The Economics of Money, Banking, and

Financial Markets
Eighth Canadian Edition

Chapter 3
What Is Money?

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Learning Objectives
1. Describe what money is.
2. List and summarize the functions of money.
3. Identify different types of payment systems.
4. Compare and contrast the M1, M2, and M3 money
supplies.

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Meaning of Money
• Money is something that is accepted as payment for goods or services
or in the repayment of debts
• An asset is a claim on current and/or future resource/financial flows
that you own; a liability is a claim against you on current and/or future
resource/financial flows
• For the holder of money, it is an asset. For the issuer, it is a liability
• Money can be publicly or privately created. Most money is privately
created
• It is backed by something -- something tangible (e.g. precious metals)
or intangible (e.g. full faith and credit)
• What is (and isn’t) money is increasingly less clear

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Meaning of Money
• Money: Anything that is generally accepted in
payment for goods or services or in the repayment of
debts.
– Definition implies that there may be debate about the
instruments that count as money, and that such
instruments may change over time
– Currency: Money in the form of bank notes and coins
• Money is different from:
– Wealth: Total property that stores value
– Income: Flow of earnings per unit of time

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Functions of Money: Medium of Exchange
• Function #1: Medium of Exchange
– Facilitates exchange (lower transaction costs)
– Eliminates need for double coincidence of wants
– Allows for specialization and division of labour
• An effective medium of exchange must:
– Be easily standardized
– Be widely accepted
– Be divisible
– Be easy to carry
– Not deteriorate quickly
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Functions of Money: Unit of Account
• Function #2: Unit of Account
– Units in which value is denominated throughout the
economy
– Reduces transaction costs
• Consider a store with 10 goods
– If dollars are the unit of account, we only need 10
prices as everything would be reported in dollars
– Without a unit of account, we would need many more
prices to exchange one good for another. In fact: 10
goods, so 10*9/2=45 pairs of goods, so 45 prices

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 Functions of Money: Unit of Account (cont’d)

In a barter economy each good has as many prices as there

are other goods:
n(n-1)/2
with n = 10, 10(10 - 1)/2 = 45 prices
with n = 100, 100(100 - 1)/2 = 4950 prices
with n = 1000, 1000(1000 - 1)/2 = 499,500 prices
A monetary economy with n goods has n prices.

Note: Unit of account is important (particularly in a diverse

economy), though anything could serve as a unit of account.
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Functions of Money: Store of Value
• Function #3: Store of Value
– Repository of purchasing power over time
– Other assets may provide this function as well, such as
stocks, bonds, land, houses, art, jewelry, etc.…
– Other assets may even be a better store of value, as
money loses value through inflation, but money is
perfectly liquid by definition
• Functions of money are related. Example: currency is
a poor store of value during a hyperinflation (when
inflation > 50% per month) at which stage it become a
poor medium of exchange at well.
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Liquidity
• As a store of value, money tends to be crummy relative to
other assets like stocks and houses, which offer some
expected return over time
• Why then do people hold money? Because they value liquidity
• One popular definition of liquidity: ease with which an asset
can be converted into a medium of exchange (i.e. money)
• Money is the most liquid asset because it is the medium of
exchange
• If you held all your wealth in housing, and you wanted to buy a
car, you would have to sell (liquidate) the house, which may
not be easy to do, may take a while, and may involve selling at
a discount if you must do it quickly
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Liquidity (continued)
• Need to take a somewhat nuanced interpretation of “ease with which an
asset can be converted into a medium of exchange”
• We will use the term “cash” to refer to physical currency or demand
deposits which can be used in exchange
• Shares of stock are nearly perfectly liquid in that I can easily convert them
to cash quickly . . .
• . . . but maybe not at the price I expect
• Example: I have $1000, and I don’t need to spend it today. I might need to
spend it tomorrow (or the day after)
– I could store cash (either in currency under my mattress or in a
checking account), or I could buy Apple stock (AAPL)
– If I store $1000 in cash, I will have $1000 in cash when I need it
– If I buy $1000 in Apple, I can get cash when I need it, but I’m uncertain
as to how much cash (i.e. price could go up or down)
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Liquidity (continued)
• In addition to market liquidity, by which we mean the actual ease of selling
an asset without affecting its market price, one might also measure an
asset’s liquidity by how much that asset’s price fluctuates
• The (nominal) value of money doesn’t fluctuate -- one dollar in cash today
gives you one dollar with certainty tomorrow. Money is a special asset
because it “trades at par” (par = face value)
• Not true for other assets like stocks, real estate
• So-called near monies are assets that are very nearly as liquid as cash
with either small transactions cost of liquidating them or small price
uncertainty:
– Money market funds
– Non-transactions deposits (savings accounts, time deposits)
– Government bonds with short time to maturity

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Evolution of the Payments System (1 of 3)
• Payments System: method of conducting
transactions in the economy
• Commodity Money
– Money made of precious metals (gold, silver) or other
commodities
– Problems:
 hard to transport
 potentially difficult to divide
 price may fluctuate if precious metal or commodity has
consumption value independent of medium of exchange role
(i.e. not really perfectly liquid)

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Evolution of the Payments System (2 of 3)
Fiat Money
• Fiat money is currency, checks, and/or electronic entries that are not backed by
any commodity or precious metal
• In other words, fiat money is not “convertible”: you can’t trade it in for pieces of
gold, for example
• It is only backed by the “full faith and credit” of an issuing government

• Fiat money has no “fundamental” value -- it is only valuable because people

accept it in exchange. For this reason, sometimes people say fiat money is a
“bubble”
• Advantages: easily divisible, can be fully electronic, value does not fluctuate due to
demand and supply of a commodity, easy for government to change quantity
• Potential problems: maybe too easy for government to manipulate quantity to pay
its bills (inflation tax). Precarious in the sense of being a bubble -- only has value
because people believe it does

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Evolution of the Payments System (3 of 3)
• Cheques
– Instructions to your bank to transfer money from your
account to someone else’s account
– Eliminate need to carry currency around, lower
transaction costs, but take time to clear
– Problems: processing of cheques and transfer is
potentially costly, and people may not accept cheques if
they doubt the soundness of your financial institution
• Electronic Payments and E-Money (electronic
money)
– Like cheques, but transfer happens instantaneously with
a complete record (i.e., debit cards, smart cards, and e-
cash)
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FYI: Are We Headed for a Cashless Society?
• Predictions of a cashless society have been
around for decades
• E-money might be more convenient and efficient
than a payments system based on paper
• Several factors work against the disappearance of
the paper system
• The use of e-money will increase in the future
• Cryptocurrencies?

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FYI: Are We Headed for a Cashless Society?
(continued)
Cryptocurrencies
• Since the creation of Bitcoin in 2009, over
6,000 cryptocurrencies have been created (for example,
Ethereum, Litecoin, etc.).

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Table 3-1: Measuring the Money Supply
The Bank of Canada’s Monetary Aggregates (1 of 2)
Asset M1+ M1++ M2 M2+ M2++ M3
Currency outside banks ✓ ✓ ✓ ✓ ✓ ✓
Personal deposits at chartered banks Blank Blank ✓ ✓ ✓ ✓
Non-personal demand and notice Blank Blank ✓ ✓ ✓ ✓
deposits at chartered banks
Fixed-term deposits Blank Blank ✓ ✓ ✓ ✓
Deposits at trust and mortgage loan Blank Blank Blank ✓ ✓ Blank
companies (TMLs)
Deposits at credit unions and caisses Blank Blank Blank ✓ ✓ Blank
populaires (CUCPs)
Life insurance company individual Blank Blank Blank ✓ ✓ Blank
annuities
Personal deposits at government-owned Blank Blank Blank ✓ ✓ Blank
savings institutions
Blank Blank Blank ✓ ✓ Blank
Money market mutual funds
Blank Blank Blank Blank ✓ Blank
Other retail instruments
Blank Blank Blank Blank ✓ Blank
Non-money market mutual funds

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Table 3-1: Measuring the Money Supply
The Bank of Canada’s Monetary Aggregates (2 of 2)

Asset M1+ M1++ M2 M2+ M2++ M3

All chequable deposits at chartered ✓ ✓ Blank Blank Blank Blank
banks, TMLs, and CUCPs
All nonchequable deposits at Blank ✓ Blank Blank Blank Blank
chartered banks, TMLs, and CUCPs
Blank Blank Blank Blank Blank ✓
Non-personal term deposits at chartered banks
Foreign currency deposits of residents Blank Blank Blank Blank Blank ✓
at chartered banks

Note Monetary aggregates exclude interbank deposits and include continuity adjustments. In January 2007, the monetary
aggregates were redefined to reflect (i) the elimination of demand deposits and (ii) the inclusion of private-sector float.

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Figure 3-1 Definitions of the Money Supply (1 of 2)

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Figure 3-1 Definitions of the Money Supply (2 of 2)

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Growth Rates of Monetary Aggregates
• Does it matter which measure of money is
considered?
• Aggregates can move in different directions in the
short run
• Conclusion: The choice of monetary aggregate is
important for policymakers

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Figure 3-2 Growth Rates of the M2, M1++, and M2++
Aggregates, 1969–2020

The timing of the rise and fall of growth rates is roughly similar for both M1 and M2. There were periods,
however, during which they moved in opposite directions, leading to conflicting recommendations about
the best course of monetary policy.
Source: Statistics Canada CANSIM series V41552796, V37152, and V41552801.

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Money as a Weighted Aggregate
• The Bank of Canada’s money supply measures are
“simple-sum” indices. Specifically,
M = x1 + x2 + … + xn,
were xj is one of the n monetary components of the
monetary aggregate M
• Weighted monetary aggregates seem to predict
inflation and the business cycle somewhat better than
the conventional measures

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FYI: Where Are All the Dollars?
• Almost C$2000 of currency is held per person in the
Canada and over US$5000 in the United States
– Do you know anyone who carries $2000 in their
pocket?
• Where are all these dollars and who is holding them?
– Criminals
– Foreigners (especially for U.S. dollars)

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