Money and Liquidity Flashcards

Money and Liquidity

Definition of Money

• Money is any asset generally accepted in a society as a means of payment or settling debts.
• People hold money with the expectation it can be easily exchanged for goods or services.
• Money can be defined by its functions:
  • Medium of exchange
  • Unit of account
  • Store of value
  • Standard of deferred payments

Types of Money

• The instruments classified as money have evolved over time, from precious metal coins to central bank currency and current account deposits.

Commodity Money

• Money whose value comes from a commodity it is made of.
• It has intrinsic value because the material has value on its own, apart from its use as money.
• Examples include gold, silver, copper, salt, and cattle.
• Advantages:
  • Intrinsic Value: Retains value even if it ceases to be used as money (e.g., gold can be used for jewelry).
  • Provides options to holder: they can either use or spend the money.
  • Inflation Resistance: Supply is typically limited.
• Disadvantages:
  • Supply limitations.
  • Storing and protecting valuable commodities can be difficult and costly.
• Replaced by metallic money.

Metallic Money

• Money made from metals with intrinsic value, such as gold, silver, and copper.
• Metals are minted into coins.
• Advantages:
  • Inflation Resistance: Limited supply of metals.
  • Durability: Long-lasting and can be stored without significant degradation.
  • Value Retention: Retains value even if no longer used as a medium of exchange.
• Disadvantages:
  • Limited Supply: May not keep pace with economic growth, leading to deflationary pressures.
• Largely replaced by paper money and electronic forms of currency, but base metal coins still circulate for smaller transactions.

Fiat Money

• A monetary standard (coins and notes) that people are legally required to accept as a medium of exchange and/or standard of deferred payment.
• Face value is far greater than the value of the asset it is made from (e.g., a 10,000 Tanzanian shilling note).
• Government-issued currency not backed by a commodity.
• Government declares it legal tender.
• Advantages:
  • Ease to Create: Central banks/governments can create more money according to economic conditions.
  • Money supply can grow with the economy and keep prices stable.
  • Stability: Can provide greater economic stability as its value is not tied to a physical commodity.
• Disadvantages:
  • Inflation Risk: If the government prints too much money, it can lead to inflation and devaluation.
  • Loss of Value: If people lose faith in the currency (e.g., during hyperinflation).
  • No Intrinsic Value: Can become worthless if the issuing government fails or loses public confidence.

Commercial Bank Money/Demand Deposit

• Money created by commercial banks through accepting deposits and making loans; also known as deposit money or bank money.
• A claim against financial institutions that can be used to buy goods and services.
• Demand deposit account: funds can be withdrawn at any time without prior notice.
• Banks have a legal obligation to return funds immediately upon demand.
• Commercial bank money is created through credit creation process.
• Characteristics:
  • Electronic Nature: Exists in electronic form as balances in bank accounts.
  • Created Through Lending: Banks create new money when they issue loans.
  • Transferable: Easily transferred between accounts (checks, EFT, debit cards, online banking).
  • Interest-Bearing: Bank deposits can earn interest.
  • Backed by the Banking System: Value depends on the solvency and stability of the banking system.
• Advantages:
  • Liquidity: Provides liquidity for the economy by facilitating transactions.
  • Efficiency: Makes financial transactions more efficient through electronic transfers.
• Disadvantages:
  • Credit Risk: Banks face the risk of loan defaults.
  • Inflation: Excessive creation can contribute to inflation.

Electronic Money

• Also known as e-money or digital money; exists in electronic form rather than physical notes and coins.
• Stored digitally and used for electronic transactions.
• Examples: bank account balances, prepaid cards, and digital wallets.

Electronic Cards

• Cards used to conduct electronic transactions.

Debit Cards

• Linked directly to a bank account; allows customers to access funds electronically.
• Funds are withdrawn directly from the linked account when a transaction is made.
• Used for point-of-sale (POS) transactions, online purchases, and ATM withdrawals.
• Examples: Visa Debit, MasterCard Debit.

Credit Cards

• Allow users to borrow money from a credit issuer up to a certain limit.
• Credit card holders have a monthly bill to pay (interest) because of credit and overdraft facilities.
• Used for POS transactions, online purchases, and sometimes for cash advances.
• Examples: Visa, MasterCard, American Express.

Prepaid Cards

• Loaded with a fixed amount of money before use; not linked to a bank account.
• Used for POS transactions and online purchases until the preloaded balance is exhausted.
• Examples: Gift cards, travel money cards, reloadable prepaid cards.

Advantages of Electronic Cards

• Time savings.
• Reduced risk of loss and theft.
• Low commissions.
• Ease of use.
• Convenience: transfers can be performed anytime, anywhere, with internet access.

Disadvantages of Electronic Cards

• Cybersecurity Risks: Vulnerable to hacking, fraud, and other cyber threats.
• Internet access: If Internet connection fails, you cannot get to your online account.
• Restrictions: Each payment system has its limits regarding the maximum amount in the account, the number of transactions per day and the amount of output.

Essential Characteristics of Money

• Acceptability: Generally accepted as a medium of exchange.
• Legal Tender: Designated legal tender by the government.
• Relative Scarcity: Value derives from its scarcity (supply and demand).
• Portability: Small, transportable, and transferable.
• Divisibility: Can be broken down into smaller units.
• Durability: Long life span.
• Stability of Value: Remains fairly stable in value despite inflation and deflation.
• Hard to Counterfeit: Difficult to copy by unauthorized money-makers.

Functions of Money

Medium of Exchange

• Passes from hand to hand in exchange for goods and services or in payment of debt.
• Accepted not for its own sake but for the goods and services it can buy.

Store of Wealth

• Holding wealth in the form of money represents a claim over present and future goods and services.
• Idle money is a non-income-earning asset.
• Holder of idle money suffers a loss in purchasing power when prices rise.

Unit of Account

• Values of all economic goods are measured in terms of money.
• The money value of economic goods is called price.
• Facilitates comparison of goods and services.
• Example: If a coke is TZS 500 and bread is TZS 1000, the bread's money value is twice the coke's.

Standard of Deferred Payment

• Money is used as a benchmark for specifying future payments for current purchases (buying now and paying later).
• Facilitates loans and credit, allowing economic activity to be spread over time.
• Relies on money retaining its value over time.

The Inseparability of Money's Functions

• The functions of money as a store of value and as a medium of exchange are inseparable.
• To serve as a good medium of exchange and standard of deferred payment, money's purchasing power must be stable.
• If money shrinks in purchasing power (inflation), people may lose confidence in it as a store of value and medium of exchange.
• The effectiveness of money as a medium of exchange relies on its ability to serve as a reliable store of value, and vice versa.

Static and Dynamic Roles of Money in an Economy

Static Roles of Money

• Removes the need for double coincidence of wants associated with barter, by serving as a medium of exchange.
• Acts as a unit of account, providing a common measure of value.
• Simplifies the taking and repayment of loans, by acting as a standard of deferred payments.
• Removes the problem of storing commodities under barter, by acting as a store of value.

Dynamic Roles of Money

• Influence on the economy’s overall functioning and growth.
• Facilitates the collection of taxes, fees, and charges.
• Central banks use monetary policy tools to control interest rates, influencing borrowing and lending.
• Impacting Exchange Rates: Example, an increase in the money supply can lead to depreciation of the domestic currency, making exports cheaper and imports more expensive.
• A means of capital formation: By transferring savings into investment.
• In distribution and calculation of income: rewards to factors of production are paid in money.
• As an index of economic growth: Various indicators of growth are national income, per capita income and economic welfare.
• Money facilitates both national and international trade.
• In solving central problems of the economy (what, how, and where to produce).

Money as a Liquidity Asset

Liquidity

• The ease with which an asset can be converted into cash quickly and easily.
• Ability to sell an asset and convert it into cash at a price equal or close to its true value in a short period of time.
• The "moneyness" of an asset.
• Basic determinants of liquidity:
  • Capital certainty or the stability in value
  • Shiftability or transferability
• Money is the most liquid asset, possessing perfect liquidity.
• Assets like common stocks are a store of value but are not as stable as money; they do not possess the liquidity of money and are potentially risky.
• Other assets like savings accounts, bonds, government securities, treasury bills, and real estates serve as a store of value but differ in degree of liquidity.
• Exchanging an asset for cash involves a time-lag cost and even capital uncertainty.

Money and Near Money

• Essential concepts for understanding the liquidity spectrum.
• Near money: assets that are not cash but can quickly be converted into cash with minimal loss of value.
• Modern concept of money includes currencies (legal tender), demand deposits with commercial banks, and financial assets such as bonds.
• Economists distinguish between money and near money by treating cash and demand deposits as pure money, while other financial assets are treated as near money.

Differences Between Near Money and Money Proper

• Money refers to coins, currency notes, and demand deposits of banks.
• Near money refers to financial assets like savings deposits, time deposits, treasury bills, government bonds.
• Money has 100 percent liquidity; near money lacks such 100 percent liquidity.
• Holding pure money is regarded as cash balances that earn no interest; near money is an income-earning asset.
• Pure money functions as a unit of account and a common measure of value; near monies do not have such functions.
• The value of near money is expressed in terms of currency money.
• Money and near money together act as stores of value. Near money is a better store of value because it also earns income.

Economic defects or weakness of money in an economy

• Instability in the value of money.
• Unequal distribution of wealth and income i.e., inflation or deflation brings benefits to some and damages to others.
• Growth of monopolies i.e., of money in few hands.
• Wastage of resources i.e., leads to over capitalization and overproduction.
• Black money. Money being the store of value lures people to hoard it.

Examination Sample Questions

Question Two [May 2018]

• (a) Explain the static and dynamic roles of Money in an economy. (10 marks)
• (b) Explain any five economic defects of money in an economy. (05 marks)
• (c) Distinguish between Money supply and Money Demand. (04 marks)
• (d) Explain any six factors that determine the supply of money in an economy. (06 marks)
  [Total: 25 marks]

Question Two [May 2016]

• (a) Briefly explain the meaning and state two advantages and disadvantages of:
  • (i) Commodity money [5 marks]
  • (ii) Fiat money [5 marks]
  • (iii) Electronic payment [5 marks]
• (b) Distinguish between a financial asset and physical asset. [3 marks]
• (c) Explain seven characteristics of financial assets. [7 marks]
  [Total: 25 marks]