Money facilitates transactions in the economy. The mechanism for conducting such transactions is known as a payments system. The payments system has evolved overtime from relying on payments made in gold and silver coins, to payments made with paper currency and checks written on deposits in banks, to payments made by electronicfunds transfers.
The Transition from Commodity Money to Fiat Money
Although historians disagree about precisely when metallic coins first came into use,examples have survived from China from around the year 1000 B.C. and from Greece from around the year 700 B.C. For centuries thereafter, buyers and sellers used coins minted from precious metals, such as gold, silver, and copper, as money. Gold and silver coins suffer from some drawbacks, however. For instance, from the days of the Roman Empire, to gain additional funds, governments would sometimes debase the currency, melting down coins and re-minting them with a greater amount of less valuable metals mixed in with the gold and silver. An economy’s reliance on gold and silver coins alone makes for a cumbersome payments system. People had difficulty transportinglarge numbers of gold coins to settle transactions and also ran the risk of being robbed. To get around this problem, beginning around the year A.D.1500 in Europe, governments and private firms—early banks—began to store gold coins in safe placesand issue paper certificates. Anyone receiving a paper certificate could claim the equivalent amount of gold. As long as people had confidence that the gold was available if they demanded it, the paper certificates would circulate as a medium of exchange. In effect, paper currency had been invented.
In modern economies, the central bank, such as the Federal Reserve in the United States, issues paper currency. The modern U.S. payments system is a fiat money system because the Federal Reserve does not exchange paper currency for gold or any other commodity money. The Federal Reserve issues paper currency and holds deposits from banks and the federal government. Banks can use these deposits to settle transactions with one another. Today, the Fed has a legal monopoly on the right to issue currency. Although in the nineteenth century private banks issued their own currency, they can no longer do so.
The Transition from Commodity Money to Fiat Money
Although historians disagree about precisely when metallic coins first came into use,examples have survived from China from around the year 1000 B.C. and from Greece from around the year 700 B.C. For centuries thereafter, buyers and sellers used coins minted from precious metals, such as gold, silver, and copper, as money. Gold and silver coins suffer from some drawbacks, however. For instance, from the days of the Roman Empire, to gain additional funds, governments would sometimes debase the currency, melting down coins and re-minting them with a greater amount of less valuable metals mixed in with the gold and silver. An economy’s reliance on gold and silver coins alone makes for a cumbersome payments system. People had difficulty transportinglarge numbers of gold coins to settle transactions and also ran the risk of being robbed. To get around this problem, beginning around the year A.D.1500 in Europe, governments and private firms—early banks—began to store gold coins in safe placesand issue paper certificates. Anyone receiving a paper certificate could claim the equivalent amount of gold. As long as people had confidence that the gold was available if they demanded it, the paper certificates would circulate as a medium of exchange. In effect, paper currency had been invented.
In modern economies, the central bank, such as the Federal Reserve in the United States, issues paper currency. The modern U.S. payments system is a fiat money system because the Federal Reserve does not exchange paper currency for gold or any other commodity money. The Federal Reserve issues paper currency and holds deposits from banks and the federal government. Banks can use these deposits to settle transactions with one another. Today, the Fed has a legal monopoly on the right to issue currency. Although in the nineteenth century private banks issued their own currency, they can no longer do so.
The Importance of Checks
Paper money has drawbacks. For instance, it can be expensive to transport paper money to settle large commercial or financial transactions. Imagine going to buy a car with asuitcase full of dollar bills! Another major innovation in the payments system came inthe early twentieth century, with the increasing use of checks. Checks are promises topay on demand money deposited with a bank or other financial institution. They canbe written for any amount, and using them is a convenient way to settle transactionsSettling transactions with checks does, however, require more steps than settlingtransactions with currency. Suppose that your roommate owes you $50. If she gives you $50 in cash, the transaction is settled. Suppose, however, that she writes you acheck for $50. You first take the check to your bank. Your bank, in turn, must presentthe check for payment to your roommate’s bank, which must then collect the moneyfrom her account. Processing the enormous flow of checks in the United States coststhe economy several billion dollars each year. There are also information costs to usingchecks—the time and effort required for the seller to verify whether the check writer(the buyer) has a sufficient amount of money in her checking account to cover the amount of the check. Accepting checks requires more trust on the part of the sellerthan accepting dollar bills does
Electronic Funds and Electronic Cash
Breakthroughs in electronic telecommunication have improved the efficiency of the payments system, reducing the time needed for clearing checks and for transferring funds. Settling and clearing transactions now occur over electronic funds transfer systems, which are computerized payment-clearing devices such as debit cards, AutomatedClearing House (ACH) transactions, automated teller machines (ATMs), and e-money. Debit cards can be used like checks: Cash registers in supermarkets and retail stores are linked to bank computers, so when a customer uses a debit card to buy groceries or other products, his bank instantly credits the store’s account with the amount and deducts it from his account. Such a system eliminates the problem of trust between the buyer and seller that is associated with checks because the bank computer authorizes the transaction.
ACH transactions include direct deposits of payroll checks into the checking accounts of workers and electronic payments on car loans and mortgages, where the payments are sent electronically from the payer’s account and deposited in the lender’s account. ACH transactions reduce the transactions costs associated with processing checks, reduce the likelihood of missed payments, and reduce the costs lenders incur n notifying borrowers of missed payments.
Thirty-five years ago, ATMs did not exist, so to deposit or withdraw money from your checking account, you needed to fill out a deposit or withdrawal slip and wait in line at a bank teller’s window. Adding to the inconvenience was the fact that many banks were open only between the hours of 10 A.M. and 3 P.M. Today, ATMs allow you to perform the same transactions at your bank whenever it is most convenient for you. Moreover, ATMs are connected to networks (such as Cirrus) so that you can make withdrawals of cash away from your home bank.
The boundaries of electronic funds transfers have expanded to include e-money, or electronic money, which is digital cash people use to buy goods and services over the Internet. A consumer purchases e-money from an Internet bank, which transfers the money to a merchant’s computer when the consumer makes a purchase. The bestknown form of e-money is the PayPal service, which is owned by eBay, the online auction site. An individual or a firm can set up a PayPal account by transferring funds from a checking account or credit card. As long as sellers are willing to accept funds transferred from a buyer’s PayPal (or other e-money) account, e-money functions as if it were conventional, government-issued money. The central bank does not control e-money, though, so it is essentially a private payments system. PayPal was originally developed to make payments for online auctions easier, but in recent years, PayPal and other e-money providers, such as Amazon.com’s PayPhrase, have attempted to expand to capture a greater share of the payments made online.
The developments in e-money are exciting and lead some commentators to talk about a “cashless society.” A Federal Reserve study found that noncash payments continue to increase as a fraction of all payments, and electronic payments now make up more than two-thirds of all noncash payments.Not surprisingly, the number of checks written has been dropping by more than 2 billion per year. In reality, though, an entirelycashless (or checkless) society is unlikely for two key reasons. First, the infrastructurefor an e-payments system is expensive to build. Second, many households and firms worry about protecting their privacy in an electronic system that is subject to computer hackers. While the flow of paper in the payments system is likely to shrink, it is unlikely to disappear
The efficiency of the payments system,which increases as the cost of settling transactions decreases, is important for the economy. Suppose that the banking system broke down, and all transactions—commercial and financial—had to be carried out in cash. You would have to carry large amounts of cash to finance all your purchases and would incur additional costs for protecting your cash. No bank credit would be possible, severely harming the financial system’s role in matching savers and borrowers. Disruptions in the payments system increase the cost of trade and credit. Many economists, for example, blame the collapse of the banking system for the severity of the Great Depression of the 1930s. The efficient functioning of the economy’s payments system is a significant public policy concern. Governments typically regulate the medium of exchange and establish safeguards to protect the payments system.
Paper money has drawbacks. For instance, it can be expensive to transport paper money to settle large commercial or financial transactions. Imagine going to buy a car with asuitcase full of dollar bills! Another major innovation in the payments system came inthe early twentieth century, with the increasing use of checks. Checks are promises topay on demand money deposited with a bank or other financial institution. They canbe written for any amount, and using them is a convenient way to settle transactionsSettling transactions with checks does, however, require more steps than settlingtransactions with currency. Suppose that your roommate owes you $50. If she gives you $50 in cash, the transaction is settled. Suppose, however, that she writes you acheck for $50. You first take the check to your bank. Your bank, in turn, must presentthe check for payment to your roommate’s bank, which must then collect the moneyfrom her account. Processing the enormous flow of checks in the United States coststhe economy several billion dollars each year. There are also information costs to usingchecks—the time and effort required for the seller to verify whether the check writer(the buyer) has a sufficient amount of money in her checking account to cover the amount of the check. Accepting checks requires more trust on the part of the sellerthan accepting dollar bills does
Electronic Funds and Electronic Cash
Breakthroughs in electronic telecommunication have improved the efficiency of the payments system, reducing the time needed for clearing checks and for transferring funds. Settling and clearing transactions now occur over electronic funds transfer systems, which are computerized payment-clearing devices such as debit cards, AutomatedClearing House (ACH) transactions, automated teller machines (ATMs), and e-money. Debit cards can be used like checks: Cash registers in supermarkets and retail stores are linked to bank computers, so when a customer uses a debit card to buy groceries or other products, his bank instantly credits the store’s account with the amount and deducts it from his account. Such a system eliminates the problem of trust between the buyer and seller that is associated with checks because the bank computer authorizes the transaction.
ACH transactions include direct deposits of payroll checks into the checking accounts of workers and electronic payments on car loans and mortgages, where the payments are sent electronically from the payer’s account and deposited in the lender’s account. ACH transactions reduce the transactions costs associated with processing checks, reduce the likelihood of missed payments, and reduce the costs lenders incur n notifying borrowers of missed payments.
Thirty-five years ago, ATMs did not exist, so to deposit or withdraw money from your checking account, you needed to fill out a deposit or withdrawal slip and wait in line at a bank teller’s window. Adding to the inconvenience was the fact that many banks were open only between the hours of 10 A.M. and 3 P.M. Today, ATMs allow you to perform the same transactions at your bank whenever it is most convenient for you. Moreover, ATMs are connected to networks (such as Cirrus) so that you can make withdrawals of cash away from your home bank.
The boundaries of electronic funds transfers have expanded to include e-money, or electronic money, which is digital cash people use to buy goods and services over the Internet. A consumer purchases e-money from an Internet bank, which transfers the money to a merchant’s computer when the consumer makes a purchase. The bestknown form of e-money is the PayPal service, which is owned by eBay, the online auction site. An individual or a firm can set up a PayPal account by transferring funds from a checking account or credit card. As long as sellers are willing to accept funds transferred from a buyer’s PayPal (or other e-money) account, e-money functions as if it were conventional, government-issued money. The central bank does not control e-money, though, so it is essentially a private payments system. PayPal was originally developed to make payments for online auctions easier, but in recent years, PayPal and other e-money providers, such as Amazon.com’s PayPhrase, have attempted to expand to capture a greater share of the payments made online.
The developments in e-money are exciting and lead some commentators to talk about a “cashless society.” A Federal Reserve study found that noncash payments continue to increase as a fraction of all payments, and electronic payments now make up more than two-thirds of all noncash payments.Not surprisingly, the number of checks written has been dropping by more than 2 billion per year. In reality, though, an entirelycashless (or checkless) society is unlikely for two key reasons. First, the infrastructurefor an e-payments system is expensive to build. Second, many households and firms worry about protecting their privacy in an electronic system that is subject to computer hackers. While the flow of paper in the payments system is likely to shrink, it is unlikely to disappear
The efficiency of the payments system,which increases as the cost of settling transactions decreases, is important for the economy. Suppose that the banking system broke down, and all transactions—commercial and financial—had to be carried out in cash. You would have to carry large amounts of cash to finance all your purchases and would incur additional costs for protecting your cash. No bank credit would be possible, severely harming the financial system’s role in matching savers and borrowers. Disruptions in the payments system increase the cost of trade and credit. Many economists, for example, blame the collapse of the banking system for the severity of the Great Depression of the 1930s. The efficient functioning of the economy’s payments system is a significant public policy concern. Governments typically regulate the medium of exchange and establish safeguards to protect the payments system.
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