Money and Payments System

Introduction to Money and Payments System

• Money is anything that is generally accepted in payment for goods or services or in the repayment of debts.
• Functions of money:
  • Medium of exchange: facilitates economic efficiency by minimizing time spent in exchanging goods and services.
  • Unit of account: measures value in the economy.
  • Store of value: a repository of purchasing power over time.
  • Standard for deferred payments: facilitates credit transactions.

Evolution of Payments System

• Commodity money: made up of precious metals or another valuable commodity.
• Paper money: carried a guarantee that it was convertible into coins or a fixed quantity of precious metal.
• Fiat money: paper money decreed by governments as legal tender, but not convertible into coins or precious metal.
• Electronic payments: enabled by technological advancements.
• E-money: money that exists in electronic form (e.g. debit cards, smart cards, e-cash).

Measuring Money

• The problem of measuring money: what makes money, money is that people believe it will be accepted by others when making payments.
• Money aggregates:
  • M1: paper money and coins in the hands of the non-public, demand deposits, and traveler's checks.
  • M2: includes M1, small denomination time deposits, and certificates of deposits.
  • M3: includes M2, large denomination time deposits, and repurchase agreements.

Financial Markets

• Financial markets: channel funds from those with surplus funds to those with a shortage of funds.
• Importance of financial markets:
  • Promotes economic efficiency and economic welfare.
  • Allows funds to be channeled to people who have investment opportunities but lack enough funds.

Structure of Financial Markets

• Determined by:
  • What it issues: debt and equity markets.
  • How it is issued: primary and secondary markets.
  • Way it is organized: exchanges and over-the-counter markets.
  • Maturity of securities: money markets and capital markets.

Financial Market Instruments

• Money market instruments:
  • Treasury bills: short-term debt instruments of the government.
  • Negotiable Bank Certificates of Deposit: debt instrument sold by a bank to depositors.
  • Commercial Paper: short-term debt instrument issued by large banks and well-known corporations.
  • Bankers' Acceptances: bank drafts, a promise of payment similar to a check.
  • Repurchase Agreements (Repos): short-term loans with maturity of less than 2 weeks.
• Capital market instruments:
  • Stocks: claim on the net income and assets of a firm.
  • Mortgages: loan to households/firms for purchasing housing, land, or other real structures.
  • Corporate Bonds: long-term bonds issued by corporations with strong credit ratings.
  • Convertible Bonds: allowing the holder to convert them into a specified number of shares of stock at any time up to the maturity date.
  • Government Securities: long-term debt instruments issued by the government to finance deficits.

Financial Intermediaries

• Form: indirect way of channeling funds.
• Functions:
  • Reduce transaction costs.
  • Risk sharing/asset transformation: allows for diversification.
  • Overcome asymmetric information problems.
• Types of financial intermediaries:
  • Depository institutions: commercial banks, savings and loan associations, mutual savings banks, and credit unions.
  • Contractual savings institutions: pension funds, insurance companies, and government retirement funds.
  • Investment intermediaries: finance companies, mutual funds, and investment banks.

Regulation of Financial System

• Reasons for regulation:
  • To increase the information available to investors.
  • To ensure the soundness of the financial system.
• Types of regulations:
  • Restriction on entry.
  • Disclosure.
  • Restriction on assets and activities.
  • Deposit insurance.
  • Limit on competition.
  • Restrictions on interest rates.