Book cover for The Economics of Money, Banking, and Financial Markets

The Economics of Money, Banking, and Financial Markets

Frederic S. Mishkin

ISBN #9780132770248

10th Edition

610 Questions

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33,211 Students Helped

Homework Questions

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Summary
Learning Objectives
Key Concepts
Example Problems
Explanations
Common Mistakes

Summary

This chapter provides a clear definition of money from an economist's standpoint, contrasting it with other economic measures like wealth and income. It emphasizes the three key functions of money—serving as a medium of exchange, a unit of account, and a store of value—and traces the evolution of payment systems from commodity money to modern electronic forms. Additionally, it explains the significance of monetary aggregates (M1 and M2) in monitoring the money supply and guiding monetary policy decisions.

Learning Objectives

1

Define money from an economist’s perspective and distinguish it from broader concepts like wealth or income.

2

Explain the three major functions of money: medium of exchange, unit of account, and store of value.

3

Describe the evolution of the payments system from commodity money to modern electronic methods.

4

Understand the role of monetary aggregates, particularly M1 and M2, in measuring the money supply and informing monetary policy decisions.

Key Concepts

CONCEPT

DEFINITION

Money

An asset that is universally accepted in exchange for goods and services, distinct from broader concepts such as wealth or income.

Medium of Exchange

A function of money that allows it to be accepted universally in trade transactions.

Unit of Account

A function of money that provides a common measure for valuing goods and services.

Store of Value

A function of money that allows it to preserve value over time, making future purchases possible.

Monetary Aggregates

Measures of the money supply in an economy, which include various categories of money such as M1 and M2.

M1

A monetary aggregate that includes the most liquid forms of money, such as cash and checking deposits.

M2

A broader monetary aggregate that includes M1 as well as other types of deposits that are not as liquid, like savings accounts.

Example Problems

Example 1

Why is simply counting currency an inadequate measure of money?

Example 2

In prison, cigarettes are sometimes used among inmates as a form of payment. How is it possible for cigarettes to solve the "double coincidence of wants" problem, even if a prisoner does not smoke?

Example 3

Three goods are produced in an economy by three individuals: $$\text {Good $\space$$\space$$\space$$\space$ Producer} $$ $$\text {Apples $\space$$\space$$\space$$\space$ Orchard owner} $$ $$\text {Bananas $\space$$\space$$\space$$\space$ Banana grower} $$ $$\text {Chocolate$\space$$\space$$\space$$\space$ Chocolatier} $$ If the orchard owner likes only bananas, the banana grower likes only chocolate, and the chocolatier likes only apples, will any trade between these three persons take place in a barter economy? How will introducing money into the economy benefit these three producers?

Example 4

Why did cavemen not need money?

Example 5

Most of the time it is quite difficult to separate the three functions of money. Money performs its three functions at all times, but sometimes we can stress one in particular. For each of the following situations, identify which function of money is emphasized. a. Brooke accepts money in exchange for performing her daily tasks at her office, since she knows she can use that money to buy goods and services. b. Tim wants to calculate the relative value of oranges and apples, and therefore checks the price per pound of each of these goods quoted in currency units. c. Maria is currently pregnant. She expects her expenditures to increase in the future and decides to increase the balance in her savings account.
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Step-by-Step Explanations

QUESTION

How does money function as a medium of exchange?

STEP-BY-STEP ANSWER:

Step 1: Identify the common feature of money that allows it to be accepted by all parties in a transaction.
Step 2: Recognize that this acceptability simplifies transactions, eliminating the need for barter systems where direct exchange of goods is required.
Step 3: Understand that in modern economies, money’s role as a medium of exchange facilitates trade by acting as an intermediary in the buying and selling processes.
Final Answer: Money functions as a medium of exchange because it is universally accepted in transactions, making the exchange of goods and services efficient and convenient.

Medium of Exchange

QUESTION

What are M1 and M2, and how do they help guide monetary policy?

STEP-BY-STEP ANSWER:

Step 1: Define M1 as the measure of the most liquid forms of money, including cash and checking deposits.
Step 2: Define M2 as a broader measure that includes M1 plus additional types of deposits like savings accounts.
Step 3: Explain that these aggregates help economists and policymakers assess the total amount of money available in the economy.
Step 4: Understand that changes in M1 and M2 can influence decisions on interest rates and other aspects of monetary policy by indicating shifts in liquidity and consumer spending.
Final Answer: M1 and M2 are monetary aggregates used to measure the liquidity in an economy and play a crucial role in guiding monetary policy decisions by reflecting the availability of money for transactions and savings.

Monetary Aggregates (M1 and M2)

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Common Mistakes

  • Confusing the concept of money with wealth or income, when money specifically refers to a universally accepted medium of exchange.
  • Overlooking the distinct functions of money by assuming its value is solely in its purchasing power, rather than its roles as a medium, unit, and store.
  • Neglecting the evolution of money, and thus underestimating the impact of modern electronic payment methods on the economy.
  • Misinterpreting monetary aggregates by not recognizing the differences between M1 and M2, leading to incorrect assessments of liquidity.