2 | Money and the Payments System Notes

Do We Need Money?

Money is generally accepted as payment for goods, services, and debt settlement.
Economies can function without money through barter systems, but these are inefficient.
Barter: Direct exchange of goods/services without money, common in early economies but inefficient.

Double Coincidence of Wants: High transaction costs because both parties must want what the other has.
Transaction Costs: Resources (time, etc.) spent agreeing on and executing an exchange.
Too Many Prices: With N items, the number of prices is N(N - 1)/2, leading to confusion and complexity.
Lack of Standardization: Varying quality and prices for goods based on the trade.
Difficulty Accumulating Wealth: Hard to store and preserve value in tangible goods.

Money emerged to overcome barter inefficiencies by identifying a widely accepted medium of exchange.
Commodity Money: A good used as money that has intrinsic value (e.g., gold, silver).
Fiat Money: An item used as money with no intrinsic value (e.g., paper money).
Money enables specialization, boosting productivity and incomes.
Specialization: Individuals focus on producing goods/services they're best at.

Medium of Exchange: Accepted for payment in trade.
Unit of Account: Measures value in an economy.
Store of Value: Accumulates wealth to buy goods/services in the future.
Standard of Deferred Payment: Facilitates exchange over time, not just at a single point.

Flow: Measured over a period (e.g., GDP for a quarter).
Stock: Measured at a specific moment (e.g., bank balance at a specific time).

Fiat money has no intrinsic value but is used as money (e.g., paper currency).
Accepted because it is legal tender.
Legal Tender: Government designation requiring acceptance for taxes and debts.
Society's willingness to accept Federal Reserve Notes makes them a medium of exchange.
The U.S. moved from the gold standard (1879) to a complete fiat currency system (1971).

Currency in circulation has tripled since 2000, reaching over $5,200 per person in mid-2020.
Approximately 70% of U.S. currency is held outside the United States.
Some countries (e.g., Panama, El Salvador, Ecuador, Zimbabwe) use the U.S. dollar as their official currency.
Large-denomination bills are used in illegal activities.

The Fed's desired outcomes for a payments system:
1. Speed
2. Security
3. Efficiency
4. Smooth international transactions
5. Effective collaboration among participants
Electronic Funds Transfer Systems: Computerized payment clearing devices.
Automated Clearing House (ACH): Direct deposits and electronic transfers, reducing transaction costs.
Automated Teller Machines (ATMs): Allow fund withdrawals anytime.
Real-Time Payments System: Makes payments available within minutes, 24/7/365.
E-money or Bitcoin may replace traditional money.

Monetary Aggregates: Measures of the quantity of money broader than currency.
M1: Narrow definition, includes currency in circulation and checking account deposits.
M2: Broader definition, includes M1, time deposits ( < $100,000), savings accounts, money market deposit accounts, and non-institutional money market mutual fund shares.
Liquidity: How easily and inexpensively an asset can be converted to money.
Liquidity order: Currency < Time Deposit < Bonds < House
People may hold more liquid assets with lower returns when there are more risks.

Economic Model: A theory about how things work including:
1. Endogenous Variables: Variables to be explained.
2. Exogenous Variables: Factors affecting endogenous variables.
3. Theory: Explanations of how exogenous variables affect endogenous variables.
4. Mathematical Model: Equations representing the theory.
Irving Fisher and the Equation of Exchange: M × V = P × Y, where M is the money supply, V is the velocity of money, P is the price level, and Y is the real GDP. V = PY/M, where PY equals nominal GDP.
Quantity Theory of Money: Assumes V is constant, turning the equation of exchange into a theory. It connects money and prices, velocity is determined mainly by institutional factors and is roughly constant in the short run.

Taking a log to Xt and differentiating it with respect to t gives us a growth rate \frac{\partial Xt}{\partial t} \frac{1}{X_t}.
Convert quantity equation to percentage changes:
\text{% Change in M + % Change in V = % Change in P + % Change in Y}
Inflation Rate = % Change in M - % Change in Y, where the percentage change in price level is inflation.
The model explains inflation as being affected by the money supply and real GDP growth.

Velocity can be erratic in the short run, the quantity theory does not provide accurate short-run forecasts of inflation, but good in the long run.
Most of the variation in U.S. inflation rates across decades comes from variation in money growth.
Countries where the money supply grew rapidly tended to have high inflation rates.
Zimbabwe's inflation rate was 15 billion percent during 2008.
Hyperinflation: Extremely high inflation rates (> 50% per month).

Causes: The money supply (M) rising more rapidly than real output (Y).
Hyperinflation occurs usually when governments spend more than they collect in taxes.
A country can monetize the government’s debt by forcing its central bank to print money.
Hazards: Prices rose rapidly; money purchased fewer goods/services each day.
Households and firms refused to accept money, leading to economic contraction and unemployment.

The more independent a central bank is, the lower the country’s inflation rate is.
Critics argue that the Fed's independence violates democratic principles.