Chapter 10:

Money, Money Supply, and

Interest
 What is Money?
Anything that is generally acceptable in exchange for goods
and services and/or repayment of debt.
 Dollarization
• Can be official or “full” dollarization.
• The situation when market participants use another country’s currency as
money.
• However, it can also be de facto, where “in fact” the people use another
country’s currency as their own money. This is also referred to as “unofficial
dollarization” or the even more vague “currency substitution”.
 Legal Tender
Assets accepted for repayment of debt to the government as well as
private transactions.
 Function of Money
Medium of Exchange
• A good that is accepted by both sides in a transaction.

Why medium of exchange is important?

Without a money we would then have to rely on barter.
Double coincidence of wants
• The situation where each party wants what the other has to offer for sale.

Unit of Account
• An agreed-upon method of placing relative value on assets.

Store Value
• A money must retain some of its purchasing power over time.
 The Amount of Money Matters
• If money supply increases too quickly, you have too much money chasing
too few goods. On the other hand, if the money supply does not grow fast
enough, there will not be enough money for transactions to take place and
the economy will slide into a recession or depression.
 Money Through Time
Commodity Money
• An asset that is used as money but also has another, or different, use.
• Money that has some other use other than being a medium of exchange,
being a unit of account, and having a store value.
 Criteria:
• It must be easily standardized so that the prices of two units can be easily compared. That is,
the good that is functioning as money has to homogenous or the same.
• It must be divisible. Not all goods are going to have their value stated in nice round
amounts; sometime you have to “make change.”
• It must be easy to carry around. The good functioning as money has to be portable. Steel I-
beams would obviously not make good currency.
• It must be physically durable. The good cannot spoil over time or being in the sun too long.
• It must be broad demand so that one can exchange it for some other good , which can then
be traded for the good the person actually wants.
 Fiat Money
• An asset that functions as money but has no intrinsic value.
• Fiat money does not have use value, and has value only because a
government maintains its value, or because parties engaging in exchange
agree on its value.
 Monetary Aggregates
• Broad measurements of the total amount of money within an economic
system. Also referred to as the money supply or money supplies.

M1
• One of the narrowest measurements of the money supply is given the fancy
name M1. This measurements includes the things we most often think of as
“money”.
 M1 includes currency held by the public and
transaction accounts at depository institutions:
• Currency held outside the vaults of depository institutions , the Federal
Reserve Banks, and the US Treasury.
• Demand deposits and other checkable deposits, except those due to the
Treasury and depository institutions.
• Traveler’s checks
• Less cash items in the process of collection.
 Disintermediation
• The removal of funds from a financial intermediary to invest them directly,
as through a mutual fund.
 M2
• A broader measurement of the money supply that builds M1.
 Compound Interest
• Interest earned on the principal plus interest.
 Future Value
• The nominal value of an asset, such as money, at some point in time in the
future.
 Interest
• It is payment from a borrower or deposit-taking financial institution to a lender or
depositor of an amount above repayment of the principal sum (that is, the amount
borrowed), at a particular rate.
• It is distinct from a fee which the borrower may pay the lender or some third party.
• It is also distinct from dividend which is paid by a company to its shareholders
(owners) from its profit or reserve, but not at a particular rate decided beforehand,
rather on a pro rata basis as a share in the reward gained by risk taking
entrepreneurs when the revenue earned exceeds the total costs.