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This chapter examines how the financial system works. First, we discuss the large variety of institutions that make up the financial system in our economy. Second, we discuss the relationship between the financial system and some key macroeconomic variables notably saving and investment. Third, we develop a model of the supply and demand for funds in financial markets. | 10 MONEY AND PRICES IN THE LONG RUN 29 The Monetary System THE MEANING OF MONEY Money is the set of assets in an economy that people regularly use to buy goods and services from other people. The Functions of Money Money has three functions in the economy: Medium of exchange Unit of account Store of value The Functions of Money Medium of Exchange A medium of exchange is an item that buyers give to sellers when they want to purchase goods and services. A medium of exchange is anything that is readily acceptable as payment. The Functions of Money Unit of Account A unit of account is the yardstick people use to post prices and record debts. Store of Value A store of value is an item that people can use to transfer purchasing power from the present to the future. The Functions of Money Liquidity Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange. The Kinds of Money Commodity money takes the form of a commodity with intrinsic value. Examples: . | 10 MONEY AND PRICES IN THE LONG RUN 29 The Monetary System THE MEANING OF MONEY Money is the set of assets in an economy that people regularly use to buy goods and services from other people. The Functions of Money Money has three functions in the economy: Medium of exchange Unit of account Store of value The Functions of Money Medium of Exchange A medium of exchange is an item that buyers give to sellers when they want to purchase goods and services. A medium of exchange is anything that is readily acceptable as payment. The Functions of Money Unit of Account A unit of account is the yardstick people use to post prices and record debts. Store of Value A store of value is an item that people can use to transfer purchasing power from the present to the future. The Functions of Money Liquidity Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange. The Kinds of Money Commodity money takes the form of a commodity with intrinsic value. Examples: Gold, silver, cigarettes. Fiat money is used as money because of government decree. It does not have intrinsic value. Examples: Coins, currency, check deposits. Money in the U.S. Economy Currency is the paper bills and coins in the hands of the public. Demand deposits are balances in bank accounts that depositors can access on demand by writing a check. Figure 1 Money in the U.S. Economy Copyright©2003 Southwestern/Thomson Learning Billions of Dollars • Currency ($580 billion) • Demand deposits • Traveler ’ s checks • Other checkable deposits ($599 billion) • Everything in M1 ($1,179 billion) • Savings deposits • Small time deposits • Money market mutual funds • A few minor categories ($4,276 billion) 0 M1 $1,179 M2 $5,455 CASE STUDY: Where Is All The Currency? In 2001 there was about $580 billion of U.S. currency outstanding. That is $2,734 in currency per adult. Who is holding all this currency? Currency held abroad Currency held by illegal entities THE FEDERAL RESERVE SYSTEM The .
