Financial Sector Overview

Unit 4: Financial Sector

Overview of Money

• Definition of Money: Money is anything generally accepted as payment for goods and services. It differs from wealth and income.

  • Wealth: Total collection of assets.

  • Income: Flow of earnings over time.

Types of Money

• Commodity Money:

  • Has intrinsic value and performs the functions of money.

  • Examples include gold, silver, and even cigarettes.

• Fiat Money:

  • Serves as money but has no intrinsic value.

  • Examples include paper money, coins, and digital currency.

Functions of Money

1. Medium of Exchange:

   • Facilitates buying and selling without the complications of barter.

2. Unit of Account:

   • Measures the value of goods and services, providing a standard for pricing.

   • Example: $50 for 1 goat or $10 for 1 chicken.

3. Store of Value:

   • Allows storage of purchasing power for future use.

Barter System vs Money System

• Barter System: Trade of goods and services directly, without money.

  • Problems:

  • Double Coincidence of Wants: Each trader must have what the other desires.

  • Indivisible Goods: Some goods can't be split into smaller units (e.g., 1 goat can't be divided).

• Advantages of Money: Simplifies transactions and eliminates the need for direct exchanges.

Importance of Money

• Credential Issues: Money's value is based on collective belief and confidence as legal tender.

• Characteristics for Effectiveness:

  1. Generally Accepted: Must be widely trusted.

  2. Scarce: Should not be easily reproducible.

  3. Portable & Dividable: Easy to carry and split into smaller units.

Purchasing Power

• Refers to the amount of goods and services a unit of money can buy.

• Inflation: Causes a decrease in purchasing power.

• Hyperinflation: Severely affects the acceptability of money across markets.

Classification of Money: Liquidity

• Liquidity refers to how easily an asset can be used as a medium of exchange.

• M1 (High Liquidity):

  • Includes:

  • Checkable bank deposits (checking accounts).

  • Traveler’s checks.

• M2 (Near-Moneys):

  • Includes all M1 plus:

  • Select savings accounts.

  • Time deposits (e.g., CDs).

  • Money market funds.

• M0/MB (Highest Liquidity):

  • Money currently in circulation or held on reserve by the Federal Reserve.

Unique Forms of Money

• Cultural examples: Giant stone disks as money in Yap Islands; some as large as 12 ft in diameter.

Exam Practice Questions

1. Function of Fiat Money:

   • Identify what is NOT a function.

   • Possible answers include options about intrinsic value.

2. Barter Economy vs Money Economy:

   • Discuss differences, focusing on specialization and transaction costs.

Summary

• Money simplifies transactions, provides a measure of value, allows for savings and security in trade, and is a critical component of the economy.