pay for Things (II)

Credit Cards Debit Cards Electronic Funds transfers
especially automated clearing house (ACH transactions)



Debit cards:
Like a check Electronic message to your bank to transfer funds immediately

Credit cards:
Deferred payment Issuer makes payment for you You have to pay it back

The Future of Money

Which function of money will be with us for a long time?
Means of payment: disappearing Unit of account: likely to remain Store of value: disappearing


Technological advances create new methods of payment. Cell phones and other types of handheld mobile devices are providing access to the payments system. What will be next?


SECTION II Measuring Money


Measuring Money
Changes in the quantity of money are related to
Interest Rates Economic Growth Inflation

How do we measure money?


Measuring Money: Monetary Aggregates

Different Definitions of money are based upon degree of liquidity. In USA M1: Narrowest definition Only most liquid assets
M2: Broader definition Includes assets not used as means of payment.


Monetary Aggregates In General

There are three approaches to the definitions of money: 1. Traditional Approach: Money is regarded only as a Medium of exchange Emphasizes the liquidity aspect i.e. only highly liquid instruments are included. Is expressed as M = C + D (Currency + Demand Deposits only)

2. Monetarists Approach
Money is a temporary abode of Purchasing Power It includes Currency (C), Demand Deposits (D) and Time Deposits (T) M=C+D+T

3. Liquidity Approach
Broader Definition Also includes all other financial instruments which have high liquidity. It includes, M = C + D + T + Repos + Comm. Papers etc.


Components of Monetary Assets as per SBP: M0, M1 & M2

1. Currency Issued 2. Currency held by SBP 3. Currency in tills of Scheduled Banks 4. Currency in Circulation (M0=1+2+3) 5.Scheduled Banks Demand Deposits 6. Other Deposits with SBP 7. Narrow Money (M1=4+5+6) 8. Scheduled Banks Time Deposits 9. Resident Foreign Currency Deposits 10. Broad Money = Total Monetary Assets (M2=7+8+9)

Money Growth and Inflation


SECTION III Issuance of Paper Money


Paper Money
Paper Money means documents with a value stated on them but having no intrinsic value in them. Kinds of Paper Money:
1. Representative Paper Money 2. Convertible Paper Money 3. Non-convertible Paper Money


Representative Paper Money

Paper Money that has 100% metallic reserves behind it, held by the govt. and payable to the holder on demand.


Fiat Money
Currency that a government has declared to be legal tender, despite the fact that it has no intrinsic value and is not backed by reserves. Historically, most currencies were based on physical commodities such as gold or silver, but fiat money is based solely on faith. Most of the world's paper money is fiat money. Because fiat money is not linked to physical reserves, it risks becoming worthless due to hyperinflation. If people lose faith in a nation's paper currency, the money will no longer hold any value.


Quantity Theory of Money

According to Irving Fisher (1911): P = f(M) Other things remaining the same, as the quantity of money in circulation increases, the price level also increases in the direct proportion and the value of money decreases and vice versa.

P = MV + MV / T
P = Price Level M = the Total Quantity of Legal Tender Money V = the Velocity of Money in Circulation M = the Total Quantity of Credit Money V = the Velocity of Circulation of M T = the Total Amount of Goods & Services exchanged for Money, i.e. Transactions


Assumptions of the Theory

1. T, V & V remains the same. 2. The Proportion of M & M remains constant. 3. There is full employment in the economy. 4. The theory is applicable in the long run.

Remember PT = MV + MV Demand for Money = Supply of Money

100 x 3 + 200 x 1 = Rs. 10 50 Now Doubling the M = Rs.200 P = 200 x 3 + 400 x 1 = Rs. 20 50 & . One half the M = Rs.50 P = 50 x 3 + 100 x 1 = Rs. 5 50 P=


SECTION IV Value of Money

Inflation, Deflation, Stagflation etc.


Core vs. Headline Inflation


The raw inflation figure as reported through the Consumer Price Index (CPI) that is released monthly by the Bureau of Labor Statistics.
The CPI calculates the cost to purchase a fixed basket of goods as a way of determining how much inflation is occurring in the broad economy. The CPI uses a base year and indexes current year prices based on the base year's values. The headline figure is not adjusted for seasonality or for the often volatile elements of food and energy prices, which are removed in the Core CPI. Headline inflation will usually be quoted on an annualized basis, meaning that a monthly headline figure of 4% inflation equates to a monthly rate that, if repeated for 12 months, would create 4% inflation for the year. Comparisons of headline inflation are typically made on a year-overyear basis.

Core vs. Headline Inflation

CORE INFLATION: A measure of inflation that excludes certain items which face volatile price movements. Core inflation eliminates products that can have temporary price shocks because these shocks can diverge from the overall trend of inflation and give a false measure of inflation. Core Inflation is thought to be an indicator of underlying long-term inflation. Core inflation is most often calculated by taking the Consumer Price Index and excluding certain items from the index, usually energy and food products.


Other Terminologies:
Deflation: Increasing value of Money Hyper Inflation: Very High Rate Inflation (>25%) Stagflation: Inflation + High Rate Unemployment Creeping Inflation: Slow Rate of Inflation (<3%) Running Inflation: Usually for growing Economies (8% - 10%) Reflation: Deliberately undertaken inflation to relieve a depression.

Causes of Inflation in General Causes of Inflation in Pakistan Remedial Measures for Inflation in General Remedial Measures for Inflation in Pakistan


Money Growth and Inflation

When inflation is high, money growth helps forecast inflation. When inflation is low, the relationship is not as close.


The CPI answers 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?


Measuring Inflation
Visit the site: tics/price_statistics/methodology_price_ statistics.html


Computing CPI Inflation

Survey people to see what they bought Figure out what it would cost to buy the same basket of goods & service today. Compute the percentage change in the cost of the basket of goods.


Measures of Inflation
Fixed-weight Index - CPI
Deflator GDP or Personal Consumption Expenditure Deflator Chain-weight index Half way between fixed-weight and a deflator.

Chapter 2
End of Chapter


The McGraw-Hill Companies, Inc., 2008