Week 2 Lecture: Money and Payments System PDF

Week 2 Money and the payments system BANK2011 Banking and the Financial System The University of Sydney Page 1 Learning Objectives 1. 2. 3. Define money and describe its functions. Discuss the different methods of payment and the future of money. Explain how the money supply is measured and how it i...

Week 2 Money and the payments system BANK2011 Banking and the Financial System The University of Sydney Page 1 Learning Objectives 1. 2. 3. Define money and describe its functions. Discuss the different methods of payment and the future of money. Explain how the money supply is measured and how it is linked to economic growth and inflation. The University of Sydney Page 2 Money and How We Use It – Money is an asset that is generally accepted as payment for goods and services or repayment of debt. – Income is a flow of earnings over time. – Wealth is the value of assets minus liabilities. – Money is one of those assets. The University of Sydney Page 3 Money and How We Use It Money has three characteristics: 1. It is a means of payment 2. It is a unit of account, and 3. It is a store of value. The first of these characteristics is the most important. The University of Sydney Page 4 Money and How We Use It Means of Payment – People insist on payment in money. – Barter requires a “double coincidence of wants.” – Money is easier and finalises payments so there is no further claim on buyers and sellers. – The increase in the number of transactions and the numbers of buyers and sellers requires something like “money” to make transactions smoother. The University of Sydney Page 5 Money and How We Use It Unit of Account – Money is used to quote prices and record debts - it is a standard of value. – Prices provide the information needed to ensure resources are allocated to their best uses. – Using dollars makes relative price comparisons easier. The University of Sydney Page 6 Money and How We Use It Store of Value – A means of payment has to be durable and capable of transferring purchasing power from one day to the next. – Paper currency does degrade but is accepted at face value in transactions. – Other forms of wealth are also a store of value: stocks, bonds, houses, etc. The University of Sydney Page 7 Money and How We Use It Store of Value (cont.) – Although other stores of value are sometimes better than money, we hold money because it is liquid. – Liquidity is a measure of the ease with which an asset can be turned into a means of payment. – The more costly it is to convert an asset into money, the less liquid it is. The University of Sydney Page 8 Money and How We Use It Store of Value (cont.) – Financial institutions use: – Market liquidity - the ability to sell assets for money. – Funding liquidity - the ability to borrow money to buy securities or make loans. The University of Sydney Page 9 The Payments System – The payments system is a web of arrangements that allow for the exchange of goods and services, as well as assets. – The efficient operation of the economy depends on the payments system. – The possible methods of payment are: 1. Commodity and Fiat Monies 2. Cheques 3. Electronic Payments The University of Sydney Page 10 Commodity and Fiat Monies – Commodity monies are things with intrinsic value. – Included items like silk and salt. – To be successful, a commodity money must be: – Usable by most people – Can be made into standardised quantities – Durable – Easily transportable – Divisible into smaller units – Gold has been the most common commodity money as it meets these requirements. The University of Sydney Page 11 Commodity and Fiat Monies – In 1661, Stockholm Banco issued Europe’s first paper money. – King of Sweden printed too many notes to try to finance a war and the bank failed. – Eventually governments tried issuing paper money. – In 1775, the Continental Congress of the United States of America issued “continentals” to finance the Revolutionary War. – Twenty years later, revolutionary France issued the “assignat.” – Both governments issued too much and the both currencies became worthless. The University of Sydney Page 12 Commodity and Fiat Monies – Because of the failures, people became suspicious of government-issued paper money. – In 1862, the Confederate and the Union governments printed money with no explicit backing. – After the Civil War, the United States reverted to using gold as money. The University of Sydney Page 13 Commodity and Fiat Monies – Gold coins and notes, backed by gold, were used into the 20th century. – Today’s paper money is called fiat money, because its value comes from government decree, or fiat. – We are willing to accept these bills as payment because the federal government stands behind its paper money. – In the end, money is about trust. The University of Sydney Page 14 Commodity and Fiat Monies – Today, some critics of fiat money advocate a return to the gold standard. – There is fear of governments issuing too much paper money. – Even if a government promises today to limit fiat money, it can renege on that commitment in the future, casting doubt today on the money’s value. – A gold standard may not be time consistent. – In a crisis, a government can renege on its commitment to use gold as a unit of account. – Many countries exited the gold standard during the Great Depression to restore economic stability. – A fiat currency must be limited in volume of circulation to be credible. The University of Sydney Page 15 Cheques – A cheque is an instruction to the bank to take funds from your account and transfer them to another account. – A cheque is therefore not a final payment—at least, not in the same sense as currency. – It sets in motion a series of transactions that eventually lead to the final payment. – The series of transactions put in motion can be seen in Figure 2.1: The Path of a Paper Cheque The University of Sydney Page 16 Figure 2.1: The Path of a Paper Cheque The University of Sydney Page 17 Electronic Payments – Electronic payments take the form of: – Credit and debit cards – Electronic funds transfers The University of Sydney Page 18 Electronic Payments – Debit Cards – Works like a cheque in that it tells the bank to transfer funds from the cardholder’s account to a merchant’s account. – Credit Cards – A promise by a bank to lend the cardholder money to make a purchase. – They do not represent money. The University of Sydney Page 19 Electronic Payments – Electronic funds transfers – Movements of funds directly from one account to another. – Most common form is the automated clearinghouse (ACH) transaction. Used for recurring payments such as pay cheques or utility bills. Have surpassed the value of cheques. – Banks use electronic transfers for bank-to-bank transactions, sending money through Fedwire. The University of Sydney Page 20 Electronic Payments – Electronic funds transfers (cont.) – Rapid innovation is reducing the cost and increasing the speed of payments and transfers. – There has been a proliferation of smartphone apps and infrastructure by Amazon Pay, Apple Pay, PayPal, Google Pay, Venmo, and others. – In some cases, digital wallets are linked to a person’s bank account or credit card. In others, the service provider requires the transfer of funds prior to any purchase. – The goal of these digital systems is to improve reliability, ensure security, and prevent use for criminal purposes. The University of Sydney Page 21 The Future of Money – The future of the three functions of money: – Means of payment: disappearing due to ease of electronic transactions. – Unit of account: likely to remain. Will always be needed to quote values and prices because it is efficient. – Store of value: disappearing due to liquidity of many financial instruments. The University of Sydney Page 22 Measuring Money – Changes in the quantity of money are related to – Interest Rates – Economic Growth – Inflation The University of Sydney Page 23 Measuring Money – Inflation: – The process of prices rising. – Inflation rate: – The measurement of the process. – With inflation, you need more money to buy the same basket of goods. – The primary cause of inflation is too much money. The University of Sydney Page 24 Measuring Money – The value of the means of payment depends on how much of it is circulating. – We therefore must be able to measure how much is circulating. – Defining money means defining liquidity (see Figure 2.2). The University of Sydney Page 25 Figure 2.2: The Liquidity Spectrum The University of Sydney Page 26 Measuring Money Different definitions of money are based upon degree of liquidity. Drawing the line in different places has led to several measures of money called the money aggregates: M1 and M2. M1: Narrowest definition. Only the most liquid assets. M2: Broader definition. Includes assets not used as means of payment. The University of Sydney Page 27 Table 2.1: The Monetary Aggregates The University of Sydney Page 28 Measuring Money – What do the money aggregates mean? – As of the fourth quarter of 2018, nominal U.S. gross domestic product (GDP) was $20.501 trillion. – Using the data in Table 2.1: GDP is almost five and one-half times larger than M1. GDP is nearly 40 percent larger than M2. The University of Sydney Page 29 Measuring Money – Which M do we use to understand inflation? – Until the early 1980’s we used M1. – But with changes in accounts, M2 became more useful. – The savings deposits, money-market deposit accounts, and retail moneymarket mutual fund shares in M2 represent nearly one-half of GDP, so M1 is no longer a useful measure of money. – Figure 2.3 shows the M’s growth rates. The University of Sydney Page 30 Figure 2.3: Growth Rates of the Money Aggregates The University of Sydney Page 31 Measuring Money – How useful is M2 in tracking inflation? – When the quantity of money grows quickly, it produces high inflation. – Figure 2.4 shows the inflation rate versus M2 two years earlier for the U.S. Positive correlation up until 1980. From 1990-2019 – virtually no correlation. – Growth in M2 stopped being a useful tool for forecasting inflation. The University of Sydney Page 32 Figure 2.4: Money Growth and Inflation The University of Sydney Page 33 Measuring Money – Why does M2 no longer predict inflation? – Maybe the relationship only applies at high levels of inflation. – Maybe it only shows up over longer periods of time. – Maybe we need a new measure of money. – We do know that at low levels of money growth, inflation is likely to stay low. The University of Sydney Page 34 Homework problems – CS chapter 2 – Problems 4, 15-18, 21 – Data exploration problems 1, 3, 5 The University of Sydney Page 35