The Nature of Money

Money, Banking and Interest Rates

The Nature of Money
• What is Money
– Anything that functions as a medium of
exchange, store of value, unit of account, and
standard of deferred payment.

• Legal Tender
– Money that cannot be refused as payment for
goods and services or for discharge of debts;
consists of currency and coins.

The Nature of Money
• The Functions of Money
– Medium of Exchange or Means of Payment
– Standard of Value
– Unit of Account
– Standard of Deferred Payment

The Nature of Money
• Medium of Exchange
– An attribute of money that permits it to be
used as a means of payment.
• Barter
– The direct exchange of one good for another without the
use of money

The Nature of Money
• Standard of Value
– An attribute that allows it to be held for future
use without the loss of value in the meantime.

The Nature of Money
• Unit of Account
– An attribute that permits it to be used as a
measure of the value of goods, services, and
financial assets.

The Nature of Money
• Standard of Deferred Payment
– An attribute that permits it to be used as a
means of valuing future receipts in loan
contracts.

Banks
• Banks
– Are institutions that accept various types of
deposits and use the funds primarily to grant
loans.

Banks
• Central Bank
– The entity responsible for overseeing the monetary
system for a nation (or group of nations).
– Central banks have a wide range of responsibilities,
from overseeing monetary policy to implementing
specific goals such as currency stability, low inflation
and full employment.
– Central banks also generally issue currency, function
as the bank of the government, regulate the credit
system, oversee commercial banks, manage
exchange reserves and act as a lender of last resort.

Interest Rates
• Inflation
– The rate at which the general level of prices for goods
and services is rising, and, subsequently, purchasing
power is falling.
– Central banks attempt to stop severe inflation, along
with severe deflation, in an attempt to keep the
excessive growth of prices to a minimum.
– For example, if the inflation rate is 2%, then a $1 pack
of gum will cost $1.02 in a year.
– Most countries' central banks will try to sustain an
inflation rate of 2-3%.

Interest Rates
• Interest Rate
– The cost of borrowing (or the return from
lending) expressed as a percent per year.

• Real Interest Rate
– Interest Rate adjusted for expected inflation.

Financial Intermediaries
• Financial Intermediary
– Institutions that serve as "middlemen" from
the transfer of funds from individuals,
businesses, and other entities with surplus
funds to those who borrow.
– The classic example of a financial
intermediary is a bank that consolidates bank
deposits and uses the funds to transform
them into bank loans.

Financail Intermediary

Financial Intermediaries
• Why do Financial Intermediaries exist?
– To address problems arising in "asymmetric
information", which causes adverse selection
and moral hazard problems.
– Financial Economies of Scale or the ability to
spread costs of managing funds across large
numbers of savers.

Financial Intermediaries
• Asymmetric Information
– Possession of information by one party in a
financial transaction but not by the other party

• Adverse Selection
– The likelyhood that those who desire to issue
financial instruments have in mind using the
funds they receive for unworthy, high-risk
projects

• Moral Hazard
– The possibility that the borrower might engage
in more-risky behavior after a loan has been
made.

Financial Intermediaries
• Economies of Scale
– The reduction that can be achieved in the
average cost of managing funds of managing
funds by pooling savings together and
spreading the management costs across
many savers.

Interest Rates
• Interest Rate
– The cost of borrowing (or the return from
lending) expressed as a percent per year

• Nominal Interest Rate
– Rate of return that does not reflect anticipated
inflation

• Real Interest Rate
– Interest Rate adjusted for expected inflation