4.3 Definition and Function of Money, Liquidity & Money Supply

effective money characteristics

1. durable and portable

2. recognizable

3. accepted

4. backed by a stable supply

5. difficult to counterfeit

commodity money

something that performs the function of money, but also has an alternate, non-monetary use

ex.) silver

fiat money

something that serves as a currency with no other purposes

ex.) paper money, coins

money

anything used to purchase goods and services

wealth

the accumulation of savings thru purchase of assets over time

opportunity cost of someone holding cash and not depositing it into a bank or purchasing an asset

the interest they could have earned if the money was invested

3 Functions of Money

1. medium of exchange

2. unit of account

3. store of value

medium of exchange

• money must be accepted by people when they buy/sell goods & services

• be portable

• divisible

• uniform

unit of account

• money must be useful for denominating values (prices)

• familiar

• divisible

• accepted

store of value

• money must be durable

• have a stable value

Liquidity

the efficiency with which an asset or security can be converted into ready cash without affecting its market price

• most liquid is cash

• availability of cash is important for market efficiency

High Liquidity

cash, bank accounts

Medium liquidity

stocks, bonds

low liquidity

houses/real estate, fine art

Money Supply

Currency + Liquid Assets

M0

Currency in circulation + Currency in bank reserves

Monetary Base - physical paper and coin currency used in the economy and bank deposits

• NOT included in MS

Monetary Base

physical paper and coin currency used in the economy and bank deposits

M1

includes

• paper currency and coins in circulation

• demand deposits

• savings accounts

• traveler’s checks

HIGH liquidity & function

Medium of Exchange

M2

include M1 & additional less liquid assets like

• small time deposits

• certificate of deposits (CDs)

• money market shares

MED liquidity/function

store of value

M3

= M1 + M2 + Large time deposits (>$100k) + Large liquid assets

Financial Asset Examples

1. Currency in Circulation

2. Demand Deposits

3. Traveler’s Checks

4. Small time Deposits

5. Certificate of Deposits

6. Large time Deposits

Currency in Circulation

currency in people’s hands

demand deposits

accessible account funds

Traveler’s checks

secure alternative to cash

Small time deposits

<$100k, pre-set maturity date

Certificate of Deposits

locked savings account

Large time deposits

>$100k, specified maturity

Credit Cards

• NOT considered money

• more like loans

• good medium of exchange and store of value